Last Wednesday the Federal Reserve announced that it is increasing its target for the fed funds rate to a new range of 25 to 50 basis points (0.25% to 0.5% annual rate). How does the Fed plan to accomplish this, and what does it mean for other interest rates?

The fed funds rate is the interest rate on an overnight loan of Federal Reserve deposits (accounts held at the Fed) between depository institutions. Because this is a market rate between private parties, the Fed does not control it directly. In the old days, the Fed controlled it indirectly by making use of the fact that the fed funds rate was very sensitive to the quantity of excess reserves (deposits held in excess of requirements). The Fed could change excess reserves directly by increasing or decreasing the supply of deposits through open-market operations. The Fed would pay for a Treasury security that it purchased through an open-market operation by creating new deposits, and the new excess reserves would depress the fed funds rate that emerged in equilibrium. That worked when excess reserves were around $5 to $10 billion. Today we’re talking about $2.5 trillion in excess reserves. Changing excess reserves today by a few hundred billion doesn’t matter in the slightest for the fed funds rate.

Instead of open-market operations, one of the key new tools of monetary policy is the interest rate that the Federal Reserve pays on deposits kept overnight on account with the Fed. This rate had been 25 basis points and was raised to 50 basis points on Wednesday. One’s first thought would be that this interest rate should put a floor under the fed funds rate. Why would I accept less than 25 basis points on a potentially risky loan to another bank when I could earn 25 basis points just by letting the funds sit idle in my Fed account without risk? But it’s clear that the system hasn’t worked that way. The average fed funds rate over the last two years has only been around 10 basis points, despite the 25 bp banks could earn just by sitting on the excess reserves.