Lecture 1A: The interest rate corridor
Banks pay each other all day: when you transfer money to someone at another bank, your bank's account at the central bank goes down and the other bank's account goes up. Those accounts hold reserves. At the end of the day some banks have more reserves than they need and some have too few, so they lend to each other until the next morning: an overnight loan. The interest rate on those loans is the market rate (EFFR in the US, €STR in the euro area).
The central bank wants that market rate to sit where it decided. It cannot force banks to charge a particular rate to each other, but it can offer every bank two options of its own: earn interest by parking reserves at the central bank, or borrow reserves from the central bank at a higher rate. This chapter shows that those two options alone are enough to pin the market rate between them. If that sounds abstract, keep the picture of a parking garage with a fixed price next to a street where people haggle: nobody pays more on the street than the garage charges, and nobody accepts less than the garage pays.
How the central bank makes the market follow: the interest rate corridor
The central bank does not order banks to use a certain rate. Instead it offers two standing options to every bank: parking money at the central bank at one rate and borrowing from it at a higher rate. These two rates form a corridor, and the market rate stays inside it.
- The floor (the deposit rate): a bank with spare money can always deposit it at the ECB, completely safe, and earn 2.50%. Why would it lend to another bank, which carries some risk, for less? It would not. Suppose the market rate dropped to 2.40%: smart banks would borrow at 2.40% in the market and immediately deposit that money at the ECB at 2.50%, earning a free 0.10%. This arbitrage (profiting from a price difference without risk) creates lots of demand for market loans and pushes the market rate back up to about 2.50%.
- The ceiling (the lending rate): a bank that needs money can always borrow overnight from the ECB against collateral at 2.90%. So it will never pay another bank more than 2.90%.
- When the ECB changes policy, it moves all its rates together, and the market rate moves with them.
| Role | Fed | ECB |
|---|---|---|
| Floor | Overnight reverse repo (ON RRP), bottom of the range | Deposit facility rate (DFR) 2.50% |
| Rate paid on reserves | Interest on reserve balances (IORB), inside the range | DFR |
| Weekly loans | - | Main refinancing operations (MRO) 2.65% |
| Ceiling | Standing Repo Facility (SRF), top of the range | Marginal lending facility (MLF) 2.90% |
| Market rate | EFFR, inside the range | €STR, slightly below the DFR |
The "leaky" floor. There is one catch: only banks may deposit at the central bank. Other financial institutions, such as money market funds (funds that invest people's cash in very short-term loans), cannot. They still want a return on their cash, so they lend it to banks at slightly less than the deposit rate, say 2.45%. The bank deposits that money at the ECB at 2.50% and keeps the difference. Because of these deals, the measured market rate ends up slightly below the floor: €STR is a little below the DFR, and in the US the EFFR is a little below IORB.
- ECB: it has no facility for non-banks, so the leak remains.
- Fed: it added a second, lower floor for non-banks, the overnight reverse repo facility (ON RRP), where money market funds can lend to the Fed. With the Standing Repo Facility (SRF) as ceiling, the EFFR stays inside the target range.
The central bank sets a minimum (what you earn by parking money with it) and a maximum (what you pay to borrow from it). No bank accepts worse terms from another bank, so the market rate stays between the two. It dips just below the minimum because some lenders are not allowed to park money at the central bank.
Normally no bank pays 2.90% to the ECB when it can borrow from another bank for about 2.50%. The ceiling matters on bad days: if other banks do not trust a bank, or if the market is in panic (as in 2008), the ECB is the lender of last resort and the bank can still get money, against collateral, at 2.90%. The ceiling is there so that the market rate can never run away upward, however nervous the market gets.
From quantity to price: why it works this way today
| Before 2008: scarce reserves | Today: ample reserves |
|---|---|
| Banks held only small amounts of reserves, and those paid no interest. The Fed hit its target by changing the quantity of reserves: buying government bonds (paying with new reserves) or selling them, every day. These are open market operations. Because reserves were scarce, a small change in their quantity moved the rate. | Through quantitative easing (QE), central banks bought huge amounts of bonds and created enormous reserves. With so many reserves, adding or removing some no longer changes the rate. So the central bank now sets the price directly: the interest it pays on reserves and deposits (IORB, ON RRP, DFR). |
In the past the central bank changed the quantity of money to hit the interest rate; today it sets the rate directly, through the interest it pays.
In the data: until 2008 the Fed had one target number (series DFEDTAR); since December 2008 it has a target range with an upper and lower limit (DFEDTARU and DFEDTARL).
Andere hoofdstukken van International Monetary Relations and Policy
- Lecture 1A: The basics and the course
- Lecture 1A: Central bank mandates and the policy rate
- Lecture 1A: The Taylor rule and the Taylor principle
- Lecture 1A: Using the Taylor rule in practice
- Lecture 1B: The balance of payments
- Lecture 1B: Reading current accounts and trade wars
- Lecture 1B: The NIIP and valuation changes
- Lecture 1B: The NIIP-NII paradox
- Lecture 1B: Common mistakes and summary
- Lecture 2A: Why build the New Keynesian model
- Lecture 2A: Households: the Euler equation and labor supply
- Lecture 2A: Firms: demand, markups and sticky prices
- Lecture 2A: From marginal cost to the three equations
- Lecture 2A: How the model works: transmission and shocks