How IOER and Reserve Demand Can Affect the Federal Funds Rate
Summary
The document asks how setting interest on excess reserves (IOER) to zero might affect the federal funds rate (FFR). It describes a possible incentive channel: IOER offsets some of the cost to a borrowing bank of obtaining reserves in the federal funds market. Removing that return could alter banks’ willingness to borrow and lend, potentially placing downward pressure on the market rate. The response agrees that the rate could move close to zero if reserve holders were willing to lend at any positive rate.
However, the answer emphasizes that reserve demand is not limited to regulatory minimums. Banks may hold additional balances as a buffer against liquidity shocks, and some institutions with such balances may still borrow reserves. If the central bank does not supply enough reserves to meet this demand, the FFR could rise even with zero IOER. The document provides no predictive formula or quantitative evidence linking IOER, the discount rate, and reserve supply, so it presents a qualitative mechanism rather than a calibrated rate forecast.
Key ideas
- IOER may influence the incentive to borrow or lend reserves in the federal funds market.
- Setting IOER to zero could put downward pressure on FFR if reserve holders offer funds at positive rates.
- Banks may demand reserves beyond required minimums as protection against liquidity shocks.
- Limited reserve supply can push FFR higher even when IOER is zero.
- The discussion gives a qualitative explanation, not a formula for forecasting rate changes.
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Full text
# Would FFR fall if the Fed set IOER to 0? # Would FFR fall if the Fed set IOER to 0? Even though we're currently in a corridor system and not a floor system (since FFR > IOER), if Interest On Excess Reserves were set to 0, wouldn't that cause the Federal Funds Rate to drop considerably? I'm thinking that even though FFR > IOER, IOER is still supporting FFR because it lowers the cost of holding excess reserves, increasing demand for interbank loans. If IOER were set to zero, the cost of borrowing reserves would increase because it would no longer be offset by IOER. For example, if bank A loans reserves to bank B, B is paying 1.55% (FFR) interest to A, but B is collecting 1.50% (IOER) interest on its reserves, so the loan is only costing B 0.05% interest. If IOER were zero, the loan would cost B the full 1.55% and might not be worth it anymore. I guess the best answer would be a formula that can predict changes to FFR from changes in IOER, the discount rate and supply of reserves. The graph depicted here shows a relationship between the three, but I'm wondering what that graph would look like if the IOER parameter were changed. ## Answer by dm63 (score 1) https://quant.stackexchange.com/a/49747 I agree with you- if IOER were set to zero, any bank that had excess reserves would prefer to loan them in the Fed funds market at a rate above zero, if that existed. Perhaps a small positive Fed funds rate could exist, but not significantly above zero. There is a genuine question as to what "excess" means nowadays. Traditionally it meant reserves in excess of Required Reserves set by the central bank. However banks nowadays want to hold additional reserves to satisfy regulators that they can withstand various potential liquidity shocks, so some banks with "excess" reserves can be seen to be borrowing additional reserves in the Fed Funds market. If the Fed does not supply these additional reserves, the Fed Funds rate could spike even if IOER is set to zero.
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