Banks retain adequate reserves to ensure their solvency. Before March 26, 2020, the Federal Reserve required banks to maintain a minimum reserve of approximately 10 percent of their deposits. The Fed dropped the reserve requirement to encourage lending and prevent a severe recession during the COVID pandemic. Whether mandatory or voluntary, management retains reserves. Sometimes reserves can drop to abnormally low levels when a bank lends more than anticipated or has large unanticipated withdrawals. When reserves are too low, banks usually consider borrowing from another bank or going to the Federal Reserve’s discount window for a loan.
For example, suppose you manage Cloudy Bank. You realize your reserves are inadequate. You know that Windy Bank has a lot of excess reserves. Windy Bank has been accumulating reserves because its management anticipates closing some large loans within the next few days. What would you do? One solution is to borrow some of Windy Bank’s excess reserves overnight. Windy Bank likes that idea because these reserves would earn interest.
Banks with excess reserves lend to banks short of funds rather than letting the reserves sit idle and not earn any interest daily. The Federal Open Market Committee (FOMC) sets a target rate for these overnight loans between banks. (The FOMC is the committee of the Federal Reserve that establishes the country’s monetary policy.) This rate is the federal funds rate and is determined by the law of supply and demand. The FOMC manipulates the federal funds rate by adding or subtracting reserves in the banking system. Adding reserves reduces the federal funds rate in the same way that an increase in the supply of a good decreases the equilibrium price. The Fed adds reserves to the banking system by purchasing government securities in the open market. This strategy is called “accommodating” because rates fall, and lenders are more accommodating in making loans. The Fed uses this strategy when it wants to accelerate economic growth. Conversely, the FOMC may raise the federal funds rate when the economy is heating up, and inflationary pressures mount. They do this by reducing the banking reserves by selling government securities.
Returning to our example where you manage Cloudy Bank, and the bank is in financial trouble. Other banks are fearful you will be unable to repay them and choose not to lend to you. Where do you go? You can go to your local Federal Reserve Bank and borrow from their “discount window.” The discount rate is the interest rate the Federal Reserve Banks charge when commercial banks and other depository institutions borrow from the Fed. The Federal Reserve requires collateral, such as treasury bonds or other government securities, when making these loans.
The graph above illustrates the relationship between the discount and federal funds rates from 2003 through February 2023. The discount rate is typically higher than the federal funds rate since the FOMC wants to discourage banks from using the discount window. This changed during the Great Recession in 2008 when the Fed wanted to add liquidity to the economy quickly.
Source: Federal Reserve Releases
The Federal Reserve uses the federal funds rate to manage the economy. During periods of inflation, it raises its target federal funds rate to increase borrowing rates and slow the growth of the economy’s aggregate demand while reducing business investment. It lowers the federal funds rate to prod economic growth.
Except for a brief downturn following 9-11, the economy grew between 2001 and 2007. Inflation was tame during the earlier years but began to heat up in 2004 and 2005. The Fed responded by increasing its target rate in July 2004 after inflation exceeded 3 percent for three consecutive months. It raised the federal funds rate gradually until June 2006, when it peaked at 5.25 percent.
Economic growth slowed in 2006. During the third quarter, RGDP grew by less than one percent. Signs of weakness became apparent, particularly in the residential real estate market. In August 2007, the Fed began significantly reducing the federal funds rate. It was probably too late, but policymakers had been concerned that inflation was too high because it remained above the Fed’s 2.0 percent target. Then the mortgage industry imploded. Lehman Brothers, the fourth largest investment bank, filed for bankruptcy on September 15, 2008. Ten days later, the Office of Thrift Supervision seized Washington Mutual’s banking operations. Washington Mutual was the largest savings and loan association in the United States. Many other financial institutions, including Merrill Lynch and Wachovia, were also in trouble. The Fed stepped in quickly and reduced its target federal funds rate from 5.25 percent to 4.75 percent. By the end of 2008, the target federal funds rate was between 0 and 0.25 percent.
The US economy prospered between 2009 and 2016. Inflation remained low, perhaps too low. Economists were concerned prices would deflate during 2009 and 2015 when inflation remained nearly zero. Others were concerned monetary policy would be ineffective during a recession if interest rates remained too low. So, in 2016 the Fed slowly raised the federal funds rate. By the end of 2018, their target rate was between 2.25 and 2.5 percent.
Then COVID struck in December 1919. At that time, the target federal funds rate equaled 1.5 to 1.75 percent. However, policymakers envisioned a severe recession, possibly a depression if they did not take desperate measures. Congress quickly provided households with lost income while the Fed slashed rates. In less than two months, policymakers at the Fed had cut their target rate to between 0 and 0.25 percent. A severe recession was averted. But it was replaced by inflation. Government subsidies helped increase the economy’s aggregate demand; at the same time, suppliers were facing severe challenges in delivering their products. Their costs increased, and they raised their prices.
The Fed had a belated response to the escalating price level. Many policymakers believed inflation would subside when suppliers succeeded in addressing their supply constraints. But a labor shortage and a pent-up demand persisted and pushed prices higher. In June 2022, the consumer price index reached 9.1 percent. The Fed responded with an unprecedented eight increases in the federal funds rate beginning in March 2022, including four consecutive increases of 0.75 percent. On February 28, 2023, the federal fund’s target range is between 4.5 and 4.75 percent.