FRBSF Economic Letter
2002-30; October 11, 2002
Setting the Interest Rate
The Federal Reserve's monetary policy goals are the maintenance of low
inflation and sustainable output growth. Under current operating procedures,
the Fed chooses a target for a short-term interest rate—specifically,
the overnight federal funds rate, which is an overnight interbank lending
rate—that is believed to be consistent with those policy goals.
To hit its interest rate target, the Fed relies primarily on open market
operations—it buys and sells securities to adjust the supply of
reserves available to depository institutions to meet their reserve requirements
and to clear payments transactions. The Fed also can supply reserves by
lending directly to depositories through the discount window. However,
traditionally, banks have not used the discount window as a routine source
of funding. Moreover, they have been reluctant to borrow at the window
even during tight money market conditions, when the demand for reserves
is exceptionally high, thus resulting in periodic spikes in the federal
funds rate. The willingness of banks to make use of the discount window
as a backup source of liquidity could change if the Fed were to adopt
its recently proposed rule changes governing the administration of the
discount window (Madigan and Nelson 2002). Under these rule changes, the
Fed also would alter its operating procedures; it would effectively place
a cap on the federal funds rate by standing ready to supply reserves on
demand to qualified banks at that predetermined interest rate cap.
This Economic Letter describes key features of the Fed's current
operating procedures for "setting" short-term market interest
rates, indicates how the proposed rule changes for discount window borrowing
affect the implementation of monetary policy, and outlines the economic
benefits that are expected to accrue from the rule changes.
Open market operations and market interest rates
The Fed affects market interest rates by buying and selling securities
in the open market. Most of those open market operations are temporary
in that they consist of very short-maturity (usually overnight) repurchase
agreements—repos or RPs—whereby the Fed acquires temporary
ownership of U.S. government or U.S. government-agency securities, on
which it receives a rate of return referred to as the repo or RP rate.
The RP market is huge; some estimates are upwards of $500 billion in transactions
per day (Stigum 1988). The Fed is a very small player in this market,
with a typical daily transaction (if any) of $1-$3 billion. Therefore,
its open market operations can have little direct effect on the equilibrium
value of the RP rate.
Open market operations, however, do have a direct effect on the interest
rate in the federal funds market. In this market, depository institutions
actually trade the reserves they hold in Federal Reserve accounts, which
are used: (along with vault cash on hand) to meet reserve requirements,
for check-clearing and other settlement of interbank transactions, and
for payment to the Fed for financial services rendered. By settling its
transactions involving RPs with bank reserves, the Fed essentially determines
the supply of reserves in the banking system and thereby exercises significant
control over the federal funds rate. Therefore, when Fed policy targets
a market interest rate, it targets the federal funds rate.
Why do movements in the federal funds rate influence the RP rate and
other short-term market rates? Suppose a commercial bank wants to raise
overnight funds on short notice. It might borrow reserves in the federal
funds market, or it might sell securities "under repo." In the
former case, the bank borrows at the federal funds rate; in the latter
case, it borrows at the RP rate. Because there are only minor differences
in the quality of the two assets, their rates remain very closely tied
together due to the elimination of arbitrage opportunities that would
otherwise exist for banks who participate in both markets. Similarly,
other short-term money market interest rates respond in kind in order
to maintain a portfolio balance under which all assets yield the same
expected return after adjusting for risk, maturity, and liquidity differences.
Hence, when the Fed adjusts its target for the federal funds rate, all
other short-term interest rates tend to move with it. Indeed, some short-term
interest rates may change in anticipation of the change in the target.
Controlling the federal funds rate
 Over
time, the Fed can hit its interest rate target on average. The degree
of control that it exercises over the federal funds rate in the very short
run, however, is limited. Figure 1 shows the short-run volatility in the
average daily federal funds rate, which reflects several features of the
market. In recent years, the Fed has restricted its (temporary) open market
operations to one intervention per day (if at all). The size of this intervention
corresponds to the anticipated reserves need of depositories. However,
actual supply and demand for reserves can differ from what is anticipated.
Shocks to banks' demand for federal funds arrive throughout the day, while
daily shocks to the supply of federal funds originate with unanticipated
changes in Treasury balances maintained at the Fed, along with changes
in banks' demands for currency. To the extent that these demand and supply
shocks are not completely offset by open market operations, the federal
funds rate will deviate from its target. The larger and more frequent
are the shocks relative to the overall volume of bank reserves, the greater
is the volatility in the federal funds rate (Hamilton 1996, Furfine 1997,
and Bartolini, et al. 2002).
