How does the Fed ensure the realised overnight interbank lending right stays within the Fed Funds Rate band?

Question

I am trying to understand how the target FFR set by the FOMC is actually realised in the overnight lending market. That is, by what mechanism does the market driven overnight lending rate converge to the target FFR set by the Fed?

This source seems to indicate that it is open market operations that primarily drive the market rate. I think this makes sense, it seems this directly alters the available pool of reserves, so supply and demand factors start to weigh on the realised overnight lending rate.

This source on the other hand indicates that the primary mechanism the Fed uses to indirectly change the market rate is via the IORB and ON RRP. This also makes sense to me, but I think for a slightly different reason; I suppose with the IORB (and effectively with the IORB), banks would not want to lend to other banks at any rate lower than the IORB, and so this is a clear mechanism which influences the market rate to lying within the target band set by the Fed.

Which of these is the principal driver for getting market rates to fall in line with the FFR? I could see why both in tandem might work, but then why would the Fed be willing to pay interest on reserves, if it can achieve the same monetary policy effect by just controlling the supply and demand of reserves? I.e, couldn't they avoid paying any form of interest on reserves, and purely control liquidity via open market ops?

Answer 1

Since the advent of quantitative easing in the post 2008 era, Fed Funds has been mainly controlled as described by your second source. Prior to 2008 the first source was the primary control. Elaborating, since 2008 the banking system has had excess reserves due to QE, so the main problem is how to avoid Fed Funds dropping to zero under the weight of cash to be invested. The IOER and the RRP are designed for this purpose. If they weren’t there, the Fed would have to do a large amount of Open market operations in the repo market until they absorbed all the cash at the desired rate, but this is really the same thing as having a RRP facility.

Occasionally , even in the era of ‘excess’ reserves, banks have found themselves desiring more reserves to comply with various regulatory requirements or liquidity conditions. This happened in the fall of 2019, and in the spring of 2020. In that case, the Fed funds rate is pressured upwards. To deal with this, the Fed has put in place a standing repo facility by which they lend money in the repo market ) to bring the rate back down again.

The current balances of RRP and SRF can be found on Fed websites. Usage of SRF is very low but might expand as the Fed reduces its balance sheet in the next few years.