Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / The Fed's Quiet Pivot on Bank Reserves
Transcript
- Lucas: So, Luna, I've been digging into something that sounds like a technical footnote but actually tells you a lot about where the Fed's head is at right now. It's the gap between the interest rate the Fed pays banks on their reserves — currently 3.65 percent — and the effective fed funds rate, which is sitting at 3.63 percent. Luna: A two basis point spread? That doesn't sound like much. Lucas: Right, it's tiny. But historically, that gap has been a window into how the Fed's plumbing is working — or not working. In the old days, before 2008, the fed funds rate traded well above what the Fed paid on reserves. Now, in the post-crisis world, the Fed uses what's called a floor system. It sets a floor under rates by paying banks interest on their reserves, and the actual market rate is supposed to hover just above that floor. Luna: So when the effective rate is only two basis points above the floor, the system is humming. Lucas: Exactly. But here's the thing — that spread has been widening a bit this month. The effective rate has crept up to the high end of the target range, and the volume of fed funds trades has increased. That suggests reserves are getting a little less abundant than they were a few months ago. Luna: And that's because of quantitative tightening, right? The Fed is still letting its balance sheet run off. Lucas: Yeah, but it's more nuanced than that. The Fed has been careful to avoid a repeat of September 2019, when reserves got so scarce that repo rates spiked to double digits. So they've been watching the SOFR — the Secured Overnight Financing Rate — which has been inching up. Yesterday it was around 3.68 percent, noticeably above the fed funds rate. Luna: So the market is telling us something different from the Fed's target. Lucas: It's a signal that liquidity is tightening, but not crisis-level. The Fed's own tools — the overnight reverse repo facility, or ONRRP — have seen usage drop below a hundred billion dollars recently, down from over a trillion at the peak in 2023. That's another sign that excess cash is leaving the system. Luna: So what's the Fed actually doing about it? Are they tweaking anything? Lucas: That's the interesting part. There's a growing debate inside the Fed about whether to shift from a floor system to a corridor system. In a corridor, the Fed would have a ceiling — maybe a standing repo facility — and a floor, and let the market rate trade within that range. It gives the Fed more control without having to constantly adjust the balance sheet. Luna: But that would be a pretty big change in how monetary policy is implemented. Lucas: It would be the first major redesign since the crisis, yeah. And it's not just a technical issue — it affects your money market fund yields, your mortgage rates, everything downstream. If the Fed moves to a corridor, the effective fed funds rate could become more volatile, and that would feed into how banks price short-term loans. Luna: Okay, before we go deeper — if walking through the economy with us has made something click, if you've ever thought 'that makes sense now' — that's exactly the kind of moment we hope you get here. And if you want to keep that going, you can support the show at buy me a coffee dot com slash fexingo. It's a small gesture that keeps this podcast independent and ad-free. Lucas: Yeah, every bit helps. Now, back to the corridor idea — there are some Fed officials who think we should just get on with it. But there's also a camp that says, 'look, the floor system has worked fine for fifteen years, why mess with it?' Luna: So what's the actual argument for switching? Lucas: A corridor would allow the Fed to keep a smaller balance sheet. Right now, they need to hold a lot of reserves to make the floor work — they've said they want reserves to be 'ample,' which they estimate at around two point five to three trillion. In a corridor, they could operate with less, maybe one point five trillion. That would let them shrink the balance sheet faster, which has its own benefits — less distortion in bond markets, less crowding out of private lending. Luna: But there's a risk, isn't there? If you shrink too much, you could hit the same wall as 2019. Lucas: That's the fear. And it's why any transition would have to be gradual and well-telegraphed. But there's another dimension here — politics. The Fed is under pressure from Congress to be more predictable, and also to be more accountable. A corridor system could make the Fed's operations more transparent — you'd see the ceiling and floor rates plainly. Luna: Transparent but also more visibly active. The Fed would be intervening in the market every day, setting a ceiling and floor. Lucas: Right, and that might invite more political scrutiny. The current floor system is sort of invisible — rates just sit there because the Fed pays interest on reserves. There's no obvious daily intervention. A corridor would put the Fed's thumb on the scale more explicitly. Luna: So it's a philosophical choice as much as a technical one. Lucas: Exactly. And the evidence is mixed. Look at what's been happening with the effective fed funds rate over the past few weeks. It's crept up from around the middle of the target range to the top. The target range is 3.25 to 3.5 percent, and the effective rate is now 3.63? Wait, that doesn't add up. Luna: Hold on — you said the effective rate is 3.63. The target range must be higher now, right? Lucas: I misspoke. The effective fed funds rate is 3.63, and the target range is 3.5 to 3.75. The interest on reserve balances is 3.65, which is in the middle. So the effective rate is near the bottom of the range, not the top. My mistake. Luna: Okay, so the spread between the effective rate and the floor is only two basis points, but it's been growing a bit lately. Lucas: Yes, and that's the signal. If the effective rate starts climbing toward the top of the range, it means the floor isn't holding as well. The Fed would then have to decide: do we add reserves, do we adjust the interest rate, or do we let it drift and risk a spike? Luna: And that's where the corridor idea comes back. In a corridor, you'd have a clear ceiling — say, a standing repo facility where banks can borrow at a penalty rate. That would cap the fed funds rate at a known level. Lucas: Right, and that's actually something the Fed already has on a temporary basis. The Standing Overnight Repo Facility, or the SRF, was set up in 2021 to backstop the market. But it's rarely used, and it's set at a rate that's a bit above the target range. The idea would be to make that more of a permanent, active ceiling. Luna: So the pieces are already in place. It's just a matter of flipping the switch. Lucas: Not quite flipping a switch, but yeah, it's a question of whether they want to formalize what they've already been doing ad hoc. And there's a cost — a corridor can lead to more rate volatility, which might confuse markets. But it also gives the Fed more leeway to shrink its balance sheet, which has its own benefits. Luna: Where does Chair Warsh stand on this? He's been pretty vocal about wanting a 'quieter' central bank. Lucas: He's on record saying he wants to reduce the Fed's footprint. A smaller balance sheet would fit that narrative. But he also said he's concerned about inflation, so he might not want to make waves with a big operational shift right now. There's a delicate balance. Luna: And the market is on edge anyway, with the two-year yield at 4.72 and the ten-year at 5.21. That's a pretty steep curve, right? Lucas: It's inverted, actually. The ten-year is lower than the two-year, which is unusual. That's a sign that the bond market is expecting some economic weakness down the line. But that's a topic for another episode. Luna: So what should a regular listener take away from all this plumbing talk? Lucas: The key is that the Fed's operational decisions have real-world effects. If they shift to a corridor, money market rates could become more volatile, which would ripple into your money market fund yields and maybe even your adjustable-rate mortgage. It's not just academic. Luna: So it's a 'stay tuned' moment. Lucas: Exactly. The next few months will tell us whether the Fed is just tinkering or actually moving toward a new regime. And as always, we'll be watching the SOFR and the effective fed funds rate like hawks.