There are two important statements that came out of the July 2014 FOMC minutes that outlined U.S. monetary policy for the foreseeable future:
The IOER rate would be set at the top of the target range for the federal funds rate, and the ON RRP rate would be set at the bottom of the federal funds target range
It would be appropriate to retain the federal funds rate as the key policy rate, and they supported continuing to target a range of 25 basis points
The first one is pretty straightforward: there will be a target rate band with the IOER (Interest On Excess Reserves) rate at the top of the band and the Fixed-Rate Reverse-Repurchase (FRRP) rate anchoring the lower end of the band. The second statement makes it clear that the rate band will remain at 25 basis points.* Evidently, the FOMC is continuing to use the rate band because the Fed governors recognized the difficulty of targeting a single rate with excess reserves so high. If we look at federal funds and Repo rates since the beginning of the current rate band, it’s pretty clear:
The current rate band began on December 16, 2008 when Fed announced a fed funds target rate range of .25% to 0.0%. In one way, it was a surprise to the market because the Fed has not targeted a fed funds range since the 1980s. On the other hand, having a target rate range made sense with the target set so close to zero. If the Fed went straight to a target of zero, it would have devastated the money markets over the past five years.
Since December 16, 2008, the fed funds rate averaged at 8.1 basis points,** traded as high as .3125%, and as low as .01%. Overall, it remained within the range except for a short period around the 2008 year-end.
The fed funds rate traded basically everywhere within the range over the past 5 years. Fed funds is a market with supply and demand just like any other market. But here’s the important point – the funds rate was at the high-end (.20% to .25%) of the range in 2010 when QE2 was announced. Once QE2 ended on June 30, 2011, fed funds were averaging .10%, but it eventually turned around and drifted higher. When QE3 began in September 2012, fed funds were averaging between .15% and .20% each day. The QE Fed purchases naturally pushed the rate down again over the next several months. My point is that over the past 5 years, fed funds were trying to trade at the high-end of the range the entire time. It was only because of the QE2 and QE3 Fed purchases that it averaged 8.1 basis points during the past 5 years.
General Collateral (GC) Repo traded much more volatile than fed funds over the same period of time and crossed through the upper bound of the range often. The GC rate averaged 14.7 basis points for this period, with a high of .42% and a low of 0.0%. Overall, GC averaged 6.6 basis points above fed funds during the period.
There are a few more points to note about the target rate band as it relates to Repo. First, the lower band is the FRRP rate and not the market Repo rate. Second, even though the FRRP will be the lower end of the band, the GC Repo rate can still go lower, especially in the afternoon after the facility has ended or on quarter-end and year-end when there’s limited liquidity. Finally, I like the fact that a Repo rate is officially recognized as a target rate for monetary policy.
The New Rate Band
The upper band is the IOER, the rate the Fed pays banks to keep their Excess Reserves at the Fed. It’s related to the fed funds market, but instead of a bank lending cash to another bank, the bank deposits the funds directly at the Fed. The lower band is the Fixed-Rate Reverse-Repo facility rate which is a Repo rate. At the FRRP facility, banks, broker-dealers, and money funds exchange their cash for Treasury collateral. The IOER and FRRP are two different yet related markets.
The new target rate band will be a mechanism which helps provide the ceiling and floor in the overnight fed funds market. This is different from previous Fed rate bands which were two rates chosen subjectively and the Fed pledged to intervene when fed funds moved outside of the range.
The FRRP provides a floor to the market because as overnight rates approach the FRRP rate, more volume is executed at the facility and more collateral is added to the market, removing cash.
The IOER acts as a ceiling in the overnight market by adding cash, though indirectly. When market rates like fed funds and GC Repo trade above the IOER, banks will move cash out of Excess Reserves and into fed funds or GC Repo to maximize their overnight investments, effectively driving those rates lower. Therefore, it’s important to note, the IOER is an effective upper rate band, but only while banks have significant Excess Reserves stored at the Fed. The IOER can only be a rate ceiling as long as the Fed keeps a large balance sheet and there are massive Excess Reserves in the banking system.
I understand there’s a potential problem using the IOER as a policy rate. In order to change the IOER, the FOMC needs the approval of the Board of Governors of the Federal Reserve who are all the political appointees and they don’t include any regional Fed Presidents. Whereas the FRRP and fed funds target rate can be changed by the FOMC alone. Obviously, the FOMC will want to maintain full control of monetary policy. Though here’s a question: Can the FOMC move the target range higher and then wait for the Board of Governors to approve moving the IOER?
* Announcing the width of the rate band is important because the Fed had rate bands of 1/8th and even 3/8th in the past
** Daily federal funds opening rates