The Fed is a Market Whale
Reading about the Fed and their decisions (or “monetary policy”) in the press used to make me feel stupid. It shouldn’t.
The Fed has a few levers: they pull them, and interest rates move. The complexity is theater designed to obscure a simple market-making operation.
Here's how the machinery actually works.
The Overnight Funding Marketplace
Every night, the U.S. banking system runs a massive settlement process.
Banks that took in more deposits than they lent out have excess cash. Banks that lent more than they collected, need to borrow. This creates an overnight funding market where banks borrow and lend cash for just 24 hours.
The average rate at which these transactions occur is called the Effective Federal Funds Rate, or “Fed funds”. This rate is what economists are referring to when they talk about “U.S. interest rates”.
Unlike other central banks, (like the Bank of England, for example) the Fed doesn’t set a “bank rate”. Instead, JPow exerts his influence on the Fed funds rate indirectly, setting a “Fed funds target range”. The target range is currently 4.25% to 4.5%.
The Fed's Boring Toolkit
JPow enforces his target range by tweaking three key rates, at which he is prepared to trade in enormous size.
Interest on Reserve Balances (IORB): The Fed borrows money at 4.4% from certain banks overnight.
Basic incentive design: if you want less of something (bank lending, which leads to more dollars swilling around in the economy at large), make the alternative (parking dollars at the Fed) more attractive.
Overnight Reverse Repo (RRP): Money market funds can lend risk-free to the Fed at a guaranteed rate of 4.25% (the “lower limit”). As a result, nobody will lend to a bank for less. At peak usage in summer 2022, over $2.3 trillion was staked here daily.
Standing Repo Facility (SRF): Likewise the Fed provides an overnight collateralized loan facility at 4.5% (the “upper limit”). The SRF creates a price ceiling - banks won't borrow from each other above 4.5% when they can borrow from the Fed at that rate.
Quantitative Easing (QE)/Tightening (QT): This is another trick up JPow’s sleeve to control how many dollars are flowing through the economy.
If the Fed thinks that hiking or cutting short term rates is not enough to achieve their goals, they can buy (QE) or sell (QT) U.S. bonds.
In QE, the money given to the banks by purchasing bonds from them can be distributed to businesses and consumers, stimulating economic growth. This also means QE can cause inflation, messing with the price stability mandate we discussed earlier.
Forward Guidance: JPow.
Markets hang on his every word, because the Fed has built credibility over decades. When Powell says rates are going higher, people believe him, and trade accordingly.
Watch out for the dot plot after the next Fed meeting; this is a neat representation of where the FOMC squad expects monetary policy to head over the next few months.
The Corridor System
Here's the elegant part: the Fed doesn't have to do any trading in Fed funds to control the Fed funds rate. They just set the boundaries, at which they are the largest whale in finance, and lets the market find equilibrium.
To recap:
RRP at 4.25% = no one lends below this rate
SRF at 4.5% = no one borrows above this rate
IORB at 4.4% = banks prefer parking cash with the Fed unless they can get more elsewhere (although IORB isn’t open to all banks, and so it doesn’t act as a hard floor in the same way that RRP does)
The Fed funds rate trades between 4.25% and 4.5% (currently 4.33%) because no one would trade outside that range. The Fed has built a system where market participants voluntarily keep prices within the target range, because deviating would be irrational.
The Power of the Fed
The Federal Reserve has built an elegant system for controlling interest rates (hence USD supply) through market structure, rather than legislation.
Legislation is also an option, like changing income taxes. That’s called “fiscal policy”. Together, these levers help balance prices and U.S. economic growth. It’s powerful stuff - the Fed is independent from the government, for example, because administrations seeking re-election would try to get a quick growth boost by cutting rates, at the expense of long-term price stability.
The reason it works so well is that everyone knows the Fed is the biggest whale in markets; JPow’s good to trade in unlimited size to keep Fed funds exactly where he wants it.