Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Set Interest Rates on Reserves
Transcript
- Lucas: So you hear all the time that the Federal Reserve raised interest rates by 25 basis points, or cut by half a point. But what does that actually mean in practice? The Fed doesn't just announce a number and have it magically appear across the economy. Luna: Right, there's a specific tool they use to make that rate real. And it's not the same tool they used 20 years ago. Lucas: Exactly. The main tool today is called the Interest on Reserve Balances rate — IORB for short. That's the interest the Fed pays to commercial banks on the reserves those banks hold at the Fed. And by setting that rate, the Fed effectively sets a floor under short-term interest rates. Luna: A floor — meaning banks won't lend to each other at a rate lower than what they can earn risk-free by just leaving money at the Fed. Lucas: Precisely. If a bank can earn 5 percent IORB by parking reserves at the Fed, why would it lend those reserves overnight to another bank at 4.9 percent? It wouldn't. So the fed funds rate — the rate banks charge each other for overnight loans — tends to hover just above IORB. Luna: But this wasn't always how it worked. Before 2008, the Fed didn't have the authority to pay interest on reserves. So how did they control rates back then? Lucas: They used a much clunkier method. The Fed would buy or sell Treasury securities in the open market to add or drain reserves, which would push the fed funds rate up or down. They had to constantly fine-tune the supply of reserves to hit their target. It worked, but it required a lot of active trading. Luna: And then the financial crisis happened, and the Fed created trillions of dollars in new reserves through quantitative easing. Suddenly there was way more reserves in the system than banks needed. The old method broke down. Lucas: Right. With so many reserves, open market operations couldn't effectively raise rates. So Congress gave the Fed the power to pay interest on reserves in 2008, and that became the primary tool. Now, with abundant reserves, the Fed sets IORB and that anchors the whole rate structure. Luna: But there's another rate that works alongside IORB — the overnight reverse repo rate, or ON RRP. What's that for? Lucas: Good question. The ON RRP rate is a backup facility. The Fed offers it to a broader set of financial institutions — money market funds, government-sponsored enterprises — not just banks. And it's set slightly below IORB. So think of it as a second floor, a bit lower, that prevents rates from falling too far. Luna: So you've got two floors: IORB for banks, ON RRP for non-banks. And the fed funds rate trades in between them? Lucas: Usually a bit above IORB, actually. But the gap between IORB and the fed funds rate is typically just a few basis points. When the Fed wants to tighten, it raises IORB, and the whole complex shifts up. When it eases, it lowers IORB. Luna: So when we hear 'the Fed raised rates by 25 basis points' — they're literally changing the IORB rate? Lucas: Yes. The Federal Open Market Committee votes on a target range for the fed funds rate, and then the Fed's trading desk adjusts IORB to the top of that range. The ON RRP rate is set to the bottom. So the range is, say, 5.00 to 5.25 percent, with IORB at 5.25 and ON RRP at 5.00. Luna: And that gives them a corridor. But I've read some criticism that IORB might be too generous to banks — that it effectively subsidizes them. Lucas: That's a real debate. Banks are earning interest on reserves that they didn't have to work for. Some argue it's a taxpayer-funded gift. But the Fed's position is that it's necessary to maintain control over rates. Without IORB, the fed funds rate could drop to zero, especially with the massive level of reserves still in the system. Luna: There's also the question of whether the Fed should narrow the spread between IORB and ON RRP. Currently it's 25 basis points. Some economists think 10 or 15 would be enough. Lucas: Yeah, that's been discussed. A narrower spread would mean less subsidy to banks and money market funds. But the Fed has kept it at 25 for operational simplicity. And it works — the fed funds rate has stayed within the target range almost every day since the current framework was put in place. Luna: So for the listener, when you see your savings account rate go up or your mortgage rate adjust, the first domino is this IORB rate changing. Lucas: Exactly. The Fed adjusts IORB, that shifts the fed funds rate, which ripples through to Treasury bills, then to corporate bonds, then to mortgages. It's not instant, but that's the transmission mechanism. Luna: Speaking of which, this is the kind of thing where a deeper understanding really changes how you read the news. And if walking through the economy with us has made something click for you, it's worth knowing that this show stays ad-free because of a handful of listeners who chip in. Lucas: Yeah, it's a small group, but it makes a big difference. We don't run ads, no sponsors — it's just listener support through buy me a coffee dot com slash fexingo. If you've gotten value from these episodes, that's where you can keep it going. Luna: And truly, every bit helps us keep making deep dives like this one. So thanks to those who already do. Lucas: Alright, back to the plumbing. One thing that's been in the news lately is the debate about whether the Fed should start paying IORB only on a portion of reserves — a tiered system. Luna: Right, like some other central banks do. The Bank of Japan has a three-tier system, and the European Central Bank has used tiering too. The idea is to reduce the subsidy while still controlling rates. Lucas: Exactly. Under a tiered system, only a certain amount of each bank's reserves earn IORB. Anything above that threshold earns a lower rate or nothing. That would push banks to lend out excess reserves instead of parking them at the Fed, potentially stimulating the economy. Luna: But the Fed has resisted that so far. Why? Lucas: Complexity, mainly. The current system is simple and effective. Introducing tiers would require deciding how much each bank gets, and banks would try to game it. Plus, it's not clear it would actually boost lending — banks might just hold more capital instead. Luna: So for now, IORB remains the king. But it's worth watching whether the Fed ever changes course, especially if reserves stay high. Lucas: For sure. And understanding IORB is the key to understanding modern monetary policy implementation. It's not the most glamorous topic, but it's the lever that moves markets. Luna: And we're glad we could pull back the curtain on it.