Link remains between quantity of reserves and fed funds rate, economist says

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Reserve balances still affect the fed funds rate, according to Federal Reserve Bank of Kansas City Senior Economist A. Lee Smith.

“Although substantial excess reserves in the banking system and the payment of interest on reserves have weakened the liquidity effect in absolute terms, a range of estimation strategies reveals that some linkages remain between the quantity of reserves and the funds rate,” Smith wrote in a paper released by the Bank Wednesday.

In the past decade, the policymakers moved to a system using the interest rate paid on reserve balances — the IOR rate — to move the federal funds rate within the Federal Open Market Committee’s target, rather than by tweaking the amount of reserves in the banking system, which was its prior tool of choice.

“Despite remarkably low day-to-day volatility in the federal funds rate, the funds rate has gradually moved higher relative to the IOR rate in recent years,” Smith wrote. Some attribute this to a higher funds rate, resulting from an increase “in short-term secured financing rates (also known as repo rates), reflecting an increase in Treasury bill issuance.”

Others believe even with reserve balances elevated, “the demand curve for reserves is not perfectly flat,” Smith says. “In this case, the large decline in reserve balances over the past few years may be responsible for the upward drift in the federal funds rate.”

One model suggests “reserve supply dynamics play an important role in determining the federal funds-IOR spread over the medium- and longer-term and that repo rate dynamics play a relatively less important role,” he wrote. “In this sense, the level of reserves still appears to influence the federal funds rate despite the payment of interest on reserve balances. As reserve balances decline, the federal funds rate may continue to move modestly higher against the IOR rate. Such a rise could necessitate further implementation adjustments as policymakers continue to learn about the drivers of the federal funds rate in the Fed’s new operating framework.”

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Monetary policy Federal Reserve Bank of Kansas City