Although Monetary Policy Has Focused On Setting A Proper Rat

Although Monetary Policy Has Focused On Setting An Appro Priate Level

Although monetary policy has focused on setting an appropriate level for the federal funds rate since well before the financial crisis, the mechanics since the crisis have changed. In response to the crisis, several new policies were enacted that altered the structure of the federal funds market in profound ways. On the borrowing side, the Fed’s large-scale asset purchases (LSAPs) flooded the banking system with liquidity and made it less necessary to borrow. In addition, the Federal Deposit Insurance Corporation (FDIC) introduced new capital requirements that increased the cost of wholesale funding for domestic financial institutions. On the lending side, the Federal Reserve now pays some financial institutions interest on their excess reserves (IOER).

When institutions have access to this low-risk alternative, they have less incentive to lend in the federal funds market. In this environment, the institutions willing to lend in the federal funds market are institutions whose reserve accounts at the Fed are not interest-bearing. These include government-sponsored entities (GSEs) such as the Federal Home Loan Banks (FHLBs). The institutions willing to borrow are institutions that do not face the FDIC’s new capital requirements and do have interest-bearing accounts with the Fed. These include many foreign banks.

As such, the federal funds market has evolved into a market in which the FHLBs lend to foreign banks, which then arbitrage the difference between the federal funds rate and the rate on IOER. This commentary describes the evolution of the federal funds market since the crisis. While research is ongoing about the effect these shifts in the market will have on the Fed’s ability to conduct monetary policy, events of the past decade highlight the large effect that small interventions like FDIC capital requirements can have on the structure of the financial system.

The Federal Funds Market before the Crisis

Before the financial crisis, the federal funds market was an interbank market in which the largest players on both the demand and supply sides were domestic commercial banks, and in which rates were set bilaterally between the lending and borrowing banks. The main drivers of activity in this market were daily idiosyncratic liquidity shocks, along with the need to fulfill reserve requirements. Rates were set based on the quantity of funds available in the market and the perceived risk of the borrower. Although the Federal Open Market Committee (FOMC) sets a target for the federal funds rate, the actual funds rate is determined in the market, with the “effective” rate being the weighted average of all the overnight lending transactions in the federal funds market. When the effective rate moved too far from the Fed’s target before the financial crisis, the FOMC adjusted it through open market operations. For example, if the Fed wanted to raise the effective rate, it would sell securities to banks in the open market, reducing the funds banks had available for lending in the federal funds market and driving the interest rate up. The Fed’s portfolio of securities consisted mainly of treasury bills of short maturity, and its balance sheet was small.

The Federal Funds Market since the Financial Crisis

Though the banking system has been awash in reserves and the federal funds rate has been near zero, the market has continued to operate, but it has changed. Different institutions now participate. Government-sponsored enterprises such as the Federal Home Loan Banks loan funds, and foreign commercial banks borrow. The increase in cash assets across different banks has been significant; for example, the cash assets of foreign-related institutions increased by 1,647.6 percent. Regulatory changes, including amendments to the FDIC’s assessment standards, have increased the cost of holding cash for some banks. These regulatory adjustments, alongside the Fed’s large-scale asset purchases (quantitative easing), expanded the size of the Fed’s balance sheet and increased banks’ cash holdings considerably. The Fed’s expansion aimed to buoy the mortgage markets and promote recovery by reducing the supply of securities like Treasuries and mortgage-backed securities.

The growth in the Fed’s balance sheet from $2.1 trillion in 2008 to $4.4 trillion in recent years, alongside the increased cash reserves of commercial banks, has profoundly affected the federal funds market. Domestic depository institutions now hold reserves mostly through the interest paid on excess reserves (IOER), which was initially designed to set a rate floor for lending but has not entirely achieved that effect. The effective federal funds rate has remained below the IOER rate because institutions such as Fannie Mae, Freddie Mac, and the FHLBs accept lower rates in the federal funds market than the IOER rate, which influences the overall rate structure. Foreign banks and foreign-related financial institutions, which are not regulated by the FDIC, have increased their holdings of cash assets and participate more actively as the domestic institutions’ role diminishes.

Implications for Future Monetary Policy

The significant enlargement of the Fed’s balance sheet and the evolving market structure have complicated the transmission of policy. Unlike pre-crisis settings where a target rate change was directly linked to reserve levels and open market operations, contemporary policy involves multiple layers, including interest payments on reserves and the participation of foreign entities. These developments make it harder for the Fed to influence the federal funds rate and, by extension, the broader economy. The large scale of the balance sheet means that increases in the policy rate might produce surprising and unintended effects, potentially disrupting the equilibrium in interbank lending (Ben Craig & Sara Millington, 2017).

It remains crucial for policymakers to understand the evolving dynamics in the federal funds market. The shift towards foreign banks arbitraging the spread between the federal funds rate and IOER, coupled with regulatory changes that impact domestic banks’ incentives to lend or hold reserves, creates a complex environment where traditional Open Market Operations may no longer have the intended effects in regulating short-term interest rates. Future policy decisions must carefully consider these structural changes to avoid unintended instability in the financial system and to achieve the targeted macroeconomic objectives effectively.

References

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