Fordham University Money and Banking Question

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The course’s main text book is the Economic of Money, Banking and Financial Markets (11th edition) by Frederic S.Mishkin

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Journal of Economic Perspectives—Volume 29, Number 4—Fall 2015—Pages 177–198
Rewriting Monetary Policy 101: What’s
the Fed’s Preferred Post-Crisis Approach
to Raising Interest Rates?†
Jane E. Ihrig, Ellen E. Meade, and Gretchen C.
Weinbach
F
or several decades prior to the global financial crisis that started in 2007,
the Federal Reserve through its Federal Open Market Committee (FOMC)
primarily implemented monetary policy in a certain way: It set a target for
the federal funds rate, which is an overnight interbank borrowing rate—that is, an
interest rate paid when banks borrow from other banks in the very short-term. The
Fed pursued its desired federal funds interest rate target through “open market operations” that involved modest purchases and sales of Treasury securities. However, in the
aftermath of the financial crisis and with a superabundant level of reserve balances in
the banking system having been created as a result of the Federal Reserve’s large-scale
asset purchase programs, implementing monetary policy through this traditional
approach will no longer work. Instead, the Fed intends to affect the federal funds
interest rate by using policy tools like the interest rate paid on excess reserves and a
facility to extend overnight reverse repurchase agreements.
Being able to explain and to understand this fundamental change in the Fed’s
main tools for the implementation of monetary policy has implications for a number
of groups. It obviously matters for the Fed itself; in particular, the Federal Reserve
has been influenced in recent years by academic research showing that communication and transparency have substantial effects on the credibility and strength
of monetary policy. Many investors and market-watchers seek to look below the
?
Jane E. Ihrig, Ellen E. Meade, and Gretchen C. Weinbach are Deputy Associate Director,
Senior Adviser, and Associate Director, respectively, in the Division of Monetary Affairs,
Board of Governors of the Federal Reserve System, Washington, DC. Their email addresses
are jane.e.ihrig@frb.gov, ellen.meade@frb.gov, and gweinbach@frb.gov.
†
For supplementary materials such as appendices, datasets, and author disclosure statements, see the
article page at
http://dx.doi.org/10.1257/jep.29.4.177
doi=10.1257/jep.29.4.177
178
Journal of Economic Perspectives
surface of Fed decisions—like the announced target for the federal funds interest
rate—and to understand how such decisions are actually implemented. The shift in
policy tools also affects the task of some of society’s explainers, including journalists
and teachers of economics, because most of the past textbook descriptions of how
monetary policy works will not be accurate for years to come.
Of course, the Federal Reserve is not the only central bank that will face the challenge of tightening monetary policy while holding a much larger balance sheet than
it held in the past. The Fed has seen its assets rise from about $900 billion in 2006
to about $4.5 trillion today, or from 6 percent of nominal gross domestic product
(GDP) to about 26 percent of nominal GDP. Other central banks have had similar
or larger increases. For example, assets of the Bank of Japan have increased from
about 20 percent of nominal GDP to more than 60 percent of nominal GDP over
this period, and assets of the Swiss National Bank have increased from 20 percent of
nominal GDP to more than 80 percent of nominal GDP. The net increase in assets
of the European Central Bank has so far been more modest, with assets increasing
from less than 10 percent of nominal GDP for the euro zone to more than 20 percent
of nominal GDP—but its quantitative easing program is still underway.
Though other central banks also will be confronted with similar issues, this
paper focuses on the Federal Reserve’s past, present, and future approach to implementing monetary policy. In particular, we provide a primer on how the Federal
Reserve will implement monetary policy when the Federal Open Market Committee
decides it is time to raise interest rates. We begin with the standard textbook model
of reserve balances to illustrate the approach used by the Federal Reserve before the
financial crisis to keep the federal funds rate near its desired target. We explain why
that pre-crisis approach will not work in the current environment. We then discuss
the policy tools available to implement monetary policy, and explain the approach
that the Committee intends to take when it decides to begin raising short-term
interest rates. For additional detail on the issues discussed in this paper, a useful
starting point is our discussion paper Ihrig, Meade, and Weinbach (2015).
How Did the Fed Implement Monetary Policy Prior to the Financial
Crisis?
The textbook explanation of open market operations is based on two key
features: 1) requirements that banks hold reserve balances in amounts determined
by the Federal Reserve; and 2) banks trying to keep these balances to a minimum,
in part because before the financial crisis the balances earned no return.
