How Reverse Repo and IOER Influence Overnight Rates
Summary
The document discusses how Federal Reserve facilities and administered rates affect overnight money markets and the yield curve. It distinguishes the reverse repo facility, described as supporting a floor, from interest on reserve balances, which can act as an effective ceiling. As overnight rates approach the reverse repo rate, activity at the facility can absorb cash and add collateral to the market, helping limit downward pressure on rates.
The explanation of interest on reserve balances is that banks with substantial excess reserves can shift funds toward higher yielding overnight lending when market rates rise above the administered rate. That behavior adds cash to those markets and can push rates back down. The ceiling is therefore indirect and depends on banks having significant reserves available. The exchange offers a concise account, not a full treatment of all monetary policy tools or market conditions.
Key ideas
- The reverse repo facility can support a floor under overnight rates by absorbing cash as rates approach its rate.
- Interest on reserve balances can act as an indirect ceiling by encouraging banks to lend cash when market rates are higher.
- The ceiling effect depends on banks holding significant excess reserves.
- The exchange focuses on overnight rate mechanics and does not provide a comprehensive account of monetary policy.
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# Monetary Policy and the Yield Curve PART TWO # Monetary Policy and the Yield Curve PART TWO The Fed has a number of tools/targets with which they manage monetary policy. I'm looking to refine a concise summary of them and looking for guidance/correction/validation. Think I understand these first three. Please correct me if I'm wrong: - Open Market Operations: The Federal Open Market Committee (FOMC) will often instruct the Federal Reserve Bank of New York to engage in open market operations (buying and selling of US securities) to influence interest rates. Movement at all maturities on the yield curve can reflect such operations; the Fed has been known to try and alter the shape/slope of the curve. I'm looking for further confirmation/understanding no the next two: - The reverse repo program, which enables it to set a floor under short-term secured borrowing rates. This makes sense: reverse repo = sell security, collect payment from bank, reduce their fed reserve balance, decrease supply of money in the system and put upwards pressure on the federal funds rate for example. Is this logic correct? - The interest rate on excess reserves (IOER); from comments on my prior question, I understand that this rate sets the ceiling for fed funds. IOER = interest paid on balances above the required level; how does that set a ceiling? Sounds more like a floor; for a bank to lend its excess reserves, they would want a higher rate than the IOER? This is a follow on from part one which was posted here. ## Answer by Alex C (score 1) https://quant.stackexchange.com/a/22998 According to money market expert Scott Skyrm: quote The FRRP provides a floor to the market because as overnight rates approach the FRRP rate, more volume is executed at the facility and more collateral is added to the market, removing cash. The IOER acts as a ceiling in the overnight market by adding cash, though indirectly. When market rates like fed funds and GC Repo trade above the IOER, banks will move cash out of Excess Reserves and into fed funds or GC Repo to maximize their overnight investments, effectively driving those rates lower. Therefore, it’s important to note, the IOER is an effective upper rate band, but only while banks have significant Excess Reserves stored at the Fed. End quote
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