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With several recent increases in the (U.S.) Federal Reserve's target rate, and accompanying news releases, I was refreshing my knowledge on how those changes actually operate. In the course of doing that I tried to look up what current bank reserve requirements are and saw that as of March of 2020 the net transaction accounts reserve requirement was 0%, and is likely to remain so.

With reserve requirements at 0% it seems like normal open market operations don't have a lot to operate upon when trying to change the federal funds rate, which the recent target rate increases are an attempt to do. If the penalty for inadequate reserves is gone, what would banks be lending to each other overnight for?

Googling on my own has not produced much information on this. Are there other types/categories of reserve which still apply, maintaining the target rate/federal funds rate relationship? Is the primary lever of policy now the interest on reserve balances (IORB) creating a floor on acceptable yield for other dispositions of money, and if so, how does that interact with open market operations and the target rate?

I apologize if any of my questions or underlying understanding are way off base-- this is not my area of expertise at all.

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Yes the reserve requirement in US is zero (see Fed).

If the penalty for inadequate reserves is gone, what would banks be lending to each other overnight for?

There is still reason for banks to keep reserves. They still have to meet liquidity requirements (see Fed). Prior to 2020 (mandatory) reserves were not able to be used to fulfill liquidity requirements, but free reserves were able to be used to do this. Post 2020 all reserves became free reserves.

If the bank issues a loan (and majority of loans are illiquid) they still have to somehow get some liquid assets to fulfill their liquidity requirements. The most easiest way how to do that is to borrow overnight.

Is the primary lever of policy now the interest on reserve balances (IORB) creating a floor on acceptable yield for other dispositions of money, and if so, how does that interact with open market operations and the target rate?

No, Fed still targets federal funds rate not IORB (see Fed).

IORB also does affect federal funds rate. As explained by Fed:

Because banks can always deposit their money at the Fed and earn the IORB rate, banks see the IORB rate as a reservation rate. In other words, they won’t be willing to lend their money for less than the IORB rate. Further, if banks see differences between the IORB rate and the federal funds rate – they will use arbitrage to profit from the difference. And those transactions will close any significant gap between the IORB rate and the federal funds rate.

how does that interact with open market operations and the target rate?

OMOs are way for Fed to directly increase money supply. Federal funds rate is in essence a price on the market for reserves. As you may already know from economics 101, you cannot just arbitrary set price on a market as if you set it above/below equilibrium level you will create shortages/surpluses on the market. Consequently, Fed always has to make sure that money supply is appropriately adjusted. Money supply is endogenous so part of that adjustment happens automatically as private banks change their lending but if Fed feels that more money needs to be injected to support their federal funds rate target then they can use OMOs.

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  • $\begingroup$ Thank you! I was conflating mandatory reserves with liquidity requirements, which is where the confusion about how OMOs would affect banks if neither were required. Glad to know I wasn't totally off base! $\endgroup$
    – Upper_Case
    Nov 4, 2022 at 20:48

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