The original Federal Reserve Act (as amended by the Monetary Control Act of
1980) and the International Banking Act of 1978 impose reserve requirements on
most deposit-taking institutions in the United States, requiring that commercial banks,
savings banks, thrift institutions, and credit unions—as well as most US branches and
agencies of foreign banks—(hereafter “banks,” for simplicity) are assessed reserve
requirements against certain deposit liabilities. For example, as of January 22, 2015,
Jane E. Ihrig, Ellen E. Meade, and Gretchen C. Weinbach
179
institutions needed to hold reserves equal to 3 percent of any net transaction accounts
between $14.5 million and $103.6 million, and 10 percent of any net transaction
accounts above $103.6 million (http://www.federalreserve.gov/monetarypolicy/
reservereq.htm#table1). Banks are required to satisfy their reserve requirements in
the form of vault cash, which they hold primarily to meet the liquidity needs of their
customers and, if the quantity of vault cash held is insufficient, also in the form of a
balance maintained at the Federal Reserve. Prior to the financial crisis, many banks
in the United States satisfied their reserve requirement with vault cash, though about
900 banks did not and so also needed to maintain reserve balances at the Fed. The
balances that banks maintain at the Federal Reserve that are necessary for meeting
reserve requirements are “required reserve” balances; any reserve balances held in
excess of what is necessary to meet reserve requirements are termed “excess reserve”
balances.1 Before the financial crisis and recession that started in 2007, total
reserve balances in the US banking system hovered around $15 billion, with excess
balances making up less than $2 billion of this total. As discussed in greater detail
below, reserve balances have grown tremendously since the financial crisis.
The combination of Federal Reserve–created demand for reserve balances and
the desire of banks to limit such balances drove an active interbank market, known
as the federal funds market, in which banks borrowed from and lent funds to each
other on a daily basis at an interest rate known as the federal funds rate. With reserve
balances generally scarce, the Federal Reserve could affect the market-determined
level of the federal funds rate and keep it close to target level by a combination of
announcing a target level for the federal funds rate and making small changes in
the supply of aggregate reserves as needed.
Figure 1 presents the standard demand and supply framework for reserve balances
shown in many textbooks. The demand by banks for reserves is downward sloping
because of the opportunity cost of holding reserve balances (which in the past paid
no interest). Conversely, as the price of overnight borrowing falls, banks are generally
inclined to hold more reserves in order to satisfy their reserve requirements and also
possibly to leave themselves with modest excess balances to protect against unexpected
outflows that can cause reserve balance deficiencies—for which banks are charged
a penalty. The upper left-hand side of the demand curve becomes horizontal at the
“primary credit rate,” which is the interest rate that the Fed charges banks to borrow
overnight (as part of the Fed’s discount window). Borrowing at the primary credit rate
provides banks with a source of back-up funding at an interest rate that is well above
1
In practice, banks meet their required reserve balances (also referred to as “reserve balance requirements”) with some leeway. A penalty-free band is used to create a range on both sides of the required
reserve balance within which a bank needs to maintain its average balance over a given period. For more
information on reserve requirements, see the Federal Reserve Board’s “Reserve Maintenance Manual” at
http://www.federalreserve.gov/monetarypolicy/2015-reserve-maintenance-manual-about-this-manual.
htm or its web page on “Reserve Requirements” at http://www.federalreserve.gov/monetarypolicy/
reservereq.htm. Data on reserve balances are published weekly on the H.3 Statistical Release at http://
www.federalreserve.gov/releases/h3/current.
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Journal of Economic Perspectives
Figure 1
Banks’ Demand for and the Fed’s Supply of Reserve Balances before the Financial
Crisis
Federal funds rate
Supply
Primary
credit rate
Demand
$15 billion
Reserves
Source: Authors.
the Fed’s target federal funds rate.2 Although, in theory, banks should be unwilling
to pay more than the primary credit rate for overnight funding, they sometimes do.
Borrowing from the Fed involves higher transactions costs as well as possible reputational effects (termed “stigma”) in which banks fear that borrowing from the Fed sends
a signal that they are not regarded by other financial institutions as a good credit risk.
For these reasons, some banks may choose to borrow from other institutions in the
federal funds market at interest rates that exceed the primary credit rate.
The Fed’s supply curve for reserve balances is vertical because the Fed is a
monopolistic supplier of reserves; the supply curve shifts to the right or left when
the Fed adds or subtracts reserves from the banking system using open market operations. The intersection of the demand and the supply curves occurs at the market
federal funds rate.
