How Does the Federal Reserve Set Interest Rates?

How Does the Federal Reserve Set Interest Rates?

some think that they define a single rate - namely the overnight lending rate - i.e. the rate at which the banks lend to each other overnight

but that's not the case ❌

how can the FED even set market-wide rates? 🤔

after all - there is no single rate that the whole market unanimously uses

different types of lending have different rates in the market, as it's a (somewhat) open market

the federal reserve does not set a single interest rate

instead, the FED sets a target interest rate range (the federal funds target range) alongside 4 main explicit interest rates

the FED sets a target interest rate range and 4 main explicit interest rates:

1️⃣ Overnight Reverse Repo Rate (ON RRP)
2️⃣ Interest on Reserve Balances (IORB)
3️⃣ Discount Rate - also known as Lending Rate
4️⃣ Standing Repo Facility (SRF)

more on them later (keep reading 😁)

together, ON RRP, IORB, discount rate and SRF define an interest rate corridor, composed by:

1️⃣ lower bound (floor) - the lowest possible interest rate
2️⃣ upper bound (ceiling) - the highest possible interest rate

the other market rates fluctuate between this floor and ceiling

the rates define the interest rate corridor in the following manner:

1️⃣ Overnight Reverse Repo Rate - floor
2️⃣ Interest on Reserve Balances - supplementary floor
3️⃣ Discount Rate - ceiling
4️⃣ Standing Repo Facility - supplementary ceiling

in the Federal Open Market Committee Meetings (FOMC), the Federal Reserve sets a target range - currently 4.25%–4.50%, and then it uses the ON RRP, IORB, discount rate and SRF to steer the average rate in the market

think of these 4 rates as defining a corridor with an upper and a lower bound - currently 4.25% and 4.50%

the average market interest rate will sit somewhere in between

now you should have a clear mental model of how the Federal Reserve sets the interest rates in the market

a target range is defined, and then several different interest rates are set explicitly to steer the real interest rate into that target range

so when banks and other financial institutions need to lend capital - they can do it at a rate within the target range

of course, their balance sheet capacity must allow for that - but that's another topic which I already covered in some detail in my other posts😁

now let's understand each one of the 4 key rates set by the federal reserve to keep the market rates within the target range

namely, what each one of those rates represents and how together they act as ceiling or floor for the interest rate corridor

the 4 key interest rates set by the FED are:

1️⃣ Overnight Reverse Repo Rate (ON RRP)
2️⃣ Interest on Reserve Balances (IORB)
3️⃣ Discount Rate - also known as Lending Rate
4️⃣ Standing Repo Facility (SRF)

we'll cover them in this order below

Interest on Reserve Balances (IORB) is the rate FED pays banks on their excess reserves

commercial banks have reserve accounts at the FED. regulations define the minimum amounts - any excess earns the IORB interest rate set by the FED

since banks can always deposit cash into their reserve account account at the FED and earn the IORB rate they have little incentive to lend at rates below IORB

effectively, this sets the floor (lower bound of the corridor) for interest rates for banks

Overnight Reverse Repo Rate (ON RRP) defines the rate at financial institutions can lend money overnight to the FED

in return the FED provides treasury bonds as a collateral

ON RRP is accessible to both banks & non-banks (e.g. money market funds)

ON RRP further reinforces the the floor for the market-wide interest rates

since it's accessible to a broader set of financial institutions - not only banks. those now also have little incentive to lend below the ON RRP rate

the majority of liquidity is actually created in wholesale short-term debt markets

ON RRP addresses exactly that sector, thus setting the lower bound of the target interest rate corridor for the broader financial sector

Discount Rate is the rate at which the FED lends directly to banks through its discount window

think of it as an emergency lending facility which the banks can use whenever they need funds

since banks can always get a loan at that rate - it caps the short-term interest rates

the discount rate is set higher or at the typical market rates to disincentivize its use

it's really meant to serve as an emergency lending source - only when other financing routes are exhausted: regular interbank markets, wholesale markets and SRF among others

it't called discount window for historical reasons

discounting means buying treasuries at a slightly lower price - i.e. at a discount

window comes from the fact that these were sold at counter/teller windows at the bank

Standing Repo Facility (SRF) allows banks & other financial institutions to do collateral-backed loans from the FED overnight

the institution provides high quality collateral (e.g. treasury bond) and gets a loan against it - at the set rate

thus, Standing Repo Facility (SRF) further reinforces the upper part of the target interest rate corridor

in other words, it strengthens the cap on short-term interest rates

SRF has been introduced in 2021, due to occasional spikes of short-term funding rates outside of the corridor

this is because banks avoid using the discount rate - as that is often seen as a sign of financial distress by the broader market

so how does the FED currently targets an interest rate range between 4.25%-4.50%?

let's consolidate everything with an example using current, real-world data

current rates set by FED:

1️⃣ ON RRP - 4.25% (floor) - firms won't lend below
2️⃣ IORB - 4.40% (supplementary floor) - banks won't lend below
3️⃣ Discount Rate - 4.50% (ceiling) - banks won't borrow above
4️⃣ SRF - 4.50% (supplementary ceiling) - banks & firms won't borrow above

together, ON RRP, IORB, Discount Rate and SRF create a corridor for rates, which stay within the target 4.25%-4.50%

👉 by "firms" i mean select non-bank financial institutions - think dealers, market makers & other wholesale debt institutions

and this is how the Federal Reserve steers the federal funds rate/interest rates in the market within the target range 🏦✨

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