Factors that influence how responsive the federal funds rate is to shocks
include the relative importance that banks attach to various functions
that bank reserves perform, along with the opportunity cost, or lost interest
income, that banks incur from holding positive reserve balances, which
are legislated to be non-interest bearing. Currently, most banks must
hold reserves in the form of vault cash and deposits at the Fed as a certain
percentage of their checkable deposit account liabilities. These requirements
must be met on average over a two-week reserve maintenance period, with
allowance for some carry-forward provisions (Feinman 1993). The final
day for adjusting reserves to meet required reserves is known as "bank
settlement day" and is normally characterized by heightened activity
in the federal funds market (Clouse and Dow 2002).
Banks face a modest penalty for intraday overdrafts on their reserve
accounts (Coleman 2002) and a very stiff penalty on overnight overdrafts
(400 basis points above the market rate). Avoiding overnight overdrafts
can be difficult for banks, since they do not have full control over the
timing and magnitude of outflows from their reserve accounts that are
required to settle transactions. This unpredictability gives rise to a
precautionary demand for reserves. Banks also may voluntarily agree to
hold what are (perhaps, unfortunately) termed "required clearing
balances" at the Fed on which they earn an implicit interest rate
in the form of "earnings credits" that can be applied toward
the purchase of the Fed's financial services, such as check-clearing.
The demand for required clearing balances is generally limited by the
volume of services purchased and is less interest-sensitive than the precautionary
holdings. Failure to maintain the committed required clearing balances
also may result in both pecuniary and nonpecuniary penalties (Clouse and
Elmendorf 1997).
The discount window rule changes
Currently, eligible depository institutions can borrow directly from
the Fed's discount window to meet short-term unanticipated liquidity needs.
One category of these (collateralized) loans, termed "adjustment
credit," comprises loans that are usually overnight in maturity and
are made at an administered interest rate, termed the discount rate. However,
for reasons described below, banks make only limited use of the discount
window for adjustment credit borrowing. The discount window also is used
for seasonal borrowings, mostly associated with agricultural production
loans, and for "extended credit" for banks with longer-maturity
liquidity needs resulting from exceptional circumstances.
Under current operating procedures, the discount rate normally lies
25 to 50 basis points below the federal funds rate. To prevent banks from
trying to exploit the spread between the federal funds rate and the discount
rate, the Fed requires that banks present a need for funds that is appropriate
to the discount facilities' intent (Clouse 1994). For example, a discount
window loan would not be granted to enable a bank to conclude planned
investment or loan opportunities. In addition, banks are expected to have
exhausted all other reasonable sources of credit before borrowing from
the window and should expect to face greater regulatory scrutiny if they
borrow at the window too often. Due to these nonpecuniary costs, many
banks have become reluctant to borrow at the discount window for adjustment
credit, concerned over a perceived "negative signal" that this
action would send. Currently, the volume of borrowed reserves is less
than 1% of total reserves.
An important change in the administration of the discount window that
is being proposed by the Fed is to set the discount rate above the federal
funds rate target. This could allow for more reliance on explicit market
pricing to determine the volume of discount window borrowing and remove
the perceived stigma to borrowing. That is, eligibility requirements would
be streamlined and rendered consistent with reliance on the discount window
as a relatively unfettered source of liquidity for financially sound banks
during tight money market conditions that would otherwise result in a
spike in the federal funds rate.
The initial proposal sets this cap at 100 basis points above the federal
funds rate target. As suggested by Figure 1, historically, this cap would
have been breached by the average daily federal funds rate only about
1% of the time, with roughly half of those days coming on bank settlement
days. However, the frequency with which individual trades throughout the
day would have exceeded the cap is significantly higher. For example,
the closing federal funds rate would have exceeded this cap approximately
4% of the time. As banks adjust their reserve management practices under
the new operating procedures, this cap could become binding more frequently
than history would suggest. In any case, the average daily cost of federal
funds to banks should be reduced and the federal funds rate should remain
closer to the Fed's target.
This rule change is expected to have several benefits. First, providing
a cap on the federal funds rate by endogenously supplying reserves to
meet high periods of demand should reduce interest rate volatility. This
may become more significant as continual financial innovation would otherwise
further reduce banks' required reserves and render the demand for reserves
more interest inelastic, as required clearing balances assume a larger
share of the total demand for reserves (Clouse and Elmendorf 1997). Second,
the simplification of discount window borrowing procedures should lead
to reduced administrative costs. Third, these simplifications also will
help clarify the intent of individual discount window regulatory decisions,
since less subjective assessment is required. Finally, monetary policy
could be rendered more effective, to the extent that the discount rate
can become a tool for capping the federal funds rate. This cap can be
adjusted to keep the federal funds rate close to the target value, where
"close" is determined as a matter of monetary policy decisions
that reflect current market conditions.
Milton Marquis
Senior Economist
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