Prior to the financial crisis, the supply and demand curves for bank reserves
intersected on the downward-sloping portion of the demand curve. As a result,
if the market federal funds rate was above the target federal funds rate, then
the Fed would execute purchases of securities that would add reserve balances
to the banking system and shift the supply curve to the right. Conversely, if the
market federal funds rate was below the target federal funds rate, then the Fed
2
Data on banks’ aggregate borrowings from the Fed are published weekly on the H.3 Statistical Release
at http://www.federalreserve.gov/releases/h3/current. For more information on the Fed’s discount
window programs, see Purposes & Functions (Federal Reserve System 2005).
Rewriting Monetary Policy 101
181
would execute sales of securities that would drain reserve balances from the
banking system and shift the supply curve to the left. (Of course, when banks
trade existing reserve balances among themselves in the federal funds market,
that trading leaves the aggregate amount of reserve balances unchanged; see the
online Appendix available with this paper at http://e-jep.org for a discussion of
this point.) Each business day, the Federal Reserve examined demand and supply
conditions and, informed by staff models, determined whether an adjustment to
reserve supply was needed, including which kind was suitable and the approximate size that would be appropriate. Judson and Klee (2010) discuss how forecasts
were used to determine open market operations.
Prior to the financial crisis, the kind of open market operation that the Fed
would use to produce the desired movement in reserve supply depended on its
assessment of conditions in the market for reserves. For example, suppose the goal
was to reduce the federal funds interest rate. In this situation, the Federal Reserve—
more specifically, the Open Market Trading Desk at the Federal Reserve Bank of
New York—would purchase a security from the private sector, a transaction that
cleared through banks and resulted in reserve balances being added to the banking
system. This purchase could be permanent or it could be temporary (the latter
transaction is termed a repurchase agreement). In Figure 1, this transaction would
shift the supply curve to the right for as long as the Fed owned the security, and
thereby put downward pressure on the market federal funds rate. (The online
Appendix available with this paper at http://e-jep.org describes the mechanism by
which increases in the Fed’s securities holdings result in a commensurate increase
in the amount of reserve balances held by the banking system.)
The Fed’s monetary policy targeted the federal funds interest rate, and then other
short-term market interest rates tended to move with that rate. For example, Figure 2
shows three different overnight market interest rates. The federal funds interest rate that
is targeted by the Fed reflects, as we have already discussed, a market in which banks are
the borrowers, and a mixture of banks, securities dealers, and government-sponsored
enterprises (financial services corporations created by Congress, such as Fannie Mae,
Freddie Mac, and the Federal Home Loan Banks) are the potential lenders.
The Eurodollar market, although it started in London, is now a large global
market. “Eurodollars” is a general term for large (often in the millions of dollars) US
dollar-denominated deposits in banks outside the United States, usually held for a
period of less than six months. Such deposits avoid regulations applicable to US-based
deposits. The Eurodollar market is a place for money market funds and various financial and nonfinancial lenders to store funds for relatively short periods of time.
The repurchase agreement market, or repo market, involves a two-part transaction in which one party first sells a security to another and simultaneously agrees
to repurchase that security in the near future. The original buyer of the security
is in effect lending money on a short-term basis, and earns a rate of return for
doing so, while the original seller of the security obtains additional cash in the
short-term. The difference between the sale price and the repurchase price of
the security, together with the length of time between the sale and purchase steps
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Journal of Economic Perspectives
Figure 2
Overnight Market Interest Rates
800
Treasury GCF repo
Federal funds
Eurodollar
Interest on excess reserves
Basis points
600
400
200
0
2000
2002
2004
2006
2008
2010
2012
2014
Source: Authors using data from Depository Trust & Clearing Corporation, Federal Reserve Bank of New
York, Bloomberg, and Federal Reserve Board of Governors.
Note: GCF = General Collateral Finance.
of the transaction, implies the rate of interest earned by the party that purchased
the security and loaned the funds. The repurchase market typically involves banks
and securities dealers taking the role of cash borrowers—that is, they are typically
sellers of securities in the first stage of a repurchase agreement. Money market
funds, hedge funds, government-sponsored enterprises, and securities dealers are
the lenders in this market, essentially holding the securities while lending cash
for a short time until the repurchase agreement expires or is renewed. Before the
financial crisis, many of the Fed’s daily open market purchases of securities were
structured as repo transactions.
