Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Set Interest Rates
Transcript
- Lucas: The way we think about interest rates has fundamentally broken compared to the last forty years of economics textbooks. For decades, the narrative was simple: the central bank controls the quantity of reserves, scarcity drives the price up, and that sets the rate. But since the financial crisis, that lever has snapped. Luna: Right, because now there are trillions in excess reserves sitting in the banking system. Scarcity isn't the problem anymore; it's abundance. Lucas: Exactly. So today, let's look at how the Federal Reserve actually sets the floor rate in this new environment. We need to understand why paying interest on reserve balances is the single most important innovation in modern monetary policy implementation. It turns out, the central bank doesn't need to hunt for bonds to move the needle anymore; it just needs to pay banks enough to make lending to each other unattractive. Luna: So if the Fed pays banks four percent on their idle cash, no bank will lend to another bank at three point nine percent? That seems almost too straightforward. Lucas: It is that straightforward, which is why the old view of open market operations feels archaic. In the old days, when reserves were scarce, the Fed would buy or sell Treasury securities to tighten or loosen the supply. If they sold bonds, banks had fewer reserves, competition for those few reserves drove the federal funds rate up. Now, with over five trillion dollars in reserve balances, the curve is flat. The marginal dollar of liquidity has zero bargaining power. Luna: And instead of playing whac a mole with liquidity, they just put a wage floor on it. They set the minimum compensation for holding reserves. Lucas: Precisely. Let's talk about the mechanics of that floor. The key metric here is the Overnight Reverse Repurchase Agreement, or ON RRP facility. This is where non-bank entities like money market funds can park cash with the Fed. By setting the ON RRP rate slightly below the target range, the Fed ensures that even the largest institutional players have a risk-free alternative that competes directly with private lending. If the private market tries to go below that, everyone just parks their cash at the Fed. Luna: So the ON RRP acts as a safety net for the entire financial system, not just commercial banks. It keeps the effective rate from drifting too low during times of stress. Lucas: Yes, and this is crucial for understanding the current quarter. As of late October 2026, the Fed's balance sheet remains elevated compared to pre-pandemic levels, but the distribution of those assets has shifted. The focus is no longer on shrinking the balance sheet rapidly to create scarcity, but on managing the liquidity drain while keeping the rate stable. The strategy is 'Quantitative Tightening' by absorption, not by force. Luna: I remember reading about the Treasury General Account drawdowns earlier this year. Did that threaten to spike rates because it pulled liquidity out of the system? Lucas: It did cause some anxiety, but the buffer was thicker than anyone expected. Because the Fed maintains such a high Interest on Reserve Balances rate, the pressure on the federal funds rate was minimal. When the Treasury spends money, it moves funds from its account at the Fed to commercial bank accounts, injecting reserves back into the system. The concern was always the opposite: that QT would drain too much, but the IORB kept the floor solid regardless. Luna: So the IORB is the anchor, and the ON RRP is the secondary anchor. Together they box the effective rate in. It’s less like steering a car and more like building a container. Lucas: That’s a perfect analogy. And it explains why the yield curve can still be inverted while the short end is pinned. The central bank isn't trying to influence long-term yields directly through this mechanism. They are strictly managing the cost of immediate liquidity. Long-term rates are determined by growth expectations and term premiums, not by the daily availability of reserves. Luna: But doesn't this create a moral hazard? If banks know they can get a guaranteed return from the Fed, do they stop innovating in lending? Lucas: That’s a fair critique, though data suggests banks are still lending aggressively to creditworthy borrowers. The spread between what they pay depositors and what they earn on loans is still wide enough. The IORB just prevents a race to the bottom in interbank lending. It stabilizes the plumbing so the rest of the economy can function without sudden liquidity shocks. Luna: Stability over efficiency. I can see why they prefer that trade-off in a post-crisis world. Lucas: Let's dig into one specific number that illustrates this. Look at the ratio of excess reserves to total deposits in the large commercial banks. It hovered around thirty-five percent throughout most of 2025 and 2026. That means for every dollar of deposits, thirty-five cents is sitting idle earning interest. In the nineties, that ratio was effectively zero. The entire architecture of banking has adapted to this new reality. Luna: Thirty-five percent idle capital changes