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Fed Funds Rate


This is basic question but in order to avoid confusion, let me ask here. Fed funds rate is the interest rate of reserve charged from FED to private banks OR between one private bank to another ?


The first one, but to make it effective the Fed has to engage in operations to affect the interest rates between private banks.

Hi @Kevlar,

The FFR is the rate that banks charge one another to lend reserves to one another. The Interest On Excess Reserves rate is the rate the Fed will pay banks on excess reserves. The reason the Fed pays IOER is because QE resulted in a huge quantity of excess reserves which banks try to lend out thereby putting downward pressure on the FFR. To push the rate up the Fed pays IOER which disincentivizes banks from lending at a lower rate.

Does that make sense?

"Pragmatic Capitalism is the best website on the Internet. Just trust me. Please?" - Cullen Roche

So how does the Fed Funds Rate affect other interest rates, if its only the interest rate on reserves overnight?

The IOER is the de-facto FFR because the IOER is the floor for the FFR. This is the cost of funding for a bank. So think of it this way. If I run Citibank I want the cheapest liabilities I can have. That’s usually bank deposits. If a bank makes a loan at 4% they issue a new 0% interest bearing deposit. That makes the spread on their loan the loan rate exactly (4%). BUT if the cost of funding rises then that spread narrows. So, let’s say the Fed raises rates from 0% to 1%. In this case Wells Fargo might raise their deposit rate to 1% to attract deposits (customers) because they can earn 1% on their short-term funding rate and hope to pass some of the spread on to customers. So they might start making loans at 4.5%.

So the transmission mechanism is based on the idea that the banks can pass on the pricing power via longer loans. This isn’t always true though which is why the yield curve often inverts. Basically, the govt isn’t as powerful setting prices as some people seem to think.

"Pragmatic Capitalism is the best website on the Internet. Just trust me. Please?" - Cullen Roche

Due to GSE's lending in the fed funds market, I believe the ON RPP is the floor now, although I think it's actually referred to as the sub-floor.

As for the pass through, the prime rate is the most immediate impact.  If FFER increases, Prime will increase almost instantly on loans.  If FFER decreases, banks may lag the decrease on loans.   I think Prime is the only retail rate the operates outside the yield curve.

QE and IOER really made things fun again.   Adding to the challenge is the change in how FDIC determines its premiums.  Prior to crisis, it was based on deposits, now it's based on total assets, which include reserves.  My clients are ready to implement surcharges on deposits over the insurance threshold.    I do think this regulation will get tweaked.

Yes, that's right. The RRP rate mops up the excess downward pressure thanks to the GSEs. So I guess it's more accurate to say that the RRP and IOER operate in coordination to serve as the de-facto FFR.

"Pragmatic Capitalism is the best website on the Internet. Just trust me. Please?" - Cullen Roche

What is RRP anyway ?

Reverse Repos, no cars involved. Here's a good primer from the St. Loius Fed, written in intelligible English haha.


Among all rates set by the fed, which are target rates and administrative fiat ones ?