How Federal Reserve’s rules establish a fed funds rate tug-of-war …

Listening to mainstream media you get the impression that in a couple weeks the Board of Governors of the Federal Reserve System (the Board) will enter into every bank branch and directly raise interest rates on your credit cards, mortgages, car loans, and student loans. It is not that straight forward and I do wish most times that the business media would let the general public know that.

As important to the system of governance that a change in the federal funds rate is, you would think that the majority of Americans would be glued next week to TV sets or computer screens watching a Bloomberg or CNBC presenter spit out the new fed funds rate, but no such luck. That event, arguably the most important near monthly event of the last year and a few months, is reserved to us business news nerds.

Changes in the federal funds rate, the rate that banks charge each other overnight for lending each other their excess reserves deposited at a Federal Reserve Bank, is an important benchmark. But the rate that, in my opinion, is a bit more important is the interest rate that a Federal Reserve Bank pays a commercial bank for parking its reserves with it. 12 CFR 204.10 currently sets this rate at 2.40%.

Right now, this 2.40% interest rate on reserve balances (IORB) is slightly higher than the current effective federal funds rate of 2.33%. An effective federal funds rate is the actual overnight rate negotiated by banks in the interbank market. With the IORB slightly higher than the EFFR, there appears to be some room for an increase in the overnight rate.

But the tug of war I am alluding to is between rates for say, prime credit or commercial paper and the IORB. The prime rate, i.e., the best loan rates offered to the best borrower or commercial paper, debt sold by corporations in exchange for cash, are influenced by the IORB. Banks look at the opportunity costs of the IORB and decide that if they are gong to lend money, they will follow as close as possible the IORB.

The Board, on the other hand, pays attention to what is being negotiated in the markets. If the Board wants to discourage economic activity by restricting money supply, and sees commercial paper rates greater than the Board’s rates, the Board will have an incentive to increase rates and influence banks to take money out of the system by increasing the amount of reserves kept on deposit with a Federal Reserve Bank.

As a lawyer, it would interest me to see how policymakers could have codified how rates are to be calculated, but as a political economist, I appreciate why the central bank relies on market data and market sentiment when determining rates. The back and forth between IORB and market determined rates should get a little more attention.

Alton Drew

12 September 2022

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