A helpful description of the fed funds rate

Odd Lots interviewed Josh Younger of JPMorgan about the transition from LIBOR to SOFR.

Joe asked why the new benchmark couldn't just be a direct policy rate. Josh pointed out that the Federal Reserve's target policy rate -- the effective fed funds rate -- represents at most $75-$100bn of transactions per day. Although this is more than LIBOR, SOFR represents more than $1 trillion of underlying transactions.

Josh's description of the fed funds market was the clearest summary I've heard of it. Quoted below (slightly edited):

"The federal funds rate is actually not a direct policy rate ... it is the cost of borrowing reserves at the Fed / cash on an overnight basis from another bank. In the pre [financial] crisis days, the Fed would be the end borrower or lender to maintain a rate that was pretty consistent with their target ... in the wake of the crisis in 2008, they bought a ton of treasuries, mortgages, and agency debentures, so the balance sheet got a lot bigger which meant there was a ton of cash in the market, which meant that no one really needed to borrow cash because you would typically borrow cash to make sure that you were at your minimum reserve levels for regulatory purposes ... reserves don't earn interest in that pre crisis environment, so I want to hold as little as possible and stay as close to my minimums as possible.

"Now the Fed has done two things: they've increased the supply enormously and they pay interest. So if you're a bank and you have cash at the Fed you get a positive interest rate on that cash, so you actually are perfectly fine with holding reserves for the most part -- you don't want to minimize your exposure, a corollary to that is who would actually lend reserves when they're earning interest on them at a rate that might be below the interest they'd earn by holding them overnight.

"It turns out that the way the regulations / law was changed to allow the fed to pay interest on reserves did not include non depository institutions ... the Federal Home Loan Bank system is technically not a depository institution but they are part of the federal reserve system, so they lend out their cash at a rate below the interest on excess reserves. And the borrowers of that cash are borrowing at the IOER rate and earning the spread between the two.

"Most importantly, the effective federal funds rate is a pretty idiosyncratic thing because it really reflects where the Home Loan Bank system is going to lend out cash relative to other short term investments to foreign banks. Which doesn't strike me as the index you really want to link the rest of the economy to."