Monday, March 14, 2011

Understanding the Fed Funds Rate in Relation to Treasury Bills

EPJ reader Andrew Mackenzie emails;
Could you expand on the significance of the Fed Funds Rate being above the one month yield on treasury bills a little more, for those of us who aren't as knowledgeable about money and banking as we probably should be?
Is it because the Federal Government could simply borrow from the fed, as a bank would, rather than issuing treasuries?

I'm very interested in this topic, because I believe I've heard you bring it up before. I suspect some of your more amateur readers may be as well.
The key really is the interest rate the Fed pays on excess reserves, currently 0.25%. At this rate, there is no incentive for banks to buy short-term Treasury bills and put the money into the system, with one month T-bills yielding 0.07%. It makes more sense for banks to just keep it out of the economy at the Fed at 0.25%, if they are looking for absolute, short-term, safety.

I used the example of the Fed funds versus the T-Bill rate because Krugman used Fed Funds. The Fed Funds interest rate is currently at approximately 0.15%. It is lower than the rate on excess reserves becasue there are some financial institutions that can operate in the Fed Funds market but can not earn interest at the Fed on excess reserves---otherwise the two rates would be equal.

If the Fed lowered the rate on excess reserves below the current T-Bill rate of 0.07%, it would also push the Fed funds rate down to at least the same rate as excess reserves, since some banks would move funds from excess reserves to the Fed funds rate to catch the higher yield and push that rate down. This would add money to the system. So my use of the Fed Funds rate was just a short-cut to keep the post flowing without getting into too much detail.

Currently, though, with the Fed paying interest on excess reserves at 0.25%, far above the rate on T-bills, there is no reason for money on excess reserves to enter the system.

I hasten to add that the importance of the interest rate on excess reserves only came about because of the introduction by Fed Chairman Bernanke, as one of his new "tools", the payment of interest on excess reserves. Before the introduction of this tool, the Fed always acted directly on Fed funds by draining or adding funds via the purchase or sale of Treasury securities. 


  1. So what is the Fed fund rate then if it is not in reference to banks earning money by keeping their excess reserves at the Fed? Besides my burning question, it was a great explanation.

  2. I consider myself a pretty smart guy and amateur Austrian economist. Is it me or is it just difficult to understand these ridiculous financial machinations which appear to be designed to stealthily siphon wealth in favor of government and banksters?

  3. The fed funds rate is the interest rate at which banks lend balances (federal funds) at the Federal Reserve to other depository institutions, usually overnight, i.e. the interest rate banks charge each other for loans

  4. James--I'm not an expert, but my understanding is the Fed Funds rate is the rate banks charge each other for overnight loans should they need cash to maintain their required reserves. The Discount rate is the rate the Fed charges banks for short term loans to meet reserve requirements, and Interest On Excess Reserves is the rate the Fed pays on funds deposited above the minimum reserve requirement. (if I've got any of this wrong, someone please correct me)

  5. Danger Pioneer and Allen are correct.

  6. I am a senior manager at a small bank. If the Fed eliminated the 25 bps, we would then take our excess liquidity someplace else, like we did before the crisis. However, we live in a different world now where rates are low and risks are high. I can say with certainty that the Fed has worked it out where capital is directed toward the public sector--they are essentially using our excess liquidity to fund QE2. A look at the Fed's balance sheet would indicate this. {Google: Frb H.4.1. for the weekly report that comes out every Thursday]