Monetary Policy, Part 3: Reservation Rate and Arbitrage

OVERVIEW

This video assignment explains that the interest on reserve balances rate acts as a reservation rate for banks, and explains how arbitrage ensures that it is an effective tool for steering the federal funds rate into the FOMC’s target.

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Answer Key

Grade Level

High School College

Topics

Monetary Policy & The Federal Reserve

In the last episode you learned that banks can earn interest on their deposits at their Federal Reserve Bank, or they can earn interest by lending to other banks in the federal funds market. When banks hold funds in reserve balance accounts at the Fed, they earn the interest on reserve balances rate. When banks lend funds to other banks from their reserve balance accounts, they earn the federal funds rate.

So, when banks have excess funds, they look across these two options to decide the best place to invest them. Because of this choice, the Fed uses the interest on reserve balances rate to steer the federal funds rate into the FOMC’s target range. The Fed knows the interest on reserve balances rate will steer the federal funds rate into the target range because of two economic forces, reservation rate and arbitrage. Let’s see how each of these forces work.

The first thing to understand is what is a reservation rate. A reservation rate is the lowest rate of return that a bank is willing to accept for lending out its funds. Because a bank earns interest on the funds in its reserve balance account, there’s really no need for it to lend these monies out for anything less than what it can get from the Fed.

Let’s look at an example. Suppose a bank has only two options to invest its funds overnight. Option one is to deposit its excess funds in its reserve balance account and earn the interest on reserve balances rate. And option two is to lend its excess funds to another bank in the federal funds market and earn the negotiated federal funds rate. These are both low-risk options for the bank to earn interest overnight.

What’s the choice the bank is most likely to make? It depends on the interest rates.

What if the interest on reserve balances rate is 2.5%, while the federal funds rate is around 2%? Well, the bank will most likely choose the first options. The bank will deposit its funds at the Fed and earn the higher rate.

In fact, because banks seek the best return for their money across similar risk and maturity options, they are unlikely to lend or invest in an overnight asset for less than it can earn by depositing at its Federal Reserve Bank. So, for banks, interest on reserve balances serves as a reservation rate -- the lowest rate of return that banks are willing to accept for lending out funds.

Now, how does the interest on reserve balances rate steer the federal funds rate? Meaning, in this case, help to pull the federal funds rate up? The answer has to do with arbitrage. Arbitrage here is the simultaneous purchase and sale of funds in order to profit from a difference in interest rates. Arbitrage ensures that the federal funds rate will stay near to the interest on reserve balances rate because arbitrage will close the gap between the two rates.

Let’s go back to our example: Recall option one has the interest on reserve balances rate at 2.5 percent and option two has the federal funds rate at 2 percent, the federal funds rate will be pulled up. Why? Well, in this case, banks will borrow funds in the federal funds market at a 2% rate and immediately deposit those same funds at the Fed and earn 2.5% rate. This action is arbitrage. The profit is 50 basis points, or ½ percentage point, for every dollar invested.

Now, any bank can do this—borrow in the federal funds market and deposit those funds at the Fed to earn a profit.

When more and more banks want to borrow in the federal funds market, the competition for loans increases and lenders will to start charge a bit more. That is, the federal funds rate will start to rise. In fact, arbitrage should continue until the federal funds rate rises to a level that banks no longer have the opportunity to profit.

So, arbitrage ensures that the federal funds rate never falls too far below the interest on reserve balances rate. And arbitrage would also ensure that the federal funds rate would never be too far above the interest on reserve balances rate.

Given that these economic concepts are always working in the background, the Fed can effectively use interest on reserve balances to ensure market rates move as desired.

For example, When the FOMC increases the target range, the Fed raises the interest on reserve balances rate. Arbitrage kicks in to make sure the federal funds rate moves up toward the interest on reserve balances rate and within the range. Similarly, when the FOMC lowers the target range for the federal funds rate, the Fed lowers the interest on reserve balances rate, which encourages the federal funds rate to move down into the new target range.

Now we know how the Fed is able to steer the federal funds rate into the FOMC’s target range. Join us for Part 4 to learn how the Fed decides to set the policy rate to help move the economy toward its congressionally assigned dual mandate: maximum employment and price stability.