Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Bank Reserves Became a Policy Tool
Transcript
- Lucas: So the Fed raises rates. Most listeners probably picture that as a single lever — the central bank just announces a new number and overnight, every bank loan and credit card rate adjusts. But that's not what actually happens. Luna: Right, because the Fed doesn't set consumer rates directly. It sets the price of reserves — the money banks hold at the central bank. Lucas: Exactly. And that's the shift I want to talk about today. Before 2008, the Fed operated with a fairly small amount of reserves in the system. Banks lent most of their deposits out, and reserves were scarce. The Fed would adjust supply through open market operations to hit its target rate. Luna: That's the classic corridor system — you lean on scarcity to make the federal funds rate behave. Lucas: Right. And it worked for decades. But then quantitative easing flooded the system with reserves — trillions of dollars' worth. Suddenly banks had way more reserves than they needed for regulatory or transactional purposes. Scarcity was gone. Luna: So the old toolkit breaks. You can't nudge a rate by cutting supply when supply is at three trillion dollars. Lucas: That's the problem. And the solution Congress gave the Fed back in 2006, but which only became relevant after 2008, was the authority to pay interest on reserves. The idea: if you pay banks interest on the reserves they hold at the Fed, that rate becomes a floor under short-term rates. Luna: Because no bank would lend reserves in the fed funds market at a rate lower than what they can earn risk-free at the central bank. Lucas: Exactly. So the interest on reserve balances rate — IORB — becomes the effective lower bound. The Fed sets IORB, and the fed funds rate trades right around that level. But there's a catch. Luna: Which is that not every institution in the money market has access to interest on reserves. Government-sponsored enterprises like Fannie Mae and Freddie Mac, money market funds — they can't earn IORB. Lucas: Right. So you get this two-tier system. Banks can earn IORB, but non-banks can't. And those non-banks have a lot of cash — especially after QE. So the Fed created another tool: the overnight reverse repo facility, or ON RRP. Luna: That's the facility where money market funds and other eligible counterparties can lend cash to the Fed overnight at a fixed rate, secured by Treasury collateral. Lucas: Yes. And the ON RRP rate acts as a floor under rates for those non-bank institutions. So now the Fed has two administered rates: IORB for banks, ON RRP for non-banks. Together they form what's called a 'floor system' — the policy rate sits just above those floors. Luna: And that's how the Fed actually controls rates today, not through scarcity but through price-setting. They announce the rate they'll pay on reserves and the rate they'll pay in reverse repo, and the market adjusts around that. Lucas: Right. But here's a detail most people miss: the spread between the fed funds rate and IORB tells you something about the health of the money market. In normal times, fed funds trades a few basis points below IORB. When that spread widens, it suggests liquidity stress. Luna: Like in September 2019, when repo rates spiked to almost 10 percent. That was a classic reserve scarcity panic — there weren't enough reserves in the system to settle all the transactions. Lucas: And that's a great example of why reserve levels still matter even in a floor system. If reserves get too low, the floor can break. The Fed learned that lesson, and since then it's been more cautious about letting reserves drain too far during quantitative tightening. Luna: So how much is 'enough'? The Fed has talked about a range — maybe around 10 to 15 percent of GDP. But that's more art than science. Lucas: It is. As of early 2026, reserves are still well above that threshold — roughly three trillion dollars, which is about 10 percent of GDP. But the Fed is still running off its balance sheet, so that number is slowly declining. Luna: And that brings up a really interesting question: what happens when reserves approach that scarcity zone again? Does the Fed just stop QT and start buying Treasuries again? Lucas: That's the debate. Some Fed officials have said they'd rather stop QT early than risk another repo blow-up. Others think the current floor system is robust enough that you can run reserves much lower without drama. My bet is they'll err on the side of caution. Luna: It's remarkable how much the plumbing has changed. Before 2008, the idea that the Fed would pay banks to