However, such transitory movements should have no material effect on financial conditions or the broader economy. What matters for policy transmission is the predictability that on most days money market rates will be close to the target range set by the FOMC. 13 Of course, if rates were to move substantially outside the target range and those changes were expected to persist, the Fed would take appropriate action to assure that its intended stance of policy is achieved. In addition, as highlighted in minutes to the Committee’s recent policy meetings, an operating regime with a reasonably large positive spread between the IOER and ON RRP rates would support active trading in the funds market like we see today, and would likely prevent the Fed’s involvement in the repo market from growing too large. This would, in turn, lessen the possibility that patterns of financial intermediation could be altered in unanticipated and potentially undesirable ways by the Fed’s actions. Recent changes to the overnight RRP test exercise Now I’d like to return to the ON RRP testing that the Fed has been conducting over the past year, and discuss the changes to the testing exercise that were introduced following the September FOMC meeting. You’ll recall that we began testing ON RRPs in September 2013, when the Committee instructed the Desk to examine how a potential ON RRP facility might work and how it might affect short-term interest rates.
Because the investment with the Fed is riskless, little or no economic capital would be needed to support such arbitrage by banks. In this way, the IOER rate should theoretically form a “floor” beneath short-term interest rates, allowing the Fed to achieve its target for the fed funds rate even with a very high level of reserve balances. In practice, however, many lenders in the U.S. money markets are not banks and so cannot earn IOER. Moreover, from the perspective of a potential lender to a bank, the arbitrage  2  In the five years prior to the crisis, total reserve balances averaged $ billion and excess reserves – balances in excess of those required to satisfy reserve balance requirements – averaged about $ billion. Currently, total reserve balances are about $ trillion, nearly all of which are excess reserves. 3  For discussion of changes in recent years to activity in the fed funds market, see the Liberty Street Economics blog posts, “Who’s Lending in the Fed Funds Market” and “Who’s Borrowing in the Fed Funds Market,” at http://libertystreeteconomics.newyorkfed.org/. 4  The FR 2420 is a transaction-based report that collects daily data on federal funds transactions, Eurodollar transactions, and certificates of deposits from domestically chartered commercial banks and thrifts that have $ billion or more in total assets and from U.S. branches and agencies of foreign banks with total third-party assets of $ million or more.