Federal Reserve (the Fed) Chair Jerome Powell describes the Fed’s interest rate tools as follows:
“The Federal Reserve sets two overnight interest rates: the interest rate paid on banks’ reserve balances and the rate on our reverse repurchase agreements. We use these two administered rates to keep a market-determined rate, the federal funds rate, within a target range set by the FOMC.”
“Data-Dependent Monetary Policy in an Evolving Economy.” Board of Governors of the Federal Reserve System, October 8, 2019
What is the federal funds market and federal funds rate?
The federal funds market is an overnight loans market in which the Fed, the banks, and other eligible financial institutions borrow and lend reserves. The federal funds rate (FFR) is the interest rate on these loans and is the Fed’s central monetary policy interest rate.
What is the target range for the federal funds rate?
The target range for the FFR is an upper limit (FFRU) and lower limit (FFRL), a corridor 0.25 percent wide, set by the Federal Open Market Committee (FOMC) to steer the economy toward price stability and full employment—the Fed’s mandated goals.
What is the interest rate paid to banks on their reserve balances?
The interest on reserve balances (IORB) rate is the rate the Fed pays to banks on their reserves held on deposit at the Fed. The Board of Governors sets this interest rate, and currently at 0.1 percentage points below the FFRU.
What is an overnight reverse repurchase agreement and how does it earn interest?
An overnight reverse repurchase agreement (ON RRP) is a deal between the Fed and an eligible institution in which the Fed agrees to sell securities to the institution and to buy them back at a higher price the next day. This deal is equivalent to the institution lending funds overnight to the Fed and the interest rate on that loan is the ON RRP rate. The Board of Governors sets the ON RRP rate, and currently at 0.1 percentage points below the IORB rate and 0.05 percentage points above the FFRL.
Figure 1 shows the relationship between the four administered interest rates and the market-determined FFR at their levels on December 28, 2023.
How does the market determine the federal funds rate?
Arbitrage in the federal funds market determines the FFR. Arbitrage in financial markets is borrowing at one interest rate and lending at a higher one. If it is possible to borrow at a low interest rate and lend at a high one, there is an excess demand for loans and the borrowing rate rises or the lending falls until the two rates are equal.
To see how arbitrage works in the federal funds market, let’s conduct a thought experiment. Suppose the FFR rises above the IORB rate. A bank can profit by lending reserves, and the bank’s profit per dollar is the gap between the FFR and the IORB rate. When banks take advantage of this profit opportunity, the supply of loans increases and the FFR falls. The existence of this profit opportunity prevents the FFR from remaining above the IORB rate and makes it the upper limit of the FFR. The upper limit of the FOMC’s target range is never reached.
Now suppose that the FFR falls below the IORB rate. A bank can profit by borrowing reserves and depositing the borrowed funds in its reserve account at the Fed. To borrow reserves, a bank incurs a small transactions cost that we’ll call TC.
The table summarizes the thought experiments you have just conducted.
The Fed does not need to set two administered rates to keep the federal funds rate within the target range set by the FOMC. Arbitrage and the IORB rate do the work, keeping the FFR within the range IORB rate – TC and IORB rate.
What do the data tell us?
You’ve seen how arbitrage in the federal funds market keeps the FFR between a low of IORB rate – TC and a high of IORB rate and well within the range of FOMC’s limits. The data shown in Figure 2 support this prediction.
The figure shows four of the five interest rates minus the fifth, the FFRL, between January 2021 and January 2024. On June 17, 2021, the Fed raised the IORB and ON RRP rates by 0.05 percentage points keeping the gap between those rates constant at 0.10 percentage points and narrowing the gap between those rates and the FFR upper limit.
Notice that the FFR jumped when the IORB rate increased and that the FFR is always below the IORB rate and above the ON RRP rate.
Most days, the gap between the IORB rate and the FFR is a constant 0.07 percent.
Figure 2 shows the frequency distribution of this gap. On 77 percent of days, the FFR is 0.07 or 0.08 percentage points below the IORB rate, which implies that TC ranges between these values.
Rewriting the script for Jerome Powell’s next description of the Fed’s tools:
“The Federal Reserve sets the interest rate paid on banks’ reserve balances, and arbitrage keeps the federal funds rate close to this administered rate and well within the target range specified by the FOMC.”
Now take a short quiz to ensure you understand what you just read.