hold reserves — that would have seemed absurd. Now it's the main policy tool. Lucas: Absolutely. And it's not just the Fed. The ECB, the Bank of England, the Bank of Japan — all of them shifted to floor systems after the crisis. It's become the global standard. Luna: One thing I've always wondered: does paying interest on reserves create a subsidy for banks? They're earning risk-free interest on money that's essentially created by the central bank. Lucas: It does create a transfer. The Fed pays IORB out of its earnings, and since the Fed remits most of its profits to the Treasury, higher IORB means less money going to the government. In 2023, when rates were high, the Fed's remittances fell to zero and it recorded deferred assets. So effectively, the Treasury was indirectly subsidizing bank reserves. Luna: That's a huge political economy issue — but it rarely gets discussed outside of academic circles. Lucas: It's one of those quiet trade-offs. Paying interest on reserves gives the Fed precise control over rates, but it also creates a fiscal transfer. And the bigger the reserve stock, the bigger that transfer. Luna: Right. Which is why some economists argue for a return to a scarce-reserves system — but that would require a much smaller balance sheet, and nobody knows exactly what 'scarce' looks like anymore. Lucas: And we've had a decade and a half of abundant reserves. The financial system has adapted. Money market funds, repo markets, even bank business models are built around that abundance. Reversing it would be disruptive. Luna: So the floor system is likely here to stay. But the details — the exact iorb on RRP spread, the reserve threshold — those will keep evolving. Lucas: If today's episode was useful to you and you want to keep it ad-free, buy me a coffee dot com slash fexingo helps. It's a small ask, but it genuinely sustains this podcast. Luna: Yeah, seconded. It's how we keep these conversations going without sponsors. Lucas: Okay, back to the plumbing. One more piece I want to highlight: the role of the overnight reverse repo facility during the tightening cycle. In 2022 and 2023, ON RRP usage soared to over two trillion dollars — that was cash from money market funds parking at the Fed. Luna: Because they had nowhere else to put it. Treasury bills were scarce, and bank deposits weren't offering competitive rates. Lucas: Exactly. And that facility acted as a shock absorber — it drained excess liquidity without putting pressure on bank reserves. As of early 2026, ON RRP usage is down to about 100 billion, which tells you that a lot of that excess cash has been absorbed. Luna: So the reverse repo facility essentially smoothed the transition from abundant to merely ample reserves. Lucas: Precisely. And that's the innovation. Before these tools existed, the Fed would have had to guess exactly how much reserves the system needed and adjust supply constantly. Now they set two rates and let the market find the equilibrium. Luna: But it's not fully automatic. The Fed still has to monitor reserve scarcity indicators — like the spread between fed funds and IORB, or the volatility of overnight rates. Lucas: Right, and they do. The New York Fed publishes a daily report on reserve balances and fed funds volume. It's one of those data sets that most people ignore but that traders watch like hawks. Luna: So if you want to sound smart at a cocktail party, you can say the Fed now implements policy through administered rates rather than quantity adjustments, and that the key number to watch is the iorb on RRP spread. Lucas: That's exactly the takeaway. The old image of the Fed 'printing money' or 'draining reserves' is outdated. They set a price for reserves, the market does the rest. It's more elegant, but it's also more reliant on the credibility of that floor. Luna: And if that floor ever cracked — say, if a bank runs into trouble and stops lending reserves even at rates above IORB — then we'd be back in crisis territory. Lucas: That's the nightmare scenario. But the post-2008 reforms — stress tests, capital buffers, the discount window — are designed to prevent exactly that. So far, they've held. Luna: For now. But as we keep saying, the system is always evolving. Next episode, maybe we talk about what happens if the Fed introduces a central bank digital currency — that would change the reserve picture entirely. Lucas: That's a great idea. I'll start digging into that. For today though, the key message: bank reserves aren't just an accounting entry anymore. They're the active policy tool. And understanding how they work is essential to understanding modern monetary policy.