from the New York Fed
— this post authored by John P. McGowan and Ed Nosal
The Federal Open Market Committee (FOMC) uses the federal funds rate as its policy rate to convey the stance of monetary policy and has done so for decades. Nominal changes in the rate are expected to be transmitted broadly to other financial markets to have the desired effect on overall employment and inflation expectations in the United States.
Prior to the 2007 financial crisis, trading in the fed funds market was dominated by banks.1 Banks managed the balances – or reserves – of their Federal Reserve accounts by buying these balances from or selling them to, each other. These exchanges between holders of reserve balances at the Fed are known as fed funds transactions. The amount of excess reserves in the banking system – total reserves minus total required reserves – was very small and banks actively traded fed funds in order to keep their reserves close to the required amount. When a bank’s reserves exceeded what was required, it sold fed funds; when it fell short, it bought fed funds. Starting in 2008, the amount of excess reserves in the banking system increased dramatically, first with the Fed’s provision of liquidity in response to the financial crisis, then with large-scale asset purchases conducted by the Fed’s System Open Market Account (SOMA). This increase in reserves resulted in a fed funds market that looked quite different than it did pre-crisis.
In this article, we describe conditions in the fed funds market that prevailed in the post-crisis “abundant reserves” period. We define this period as starting in 2010 and ending in early 2018, a few months after the FOMC began to redeem assets in the SOMA portfolio, which in turn reduced the level of reserves. In particular, we note that the very large increase in excess reserves in the post-crisis period changed both the types of participants that were active in the fed funds market and their motivations for participating. We also observe that day-to-day volatility in the effective federal funds rate (EFFR) decreased significantly in this period.2 In light of these changes, we examine whether the EFFR remained well connected to other short-term wholesale funding rates.
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