Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use Interest on Excess Reserves as a Policy Rate
Transcript
- Lucas: If you asked most people how the Federal Reserve sets interest rates, they'd probably say 'the Fed raises or lowers the federal funds rate.' And that's not wrong — but it's incomplete. Since 2008, the Fed hasn't actually controlled the fed funds rate by changing the supply of reserves. Instead, it uses a different tool entirely: interest on excess reserves, or IOER. Luna: So the famous fed funds rate that you see in headlines — that's a consequence, not a lever? Lucas: Exactly. Before the financial crisis, the Fed operated what's called a corridor system. The total supply of reserves in the banking system was scarce — banks needed to borrow from each other to meet reserve requirements. So the Fed could nudge the fed funds rate up or down by adding or draining reserves through open market operations. The rate lived inside a narrow corridor bounded by the discount rate above and the interest on reserves rate below. Luna: And then quantitative easing flooded the system with reserves, and that corridor broke? Lucas: Right. By 2009, banks had trillions in excess reserves. They didn't need to borrow from each other anymore. The fed funds rate would have dropped to zero if the Fed hadn't created a new floor. That floor is IOER — the interest the Fed pays on the reserves banks hold at the central bank above their requirement. If a bank can earn, say, 0.5 percent on reserves at the Fed risk-free, why would it lend to another bank in the fed funds market at 0.4 percent? So IOER effectively sets a minimum rate for short-term money markets. Luna: But there's a nuance, right? Not all institutions in the fed funds market are eligible to earn IOER. Government-sponsored enterprises like Fannie Mae and Freddie Mac — they can lend in the fed funds market but they don't earn IOER. Lucas: That's the key friction — and it's why the Fed also uses the overnight reverse repo facility, or ON RRP. That facility pays a rate slightly below IOER and is available to a broader set of counterparties, including money market funds. Together, IOER and ON RRP create a floor for the effective fed funds rate. The Fed sets the IOER rate as its primary policy rate, and the fed funds rate trades in a narrow band just below it. Luna: So when you hear 'the Fed raised rates by 25 basis points' — what they actually did was raise IOER by 25 basis points? Lucas: Typically yes. Since December 2008, the Fed's main policy announcements include a change to the interest on reserves rate. The fed funds rate target is still announced, but it's more of a reference. The actual lever is IOER. And this system is called a floor system, as opposed to the old corridor system. Luna: And it's not just the Fed. The European Central Bank, the Bank of Japan, the Bank of England — most major central banks now use a floor system or something close to it. Lucas: It's become the global standard after the 2008 crisis. But the floor system has its own quirks. Take September 2019 — the repo market suddenly spiked, and the effective fed funds rate actually rose above IOER for a couple of days. That shouldn't happen in a pure floor system. Luna: What caused that? I remember it was a big deal at the time. Lucas: A combination of factors: corporate tax payments drained reserves from the banking system, and a large Treasury settlement added to the squeeze. Banks with reserves were reluctant to lend in the fed funds market because they were uncertain about their own liquidity needs. So the rate spiked to around 2.25 percent, while IOER was 1.80 percent. The Fed had to intervene with temporary repo operations to calm the market. It showed that even in a floor system, you need to manage the supply of reserves carefully. Luna: So IOER isn't a magic bullet. It works when reserves are abundant, but if reserves get too low, the floor can crack. Lucas: Exactly. That's why the Fed now maintains a 'ample reserves' regime — it keeps the total reserve supply high enough that the floor system functions smoothly. The Fed estimates that it needs at least around one and a half trillion dollars in reserves for the floor to hold. Below that, you risk volatility. Luna: Let's talk about transmission. How does changing IOER actually affect the economy — borrowing costs, mortgages, business loans? Lucas: It works through arbitrage. When IOER rises, banks have an incentive to keep reserves at the Fed rather than lend them out at lower rates. So banks raise the rates they charge on loans to maintain their margins. The fed funds rate moves up, then short-term rates like SOFR and commercial paper rates follow. That feeds into adjustable-rate mortgages, credit card rates, and