Module 4, Section 8: Central Bank Operations in the New Norm

Overview of Module 4, Section 8: Central Bank Operations in the New Norm, which discusses the evolution of the Fed's monetary policy operations, particularly the transition from a "corridor policy" to a "floor policy" following the 2008 financial crisis.

Main Themes

1. Shift from Corridor Policy to Floor Policy

• Corridor Policy (Pre-2008): This regime operated when reserves in the banking system were scarce. The Federal Reserve used Open Market Operations (OMO) (buying and selling government securities) to adjust the money supply and steer the Federal Funds Rate (FFR) towards its target.
• Floor Policy (Post-2008): The period of significantly accommodative monetary policy, including Quantitative Easing (QE), led to an abundance of Reserves in the banking system. In this environment, changes in the money supply no longer significantly impact the FFR, as banks already hold all the Reserves they desire. The Fed now primarily influences the FFR by adjusting the interest rate paid on overnight Reserve Balances (IORB) held at the Central Bank and the interest rate offered on Overnight Reverse Repos.

2. Key Policy Rates Used in the Floor Policy

• Interest on Reserve Balances (IORB): Only available to banks, this is the interest rate the Central Bank pays to banks on their Reserve balances (similar to the interest rate your bank pays you for your deposits). IORB determines the lowest interest rate a bank would be willing to lend their Reserves because banks have no incentive to lend Reserves at a rate lower than what they can earn by keeping them risk-free at the Central Bank.
• Central Bank Overnight Reverse Repurchase Rate (ON RRP): Available to a broader range of financial institutions such as money market funds (in the US, these institutions must be approved by the Federal Reserve Bank of New York), this is the rate the Central Bank pays for reverse repos. It is conceptually equivalent to the IORB (an entity gives the Central Bank money for a short amount of time and the Central Bank pays them interest), but for a larger group of financial institutions and set slightly lower than the IORB. Analogous to the IORB for banks, the Overnight Reverse Repo rate is the lowest rate at which these non-bank financial institutions would be willing to lend their excess cash.
• Discount Rate: As in the corridor range, the discount rate is the rate at which banks can borrow directly from the Central Bank and is intentionally set above the Federal Funds target rate so that it is only used as a last resort.

3. Mechanism in which the Federal Funds Rate is Managed

• As non-bank financial institutions (such as money market funds) market do not have access to the IORB rate, they lend to banks at rates below the IORB, because doing so still offers a better return than lending through the Fed’s Overnight Reverse Repurchase facility, which offers a slightly lower rate.
• Banks remain the primary borrowers in the federal funds market. But rather than borrowing to meet liquidity needs, they do so to profit from arbitrage. Specifically, banks borrow cash from nonbanks at rates below IORB (for example, from a money market fund at 5.30%), and then immediately redeposit those funds at the Fed to earn IORB (e.g. 5.40%), capturing the spread as risk-free profit.
• The federal funds rate is then pinned down between these two rates and reflects the price nonbank institutions are willing to accept for lending cash, and banks are willing to pay, to facilitate this arbitrage.

4. The New Norm

• The floor policy is expected to remain in place until the excess reserves created by QE are reduced. This unwinding is