With the funds rate driven to levels far below its target, the FOMC had no recourse but to adjust the target accordingly.Federal Open Market Committee ; Monetary policy

Daniel L. Thornton

English

Research Papers in Economics

Economic SYNOPSES
short essays and reports on the economic issues of the day
2010 ■ Number 28
E
xcess reserves held by depository institutions are
currently in excess of $1 trillion. This situation raises
the question: Can the FOMC increase the funds rate
from its current level—between zero and 25 basis points—
without substantially reducing the supply of reserves? I
believe that it is unlikely. This synopsis explains why.
Since the late 1980s, the Federal Open Market Committee
(FOMC) has implemented monetary policy by setting a
target for the effective federal funds rate. Traditionally, it
was thought that the Fed controlled interest rates by chang-
ing the total supply of reserves through open market oper-
ations: An open market purchase of government securities
causes the funds rate to decline; an open market sale causes
the funds rate to rise. Since it was known that the FOMC
was targeting the funds rate and the FOMC began announc-
ing changes in policy in 1994, the Com  -
mittee has been able to control the funds
rate through open mouth operations—
that is, the FOMC simply announces the
target and the funds rate goes to the new
target level without the Fed having to
engage in open market operations.
The fact that the Fed has changed the
effective funds rate without significantly
increasing the supply of reserves is illus-
trated in Figure 1, which shows the
FOMC’s target for the funds rate, the
effective funds rate, and the level of total
reserves in the banking system for the
period January 2, 2007, through
September 29, 2008. The interest rate data
are daily; however, the reserves are avail-
able only biweekly. Note that the effective
funds rate stayed close to the 5.25 percent
funds rate target from January 2, 2007, to
the onset of the financial crisis, which I
date at August 9, 2007 (when the funds
rate first spiked above the target and then
fell below the target before the FOMC
reduced the target to 4.75 percent on September 18, 2007).
During this period, there was a slight upward drift in total
reserves. The FOMC then reduced the target by 325 basis
points in a series of seven moves with no appreciable change
in the growth rate of reserves. Moreover, the effective funds
rate tended to stay relatively close to the target until the
target change was announced, when it adjusted immediately
to the new target level.
Can the FOMC Increase the Funds Rate 
Without Reducing Reserves?
Daniel L. Thornton, Vice President and Economic Adviser
With the funds rate driven to levels 
far below its target, the FOMC 
had no recourse but to adjust 
the target accordingly.
6.0
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0
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8/2/2008
FOMC’s Target
Funds Rate
Total Reserves
Figure 1
An Illustration of Open Mouth Operations
Percent $ BillionsBeginning in late December 2007, the
Fed began lending a relatively large amount
of funds to financial institutions through
various new lending facilities created to
mitigate the effects of the financial crisis.
However, the Fed offset (sterilized) the
effect of this lending on total reserves by
selling an equivalent amount of govern-
ment securities so that these operations
would not affect total reserves. In any
event, the adjustment of the funds rate to
the target during this period produced no
significant change in reserves—the FOMC
controlled the funds rate using open mouth
operations.
Control of the funds rate though open
mouth operations changed dramatically
after the announcement on September 15,
2008, that Lehman Bros. would file for
chapter 11 bankruptcy protection. Follow  -
ing this announcement, Fed lending to
financial institutions increased dramati-
cally. The increased lending was so large that the Fed was
unable to continue its practice of sterilizing the effect of its
lending on reserves by selling government securities. As a
consequence, reserves increased dramatically: In the two
weeks from September 10, 2008, to September 24, 2008,
total reserves increased by $63.6 billion.
The fact that the FOMC could no longer control the
funds rate through open mouth operations is illustrated by
Figure 2, which shows the daily federal funds rate, the
FOMC’s funds rate target, and the 1-month overnight
indexed swap (OIS) rate from January 2, 2007, through
January 30, 2009. The 1-month OIS rate is a measure of
the market participants’ expectation of the overnight federal
funds rate over the next month.1 The vertical line denotes
September 15, 2008. Before September 15, 2008, not only
did the funds rate not change until the FOMC changed its
target, but the OIS rate moved in advance of the target
changes, suggesting that market participants anticipated the
FOMC’s actions. However, as noted above, the funds rate
did not change appreciably until the FOMC announced
the target was changed, when the funds rate changed very
quickly—frequently within minutes of the announcement.
These relationships changed dramatically after
September 15, 2008, however. The funds rate not only
moved in advance of the FOMC’s target, but it moved in
advance of the OIS rate as well. The reason is that the mas-
sive increase in the supply of reserves forced the funds
rate to decline relative to the funds rate target. From
September 10, 2008, to January 7, 2009, total reserves
increased by nearly $855 billion. With such a massive
increase in reserves, much of which was held in excess
reserves, the funds rate went to and stayed near zero. With
the funds rate driven to levels far below its target, the FOMC
had no recourse but to adjust the target accordingly.
Given the large amount of excess reserves, it seems
unlikely that the FOMC could increase the funds rate
through open mouth operations unless market participants
were convinced that the Fed would act to significantly
reduce excess reserves. In principle, the FOMC could raise
the funds rate target by simultaneously raising the interest
rate that it pays banks on reserves to the target rate. This
would be very costly, however, given the massive quantity
of reserves. Moreover, such an action could be viewed as
providing banks with a massive and unwarranted subsidy.
Consequently, it seems unlikely that the Fed would pursue
this alternative. Hence, I believe that if the FOMC wants
to increase the funds rate target, it must first significantly
reduce excess reserves. ■
1 For more details, see Daniel L. Thornton, “What the Libor-OIS Spread Says.”
Federal Reserve Bank of St. Louis Economic Synopses, Number 24, 2009;
http://research.stlouisfed.org/publications/es/09/ES0924.pdf. 
Economic SYNOPSES Federal Reserve Bank of St. Louis      2
research.stlouisfed.org
Posted on October 6, 2010
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
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FOMC’s Target
Funds Rate
1-Month OIS Rate
Figure 2
The End of Open Mouth Operations
Percent
9/2/2008
10/2/2008
11/2/2008
12/2/2008
1/2/2009

Can the FOMC increase the funds rate without reducing reserves?

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Can the FOMC increase the funds rate without reducing reserves?

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