The market for repos is complex. There are two basic types of repo transactions:
“bilateral” and “tri-party,” referring to the number of participants involved in the
transaction. Within the tri-party market there is a segment called the GCF (General
Collateral Finance) repo market, mostly used by securities dealers and serviced by the
Fixed Income Clearing Corporation. (For more information on the structure of repo
markets, see Copeland, Duffie, Martin, and McLaughlin 2012.) The term “general
collateral” means that the party lending the money—that is, the party buying the
security that will later be repurchased—is willing to accept a range of bonds issued by
the US Treasury and by government-sponsored enterprises as collateral for the loan.
Jane E. Ihrig, Ellen E. Meade, and Gretchen C. Weinbach
183
We will return to a discussion of repurchase agreements and how the Federal
Reserve plans to make use of their cousin, reverse repurchase agreements, later
in this paper. Here, we only wish to emphasize that overnight market interest
rates tend to track each other. This pattern reflects, in part, the fact that many of
the same financial institutions are active participants in the markets for various
money market instruments. For example, banks are active borrowers in all three
of the money markets depicted in Figure 2, and while the lenders vary a bit across
the markets, there is also notable overlap. All in all, arbitrage generally works well
to keep short-term interest rates highly correlated.
In broad terms, persistent changes in the level of short-term interest rates are
transmitted to other, longer-term interest rates as well, including those commonly
faced by businesses and households—although this connection from changes in
short-term to long-term interest rates is not a simple one-to-one process. Ultimately,
the Federal Reserve conducts monetary policy in order to achieve its statutory mandate
of maximum employment, stable prices, and moderate long-term interest rates as
prescribed by the Congress and laid out in the Federal Reserve Act. (The Federal
Reserve’s statutory mandate is often referred to as a “dual mandate” of maximum
employment and price stability, because of the belief that moderate long-term interest
rates will result if inflation is expected to be low and stable.) Thus, as economic conditions change over time, the Federal Open Market Committee adjusts monetary policy
accordingly, typically by raising or lowering its target for the federal funds rate, so as to
foster economic conditions it judges to be consistent with achieving its statutory goals.
How Did the Financial Crisis Affect the Fed’s Operational Framework?
The first event commonly associated with the global financial crisis took place
on August 9, 2007, when the French bank BNP Paribas suspended withdrawals
from three of its investment funds due to problems in the US subprime mortgage
market. At the onset of the financial crisis, the Federal Open Market Committee
began reducing its target for the federal funds interest rate, and implementing
policy using the conventional open market operations discussed in the previous
section. The target federal funds interest rate moved down from 5¼ percent in
August 2007, to its effective lower bound of 0 to 25 basis points in December 2008,
where it remained in early fall of 2015.3
3
The target or “intended” federal funds rate is published on the Federal Reserve Board’s website at
http://www.federalreserve.gov/monetarypolicy/openmarket.htm. The Federal Reserve also responded
to the financial crisis with a number of credit and liquidity programs designed to support the liquidity
of financial institutions and foster improved conditions in financial markets. Although these programs
led to significant increases in the Federal Reserve’s balance sheet, the programs have expired or were
concluded, and they are not boosting the Fed’s balance sheet today. Details of these liquidity programs
are available on the Federal Reserve Board’s website at http://www.federalreserve.gov/monetarypolicy/
bst_crisisresponse.htm.
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Journal of Economic Perspectives
Table 1
A Simplified Federal Reserve Balance Sheet: Before and After the Financial Crisis
(billions of dollars)
Before:
August 8, 2007
Assets
After:
December 24, 2014
Liabilities
Securities
Other assets
791
78
Total
869
Reserve balances
Currency
Other
Capital
Total
Assets
14
777
45
33
869
Liabilities
Securities
4,247
Other assets
262
Total
4,509
Reserve balances
Currency
Other
Capital
Total
2,610
1,294
548
57
4,509
Source: Authors using data from Federal Reserve Board of Governors H.4.1 Statistical Release, titled
“Factors Affecting Reserve Balances.”
As short-term interest rates reached near-zero, the Federal Open Market
Committee carried out a series of large-scale asset purchase programs between
November 2008 and October 2014 in which the Fed purchased in the secondary
market about $1,690 billion in Treasury securities, $2,070 billion in agency
mortgage-backed securities, and $170 billion in debt issued or guaranteed by
government-sponsored enterprises.4 These operations were unprecedented and
their effects uncertain. The programs were intended to put downward pressure on
longer-term interest rates in the economy—the purchases reduced the available
supply of securities in the market, leading to an increase in the prices of these
securities and a reduction in their yields. Academic studies provide varying estimates of the magnitude of downward pressure that these operations have put
on longer-term interest rates (Fischer 2015, table 1, titled “Empirical Studies of
LSAPs”). The purchase programs taken together are estimated to have reduced
longer-term interest rates by roughly 100 basis points, as reported in Ihrig, Klee, Li,
Schulte, and Wei (2012). The large-scale asset purchase programs also helped to
support mortgage markets (Krishnamurthy and Vissing-Jorgensen 2011).
