The The Central Bank's Tools lesson described the classic tools. Since the 2008 financial crisis, the Federal Reserve has run monetary policy in a different way, because banks now hold plenty of reserves.
Key idea
When reserves are ample, the federal funds rate (the rate banks charge one another for overnight loans of reserves) is steered mainly by administered rates that the Fed sets: interest on reserve balances (IORB) and the overnight reverse repurchase (ON RRP) rate. The Fed sets a target range for the federal funds rate and moves these rates to keep it there. Open market operations keep reserves ample, but small ones barely move the rate.
Why it works
A bank will not lend its reserves overnight for much less than it can earn by leaving them at the Fed. So IORB acts like a floor under what banks will accept, and the federal funds rate settles near it. (It can trade a little below IORB, because some lenders in that market, such as government-sponsored enterprises, cannot earn IORB; the ON RRP rate, offered to a wider set of lenders such as money market funds, is set at or near the bottom of the target range.) With reserves plentiful, the demand curve for reserves is flat around that level: adding or removing a few reserves hardly changes the rate. To raise rates, the Fed raises IORB and ON RRP.
Worked examples
Worked example: Raising rates
Reserves are ample. The Fed wants the federal funds rate 0.25 point higher. What does it do?
- Small bond sales would barely move the rate, because the demand curve is flat where supply crosses it.
- It raises IORB and the ON RRP rate by 0.25 percentage point (25 basis points), and the federal funds rate follows.
Answer: Raise its administered rates
Worked example: A bank’s choice
A bank earns 4.40% on reserves left at the Fed. Another bank offers to borrow its reserves overnight at 4.20%. What will it do?
- Compare returns: 4.40% risk-free at the Fed beats 4.20%.
- It keeps its reserves at the Fed. This is how IORB anchors the federal funds rate.
Answer: Keep the reserves at the Fed
The Fed has paid interest on reserves since October 2008, and the single rate called IORB since July 2021. With reserve requirements at zero since March 2020, the old link from reserves to lending through the reserve ratio no longer binds; the AP course teaches both the classic model and this one.
Common mistake
Assuming small open market operations still move the federal funds rate, as in the limited-reserves model. With ample reserves, administered rates do most of the work. Check: where does supply cross the demand curve for reserves, on the steep part or the flat part?
See it with real data: bank reserve balances and the federal funds rate on the Economic Data page. Reserves jumped after 2008 and the rate kept moving in steps set by policy.