Wednesday, April 24, 2019

Is the Fed's Floor System Beginning to Fold?

Last December, I participated in an AEI event where I made the case that the Fed's current floor operating system could collapse into a corridor operating system fairly soon. My argument was that even without a significant reduction in the supply of reserves, a large shift in the demand for reserves could be sufficient to move the Fed off the perfectly elastic or 'flat' portion of the bank reserve demand curve. The Fed, in other words, could have a relatively large balance sheet and still end up in a corridor operating system. 

Graphically, such a development is depicted in the figures below. The figure on the left shows a floor operating system with a large supply of reserves on the flat portion of demand curve. In this system, the IOER is both the target and overnight interest rate. The second figure on the right shows what I imagined could be happening. The demand for reserves was shifting outward because of new regulatory requirements and the supply of reserves was shifting inward as the Fed began shrinking its balance sheet. As depicted, these actions together would push the Fed off the flat portion of the reserve demand curve. In turn, this would cause overnight rates to rise above the IOER and end the Fed's floor system. 

When I brought this up late last year it was pure speculation on my part, but it was informed by the Senior Financial Officer Survey and the Fed's balance sheet reduction plans. In my AEI talk, I told George Selgin, who dislikes the floor system, that if this comes to fruition Christmas will come early for him.  

Well, Christmas did not come early for poor George. He may, however, get a late gift from Santa Claus as there is some evidence my prediction may be coming true. Jeff Cox reports that interbank interest rates are rising above the IOER rate. The figure below shows the overnight bank financing rate (OBFR), the new and improved interbank interest rate measure, has started rising above the IOER. The old federal funds rate (FFR) has been above the IOER for almost a month. (The closely-related overnight Libor replacement, the Secured Overnight Funding Rate (SOFR) tells a similar story.)

To be clear, this move is small from a broader perspective as seen below. Nonetheless, this rise in both series is part of a longer-term change in their trend, where previously they were consistently below the IOER but now are bouncing above it. If they continue to rise above the IOER, the floor system's days are numbered. 

A similar story emerges if we look to the overnight treasury repo rates. The DTCC treasury repo rate has been tending up over the past month and so has the BNY Mellon treasury repo rate.

Now the DTCC repo rate has been above the IOER for awhile, but the BNY repo rate has not. This is relatively new. And like the interbank rates, the repo rates collectively have been gone from trending below the IOER to bouncing above it as seen below. Again, if this upward movement is sustained the floor system will fold.

Now, with all that said, there is something of a puzzle here: there has been no revival in interbank lending. One would expect, all else equal, that a rise in interbank interest rates above the IOER to spark some interbank lending. Instead, it appears interbank lending has been flat to declining:

One possible resolution to this puzzle is that banks are lending to the overnight treasury repo market rather than to each other. The overnight yield is slightly higher in this market and according to the Fed's H8 database there has been an explosion of reverse repo activity as seen below. 

Maybe part of the new normal is that the treasury repo market has permanently displaced interbank lending. In any event, these developments all point to some big changes taking place that could force the Fed back to a corridor system.

If that is the case, I would recommend the Fed get ahead of this transition and intentionally guide itself to a symmetric floor system like the one in Canada. In my next post, I will offer some practical suggestions for making this journey.

P.S. The technical definition for the "federal funds sold and reverse repos" in the H8 database is as follows: "Includes total federal funds sold to, and reverse RPs with, commercial banks, brokers and dealers, and others, including the Federal Home Loan Banks (FHLB)." So maybe part of the explanation for the lack of interbank lending is that bank are lending indirectly to each other via the repo market. 


  1. David, don't go by total fed funds volume. You need to look at interbank only. GSE's have found repo an increasingly attractive alternative to lending on the fed funds market, so it could even be the case that GSE-to-bank lending has declined enough to more than offset a slight increase in interbank fed funds lending.

    Except that's not what's happening, as you can see by consulting FRED's overnight unsecured interbank lending series, which is interbank fed funds plus some Eurodollar borrowing: The series makes it clear that banks are also shifting into secured (repo) lending an borrowing.

    1. George, I agree and I believe that is the blue series in the figure second from the bottom of the post (the last FRED graph). Still, I would like to know the explanation for the last figure. Why the explosion in bank lending to the repo market.

  2. Good arguments, but have considered that IOER was actually always meant to be the floor and not the ceiling?

  3. Hello David, one plausible explanation:
    The tri-party repo market rate was consistently at or below the FED Overnight Reverse repo program (ON RRP) until 2016/2017, and this program is accessible to a much wider range of participants than the IOER facility. Since this rate acted as an effective floor on money market rates, there was no incentive to participate in tri-party repo market.
    Particularly, I liked this model:

  4. Dear Professor David Beckworth,

    Thank you for your timely and very helpful blog.

    I am learning a lot from the information.

    Looking forward to further hearing from you

    Best regards,

    Tomo Nakamaru

  5. The reason for the rise on the effective Federal Funds Rate (EFFR) is a shift in the pattern of GSE, predominantly FHLB, lending. IOER had served as a kind of ceiling since FHLBs could lend money (especially their excess cash late in the day) to banks which would then earn the IOER rate. It is crucial to note that this source of funds was loaned at the lower end of the distribution of rates used in computing EFFR. Currently the FHLBs are making use of recently developed sweep accounts which allow them to invest their funds outside the EFFR market, as well as lending to the Fed via RRP. Thus the distribution of the Fed Funds rate has changed, causing it to rise above IOER. Absent GSE lending in the Fed Funds market, why would a bank lend at or below the IOER rate? It would not since there is no better counterparty than the Fed. In this way IOER is becoming more of a floor for banks. For other lenders eligible to lend to the Fed via RRP, that is a floor.

  6. Surely IOER cannot be a floor or a ceiling because IOER are fixed in the amount created. Only if the Fed is willing to continually adjust (expand /contract) the supply must the market follow.
    As a thought experiment, imagine the Fed added a 100m tranche of reserves paying 10 pct. A few lucky banks would take them up and sit on them. Market rates wouldn't move. But let's say the Fed said it would do unlimited amounts at 10 pct. Then banks wouldn't lend to anyone else much below 10 pct and rates would immediately go to the area of 10 pct.