Is The Fed Draining Deposits?

The Federal Reserve is responsible for monetary policy, with a mandate to keep inflation close to 2%. It also regulates banks, with a mandate to sustain financial stability. One of its key programs may be placing those two goals at odds with one another.

Ever since 2008, the Fed has expressed its target for interest rates as a 25 basis point band. At the conclusion of this week’s Federal Open Market Committee (FOMC) meeting, that range was 5.00% to 5.25%. Actual interest rates are set by the markets, based on the supply and demand for money. The Fed’s task is to keep yields within its goal posts.

To keep a lid on the overnight rate, the Fed offers interest on deposits placed with it by banks. The theory is that banks will purchase funding from markets if they can earn a spread by reinvesting it. The interest rate on reserve balances (IORB) therefore contains the rates that banks are willing to pay for overnight borrowing. The IORB has typically been set near the top of the Fed’s targeted range.

To prevent overnight rates from falling below the bottom of the target band, the Fed established a reverse repurchase program (RRP) in 2015. Under this facility, the Fed takes in excess funding from select market participants for short periods, paying them an interest rate that is linked to the bottom of the target range. Those eligible would not be willing to sell their excess liquidity for less than the rate offered by the Fed, so the RRP places something of a floor on the cost of overnight money.