For the purposes of this paper, the key issue isn’t how these large-scale
asset purchase programs affected interest rates or mortgage markets, but rather
that their legacy is a dramatic alteration of the Federal Reserve’s balance sheet.
Table 1 shows a simplified version of the Federal Reserve’s balance sheet before
4
In addition, from September 2011 through December 2012, the Fed conducted a maturity extension
program where it sold or redeemed $667 billion in shorter-dated Treasury securities and purchased
the same amount of longer-dated Treasury securities, as reported on Federal Reserve Board’s website
at http://www.federalreserve.gov/monetarypolicy/bst_openmarketops.htm. Mortgage-backed securities are a type of asset-backed security that is secured by a package of mortgage loans and for which
interest and principal payments associated with the mortgages are passed through to the holders
of the securities; agency mortgage-backed securities are those issued by government-sponsored
enterprises.
Rewriting Monetary Policy 101
185
Figure 3
Total Reserve Balances held by Banks
(billions of dollars)
2,500
2,000
1,500
1,000
500
0
1985
1990
1995
2000
2005
2010
2015
Source: Authors using data from Federal Reserve Board of Governors, H.3 Statistical Release, titled
“Aggregate Reserves of Depository Institutions and the Monetary Base.”
and after the financial crisis. The left panel shows that on August 8, 2007, the
Federal Reserve’s assets were comprised principally of Treasury securities holdings of $791 billion; its liabilities were mainly currency ($777 billion), with banks
holding $14 billion in reserve balances at the Federal Reserve. As the Fed made
its purchases of securities, the Fed generally also reinvested payments of principal
and interest to keep its portfolio of securities from shrinking. As a result, by late
December 2014, the Fed’s securities holdings rose to nearly 5½ times their precrisis level, as shown in the right panel of Table 1. In addition, reserve balances
became the Fed’s largest liability, amounting to $2.6 trillion, and, as shown in
Figure 3, these balances have remained in that neighborhood since then, with
excess reserves making up all but about $90 billion of this total.
Another important factor affecting the federal funds market (and thus the
implementation of monetary policy going forward) is that since October 2008,
the Federal Reserve has paid interest on banks’ reserve balances. The Financial
Services Regulatory Relief Act of 2006 authorized interest payments on reserve
balances beginning in 2011, and the Emergency Economic Stabilization Act of
2008 advanced the effective date of this authority to October 2008. The Federal
Reserve has designated two rates of interest on reserve balances, one rate for
required reserve balances and a separate rate for excess reserve balances; the
186
Journal of Economic Perspectives
interest rates that the Fed pays on reserves that are required and those that are
excess are currently the same, although they could be set at different levels. In
the discussion in this paper, for simplicity and given the predominance of excess
reserve balances, we focus on the interest rate on excess reserve balances. All else
equal, an increase in the interest rate on excess reserves would be expected to put
upward pressure on the federal funds rate because banks would have an incentive
to borrow in the federal funds market at rates below the interest rate on excess
reserves and place those balances at the Fed.
Since the Fed began paying interest on reserves, the market federal funds
interest rate has generally been below the interest rate on excess reserves. One might
think that interest on excess reserves (IOER) (see Figure 2) should provide a floor
for the federal funds interest rate because banks would not lend at rates below what
they could receive at the Fed. However, this situation has arisen because, in addition
to banks not needing to borrow actively from each other because of the high quantity
of reserves already in the banking system, the nonbank lenders in the federal funds
market have an incentive to lend reserves at any rate above zero because they are
not eligible to earn the interest rate on excess reserves on the balances they keep at
the Fed. As explained above, the nonbanks that are active in the market for federal
funds are government-sponsored enterprises. Banks borrow from these nonbanks to
earn the spread between the market interest rate at which they borrow funds and the
interest rate they earn from the Fed by holding those funds as excess reserves.
