The Mechanics of a Graceful Exit: Interest on Reserves and Segmentation in the Federal Funds Market

65 Pages Posted: 9 Mar 2011

See all articles by Elizabeth Klee

Elizabeth Klee

Board of Governors of the Federal Reserve System

Morten L. Bech

Bank for International Settlements (BIS) - Committee on Payments and Market Infrastructures

Multiple version iconThere are 2 versions of this paper

Date Written: February 1, 2010

Abstract

To combat the financial crisis that intensified in the fall of 2008, the Federal Reserve injected a substantial amount of liquidity into the banking system. The resulting increase in reserve balances exerted downward price pressure in the federal funds market, and the effective federal funds rate began to deviate from the target rate set by the Federal Open Market Committee. In response, the Federal Reserve revised its operational framework for implementing monetary policy and began to pay interest on reserve balances in an attempt to provide a floor for the federal funds rate. Nevertheless, following the policy change, the effective federal funds rate remained below not only the target but also the rate paid on reserve balances. We develop a model to explain this phenomenon and use data from the federal funds market to evaluate it empirically. In turn, we show how successful the Federal Reserve may be in raising the federal funds rate even in an environment with substantial reserve balances.

Keywords: Federal funds, segmentation, interest on reserves, corridor system, exit strategy

JEL Classification: E4, E58, G21, G28

Suggested Citation

Klee, Elizabeth and Bech, Morten L., The Mechanics of a Graceful Exit: Interest on Reserves and Segmentation in the Federal Funds Market (February 1, 2010). FEDS Working Paper No. 07, Available at SSRN: https://ssrn.com/abstract=1782039 or http://dx.doi.org/10.2139/ssrn.1782039

Elizabeth Klee (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th and Constitution Ave NW
Washington, DC 20551
United States

Morten L. Bech

Bank for International Settlements (BIS) - Committee on Payments and Market Infrastructures ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland
41612808923 (Phone)

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