how banks manage their books. They aren't worried about being short reserves anymore; they're worried about margin compression. Lucas: Exactly. And this brings us to the operational side of things. The Fed uses standing facilities to enforce the corridor. There’s the Discount Window for emergency lending, set above the target range, and the IORB set within the target. Market participants know they can always borrow from the Fed at the discount rate, so they won't lend to each other at higher prices. The window is the ceiling; the IORB is the floor. Luna: It’s a corridor system. Ceiling and floor. Much simpler than trying to guess how many billions of Treasuries to buy or sell each week. Lucas: Much simpler, and far more transparent. Transparency reduces volatility. When markets know exactly where the floor is, they don't panic-sell during routine settlement periods. Remember the repo market spikes in 2019? Those happened right before the regime fully settled into this floor-based approach. Once the Fed clarified they would maintain ample reserves, those spikes vanished. Luna: Because everyone knew they could walk away to the Fed at any time. The threat of running out of cash disappeared. Lucas: Right. And this leads to a fascinating implication for fiscal policy. When the government runs deficits, it injects reserves. When it runs surpluses, it drains them. Under the old scarce-reserve regime, a large deficit might have been seen as inflationary because it increased the velocity of money. Here, it just increases the stock of reserves, which the Fed can neutralize by adjusting the IORB rate. Fiscal dominance becomes easier to manage monetarily. Luna: So the central bank has more insulation from political spending cycles. They can adjust the price of money independently of the quantity. Lucas: Insulation, yes, but also responsibility. Because if you mess up the IORB setting, you don't just miss your target by a fraction of a percent; you misprice the entire cost of capital for the global financial system. The precision required is immense. A miscalculation of fifty basis points can trigger massive shifts in asset allocation across hedge funds and pension funds. Luna: That’s a lot of pressure for a meeting that lasts two days twice a year. How do they decide the exact level? Lucas: They rely on a formulaic approach tied to the broader funding costs. Typically, the IORB is set roughly fifteen to twenty basis points above the mid-point of the target range. It needs to be high enough to hold the floor, but low enough to avoid distorting the wider credit markets. If it’s too high, banks hoard reserves instead of lending. If it’s too low, the effective rate drifts down. Luna: So it’s a balancing act between control and distortion. They want control, but they don't want to break the lending pipeline. Lucas: Correct. And this brings us to a practical takeaway for investors. You don't need to watch the daily reserve totals to predict rate moves. You need to watch the FOMC statement regarding the IORB. Any change there signals a structural shift in how the Fed views liquidity. It’s a leading indicator for the cost of capital, far more reliable than bond yields alone. Luna: So if I want to know where rates are going, I listen to the Fed’s pricing of liquidity, not just the market’s pricing of risk. Lucas: Exactly. The market prices risk; the Fed prices liquidity. Understanding both gives you the full picture. We’ve covered the mechanics, the history, and the current application. But before we wrap up, I want to mention something that helps keep this deep dive possible. Luna: If walking through the economy with us has made something click, a couple of dollars a month is genuinely what keeps these going. Check out buy me a coffee dot com slash fexingo — that's F. E. X. I. N. G. O. Lucas: Yeah, listener support covers the production costs so we can keep digging into these complex topics without ads interrupting the flow. It really makes a difference for the team. Luna: Thanks for the support. It allows us to spend the time researching the details rather than rushing through headlines. Lucas: Back to the topic. One final thought on the future of this system. As digital currencies evolve, whether CBDCs or private stablecoins, the definition of 'reserves' may expand. The Fed is currently exploring how a digital dollar would interact with this floor rate framework. Would retail users hold reserves directly? Or would it remain wholesale only? Luna: If retail users held reserves directly, the demand for the IORB would skyrocket. Everyone would want that risk-free return. Lucas: Which would require a complete redesign of the transmission mechanism. It’s a reminder that while our current system is stable, it is not permanent. The plumbing is always evolving. For today, though, understanding the floor rate is the key to unlocking how modern central banking works. Luna: It definitely changes how I look at the news when the Fed announces a pause. It’s not just about stopping hikes; it’s about maintaining the floor. Lucas: Exactly. The pause is often just the maintenance phase of the floor. Thanks for listening, and keep watching those reserve flows.