Why do federal funds trade at the FOMC'S target rate?

• Jurisdiction: United States
• Date: 22 March 2011
• Author: Tempelman, Jerry H.

The role of inflation expectations on the part of economic agents is being increasingly recognized and incorporated into frameworks for the setting of monetary policy (for example, Piger and Rasehe 2008, Hetzel 2008). In this article, I describe how expectations are also critical in the implementation of monetary policy. According to the textbook view, the Federal Reserve controls the federal funds rate by varying the supply of reserves available to the banking system. I will argue, however, that fluctuations in the supply of reserves are not the full explanation, thus providing additional support for Taylor (2001), who found that federal funds trade at or around the Federal Open Market Committee's target rate in part because market participants expect that if they don't, the Fed will step in and react.

A Textbook View

Federal funds are account balances of depository institutions, such as commercial banks, at the Federal Reserve. Such account balances are actively traded between these institutions. If an institution projects an account balance that is short of what it wants that balance to be, it may call on an institution that has a surplus to borrow part or all of that surplus, usually on an overnight basis. The lending institution instructs the Federal Reserve to charge its account and to credit the account of the borrowing institution. The following day, the borrowing institution instructs the Federal Reserve to charge its account and to credit the account of the lending institution the principal amount plus interest, which is calculated using the interest rate set by the two institutions, known as the federal funds rate.

For many years, the federal funds rate has been the main variable that the Federal Open Market Committee targets when it sets monetary policy. The FOMC instructs the Open Market Trading Desk at the Federal Reserve Bank of New York ("the Desk") to conduct open market operations in order to change the amount of reserves in the banking system and keep the federal funds rate at or near the FOMC's stated target level.

According to the textbook view, the market for federal funds can be described using a classic demand and supply function, with the federal funds rate representing the price at which the demand and supply of federal funds are matched. Assuming a standard, relatively fixed, downward-sloping demand curve and an intended federal funds target rate, the Desk adjusts the supply of reserves so that the equilibrium level of the actual federal funds rate equals the FOMC's target rate. All else remaining equal, a higher target rate implies supplying a lower amount of reserves, and, vice versa, a lower target rate means supplying a higher amount of reserves. (1)

Underlying the downward-sloping demand curve is a model of how depository institutions manage their excess reserves, first proposed by Poole (1968). Depository institutions maintain excess reserves as a safeguard against overdrafts of their account at the Federal Reserve, or against insufficient clearing balances or required reserves. At the same time, depository institutions strive to minimize their excess reserves because of the opportunity cost associated with holding excess reserves, on which the Federal Reserve until recently paid no interest. The resulting interest elasticity of the aggregate demand for excess reserves is what the Desk exploits when it targets a particular federal funds rate (Dow 2001).

According to this view, the principal challenge for the Desk in keeping the actual federal funds rate at or near the FOMC's target rate is estimating the location of the demand curve and the size of other factors that supply reserves to the banking system. So-called misses in the amount of reserves the Desk supplies to the system that cause the actual federal funds rate to deviate from the target rate are ultimately due to the fact that in real life the location of the demand curve and the size of the other supply factors are not known with certainty and need to be estimated.

In Search of a Demand Curve for Excess Reserves

In practice, the challenge for the Desk is...