business lines of credit. On the deposit side, banks are slower to raise deposit rates because they don't face competitive pressure — that's one criticism of the floor system. Luna: So depositors get squeezed. The Fed raises IOER, banks earn more on reserves, but they don't pass it on to savers in checking accounts. Lucas: That's been a persistent issue. Research from the Richmond Fed found that the pass-through from IOER to deposit rates is only about 20 to 40 percent. So banks capture most of the benefit. But for borrowers, the pass-through is much stronger — loan rates adjust quickly. Luna: Another thing I find interesting is that IOER blurs the line between monetary and fiscal policy. When the Fed pays interest on reserves, it's essentially transferring money to banks. That's a cost to the Treasury, because the Fed remits its profits — minus expenses — to the government. Lucas: Right. In a high-rate environment, the Fed's interest expense on reserves can be substantial. In 2023, the Fed paid over $280 billion in interest on reserves and reverse repos. That reduces the Fed's remittances to the Treasury, effectively increasing the federal deficit. Some economists argue this is an implicit subsidy to banks. Luna: But from a purely operational standpoint, the floor system is simpler than the old corridor. The Fed doesn't have to forecast reserve demand daily or fine-tune open market operations. It just sets IOER and lets the market do the rest. Lucas: Exactly. And that's why it's likely here to stay, even as the Fed eventually shrinks its balance sheet. The Fed has said it will maintain ample reserves, so we won't go back to the scarce-reserves corridor system anytime soon. IOER is now the primary policy tool, and the fed funds rate is a satellite. Luna: One more nuance: the Fed actually sets two rates — interest on reserve balances, or IORB, which replaced IOER in 2021, and the ON RRP rate. They're both administrative rates, meaning the Fed sets them directly, not through market forces. Lucas: Good catch. As of July 2021, the Fed renamed IOER to IORB — interest on reserve balances — to simplify the terminology. But functionally it's the same. IORB is paid on both required and excess reserves. The ON RRP rate is set 5 to 10 basis points below IORB to create a soft floor. The effective fed funds rate typically trades within that five-basis-point band. Luna: So if you want to know where the Fed is steering the economy, look at IORB — not the fed funds rate headline. Lucas: That's the takeaway. IORB is the throttle. The fed funds rate is just the tachometer. Luna: I like that. Speaking of taking away — if walking through the economy with us has made something click, there's a way to keep this conversation ad-free and independent. It's buy me a coffee dot com slash fexingo. Just a small way to say this matters to you. Lucas: Yeah, honestly, listener support is what keeps this show from having to run interruptive ads. We'd rather spend the whole episode on the monetary plumbing, and that's only possible because of folks who chip in. So thank you to those who do. Luna: And if you haven't yet, no pressure. But it does make a difference. Now, back to the plumbing — one thing we haven't touched on is how the floor system might evolve if the Fed eventually shrinks reserves further. Lucas: That's the open question. The Fed's current framework says it wants reserves to remain 'ample' — meaning well above the level that would cause scarcity. But 'ample' is a moving target. Some economists, like former Fed governor Randal Quarles, have argued the Fed could reduce reserves to around one trillion without losing control. Others say the floor system is robust as long as the Fed is willing to use ON RRP as a backstop. Luna: And of course, there's the international dimension. Central banks in emerging markets often don't have deep enough money markets to run a floor system. They still use reserve requirements or standing facilities. So the floor system is really a luxury of deep financial markets. Lucas: That's a great point. The floor system assumes you have a large, liquid market for reserves and a broad set of counterparties. Not every central bank can make that work. For the Fed, the ECB, the Bank of Japan, it's the new normal. And the core of that normal is IORB — the interest rate on reserves. Luna: So next time you see a headline that says 'Fed holds rates steady,' you'll know they really mean 'IORB stays put.' Lucas: And you'll understand why that matters. It's not just a technical detail — it's the mechanism through which monetary policy affects everything from your mortgage rate to the yield on your savings account. The floor system may sound arcane, but it's the foundation of how central banking works today.