In normal times, when risk factors are contained and can be diversified away, the interest rate channel, working through inter-temporal arbitrage, is the prime conduit of monetary policy (see slide 2). It sets the floor for term borrowing costs. Parsing longer-term yields into two components – the average level of the short-term policy interest rate expected over the term to maturity of the asset, and the risk premia – expectations of monetary policy pin down the first component. The mechanism through which this occurs is the inter-temporal financial arbitrage I just described. Term and liquidity premia are the additional returns that investors demand as a compensation for their reluctance to bear interest rate risk over long-duration assets, and for their decision to forgo liquidity services – I am abstracting here from credit risk, to which I will return later. When markets are properly functioning, non-depository institutions – dealers, hedge funds, investment banks – provide immediacy by offering lenders and borrowers their capacity to take positions on both sides of the market. Their ready availability to take positions as lenders and borrowers supports market liquidity, namely the ease with which a lender can liquidate a position before maturity. When market liquidity is secure, lenders are willing to engage in finance, trades in long-duration assets are active and the liquidity premia are contained. And, most importantly, they are steady. With a steady premium, the expectations  2  There are two reasons for idiosyncratic fluctuations of reserve demand by individual banks.
The Federal Reserve was therefore able to achieve the desired level of the federal funds rate, its policy target, by making slight adjustments in the supply of reserves in the system, so that it intersected the demand at that rate.3 On a typical day, implementing monetary policy entailed forecasting the level of reserves that would achieve the targeted level of the federal funds rate, and then, if necessary, conducting open-market operations to add or remove reserves. Nowadays, however, reserves are no longer scarce. The supply of reserves now fluctuates widely around roughly two trillion dollars, compared to remaining tightly around ten billion dollars in mid-2007. This largely reflects the effect of the large-scale asset purchase programs, the last of which concluded in 2014, and the FOMC’s subsequent direction to maintain the size of the balance sheet by reinvesting principal repayments. Because the stock of reserves is so large, it is impractical to use open market operations to quickly reduce reserves back to the point where the federal funds rate can be controlled with scarcity, at least for now.4 Our current framework relies, instead, on providing the market with two overnight investment opportunities to help steer money market rates: interest on reserves (IOR) and the overnight reverse repurchase agreement (ON RRP) facility.