This theoretical and empirical examination gave the Federal Reserve confidence that it could effectively raise rates when the time came while limiting undesirable effects on financial market structure, and also ensured that additional term tool options were available if the combination of the overnight tools – IOR and ON RRP – was not sufficient to provide interest rate control.21 At this point, you might have a question: from late 2008 to late 2015, the federal funds rate traded well within the FOMC’s target range of zero to 25 basis points.22 Shouldn’t this have been conclusive evidence as to the ability of the operational framework to provide sufficient control of interest rates? Unfortunately, the answer is no, because there are natural features of the financial system that likely provide support to interest rates near the zero lower bound, or ZLB. These features include the availability of physical cash and a behavioral aversion by some money market investors to investing at negative rates, and also encompass certain unique features of money markets in the United States, such as legal and regulatory incentives applicable to money market mutual funds and the ability of the government-sponsored enterprises to leave unremunerated deposits at the Federal Reserve.23 As a result, while the pre-liftoff testing suggested that the tools were likely to work well, it wasn’t possible to determine with complete certainty the extent to which market rates were driven by the tools or by ZLB effects.
This meant that if the interest rate changed during a maintenance period, the change would not have been fully reflected in the interest payments to depository institutions until the beginning of a new maintenance period. This methodology likely would have resulted in slow adjustment of market rates to changes in the IOER rate. The revised calculation bases interest payments to depository institutions on the IOER rate in effect each day and the level of balances held each day. 20  See Clouse, Ihrig, Klee, and Chen, “The Federal Reserve’s Tools for Policy Normalization in a Preferred Habitat Model of Financial Markets,” October 2014; Martin, McAndrews, Palida, and Skeie, “Federal Reserve Tools for Managing Rates and Reserves,” September 2013; and Armenter and Lester, “Excess Reserves and Monetary Policy Normalization,” September 2015. 21  Testing focused on two types of term operations. Term RRPs are similar to ON RRP in most respects; for example, both operations use the same expanded set of counterparties. The key differences are that term RRPs are conducted for longer than overnight, they each have their own, separate, aggregate capacity limit, and the term RRP does not incorporate a per-counterparty cap. Term RRPs can be used in a variety of ways. In the current framework, they have been used to offer increased RRP capacity, using an interest-rate-oriented approach, around periods when larger-than-usual demand is expected, but they could also be used in a quantityoriented way to drain reserves.