Figure 4 shows the market for reserve balances in the last few years after the
expansion of bank reserves and illustrates two key differences from Figure 1. First,
the supply curve for reserves is far to the right on the x-axis, representing the superabundant level of reserves in the banking system. The supply and demand curves
now intersect on the flat portion of the demand curve. With the supply curve for
reserves in its current position, the traditional steps to put upward pressure on
market interest rates—announcing a higher target level for the federal funds rate
and being prepared to conduct the appropriate open market operation by selling
a small amount of securities into the market and draining an equally small amount
of reserves—will no longer suffice. Second, with the Fed paying interest on reserves,
the lower portion of banks’ demand curve flattens out near the interest rate on
excess reserves, reflecting the arbitrage activity just described. In this situation,
when the time arrives to raise the target range for the federal funds interest rate,
how will the desired increase be accomplished?
What Tools Could the Fed Use to Raise Interest Rates?
The Federal Reserve has a number of policy tools—some traditional, some
new—that it can use to help raise the federal funds interest rate in a situation of
superabundant reserves. In this section, we discuss the available policy tools, along
with the ways in which those policy tools are expected to influence the federal
funds rate.
Jane E. Ihrig, Ellen E. Meade, and Gretchen C. Weinbach
187
Figure 4
Banks’ Demand for and the Fed’s Supply of Reserve Balances Today
Federal funds rate
Supply
Primary
credit rate
Demand
IOER
rate
$2.6 trillion
Reserves
Source: Authors.
Note: IOER = interest on excess reserves.
Channels of Influence of the Policy Implementation Tools
It is useful to summarize the three main channels through which the Fed’s policy
tools are generally expected to affect the market-determined federal funds interest
rate and broader interest rates in the economy: encouraging arbitrage, increasing
the scope of influence, and increasing reserve scarcity. We will refer to these concepts
below in describing how each of the available policy tools is thought to work.
A policy tool can encourage arbitrage in money markets when it offers an interest
rate that acts as a reservation rate—that is, the lowest rate of return that a financial
institution would be willing to accept for investing its funds when assessing available
investment opportunities.5 Generally speaking, financial institutions with access to
a given policy tool have an incentive to borrow funds in money markets at rates that
are below the interest rate that the Federal Reserve offers on the policy tool and
invest the funds in the policy tool, putting upward pressure on money market rates.
If a policy tool establishes a reservation rate for a broader set of financial institutions than banks, we say it has an increased scope of influence in money markets.
Access to this tool will narrow the set of institutions that might lend money below
the rate earned on the policy tool and put upward pressure on the lowest interest
rates in money markets.
5
Note that the Fed is a risk-free counterparty. Because there is no risk that the Federal Reserve will be
unable to return money, banks do not require additional compensation for default risk in the rates they
receive from the Fed.
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Journal of Economic Perspectives
Use of a policy tool can increase reserve scarcity by draining reserve balances and
moving the level of aggregate reserves closer to its traditional position. If the aggregate level of reserve balances were reduced sufficiently, banks would need to resume
borrowing federal funds to meet their demand for reserve balances, leading them
to put upward pressure on the market federal funds rate.
Available Policy Tools
Rate of Interest on Excess Reserve Balances. As noted earlier, most transactions in
the federal funds market today reflect arbitrage activity between banks that earn
interest on reserves and nonbanks that do not (Goodfriend 2015 offers more detail).
An increase in the interest rate on excess reserves should pull up the federal funds
rate in these arbitrage transactions. Similarly, other money market rates should
increase as banks arbitrage between holding excess reserve balances and alternative
money market instruments.
Of course, banks need to be willing and able to actively perform this arbitrage
for these effects to be realized. As shown in Figure 2, the federal funds rate has been
highly correlated with other money market rates, which suggests that such arbitrage
does happen. However, our understanding of the potential strength of these arbitrage effects may be incomplete, in part because interest on excess reserve balances
has only been in effect over a period of time in which short-term interest rates have
been kept near zero.
Overnight Reverse Repurchase Operations. In this type of open market operation,
the Open Market Trading Desk would sell a security to the private sector, a transaction that would initially result in a decline in the quantity of reserve balances in the
banking system, shifting the supply curve to the left. As with a repo transaction, this
transaction would include a second step in which the transaction is unwound—the
Desk would repurchase the security at a specified price at an agreed-upon time in
the future and return the funds it had been holding, leaving reserve balances back
where they started.
In the past, the Fed has conducted relatively small-dollar amounts of overnight
reverse repurchase agreements with “primary dealers,” which are institutions that
buy and sell Treasury securities directly from and to the Fed with the intention
of acting as the “middleman” between the Fed and market participants in the
private sector. A full list of primary dealers is available at http://www.newyorkfed.
org/markets/pridealers_current.html. Some well-known exa