Why Is the Effective Fed Funds Rate Below the Theoretical Floor?
Journal of Applied Finance, Vol. 24, No. 2, 2014, pgs. 61-69
9 Pages Posted: 29 Oct 2015
Date Written: 2014
Starting on December 18, 2008 the Federal Reserve began paying 25 basis points (bps) on the reserves of depository institutions. Theory argues that the rate paid on reserves establishes a floor for the federal funds market. Nonetheless, the effective federal funds rate has stayed well below this theoretical floor value, on occasion by as much as 18 bps. This suggests the possibility of an arbitrage opportunity. This paper offers an explanation of this ongoing puzzle by explaining the limits to arbitrage and arguing that the anomaly persists, in part, due to costs associated with the Federal Deposit Insurance Corporation (FDIC) assessment on the liabilities of depository institutions and capital charges. The size of the difference is also found to increase with the Federal Reserve’s quantitative easing programs.
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