From Policy Rates to Market Rates—Untangling the U.S. Dollar Funding Market

From Policy Rates to Market Rates—Untangling the U.S. Dollar Funding Market

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From Policy Rates to Market Rates—Untangling the U.S. Dollar Funding Market

How do changes in the rate that the Federal Reserve pays on reserves held by depository institutions affect rates in money markets in which the Fed does not participate? Through which channels do changes in the so-called administered rates reach rates in onshore and offshore U.S. dollar money markets? In this post, we answer these questions with the help of an interactive map that guides us through the web of interconnected relationships between the Fed, key market players, and the various instruments in the U.S. dollar funding market, highlighting the linkages across the short-term financial products that form this market.

The Fed

In today’s monetary policy framework of ample reserves, the Fed sets two rates to steer short-term interest rates in accordance with its policy target, the fed funds target range: the interest rate paid on reserves that depository institutions hold overnight at the Federal Reserve (IOR), and the rate offered to a wide range of lenders at the overnight reverse repurchase agreement facility (ON RRP). IOR is the primary tool used to influence overnight rates in the banking system, while ON RRP acts as a supplement to IOR. As discussed in the recently published report Open Market Operations during 2018, these two “administered” rates have proven effective at ensuring interest rate control, namely by maintaining the effective federal funds rate (EFFR) within the Federal Open Market Committee’s (FOMC) target range and by steering short-term interest rates so that the stance of policy is transmitted into broader financial markets.

The Fed has increased its target range and the two administered rates nine times since lift-off began in December 2015. Each time it raised the administered rates, the EFFR followed closely, as shown in the chart below.

From Policy Rates to Market Rates—Untangling the U.S. Dollar Funding Market

Starting in early 2018, the bulk of federal funds began trading at higher rates relative to the top of the target range, though still within the range. With this evolving money market dynamic in mind, and to provide greater assurance that overnight interest rates would remain within the target range, the Fed included in two of the nine rate hikes a technical adjustment where the IOR rate—a magnet for other money market rates—was set just below the top of the target range rather than exactly at the top of it, setting a spread between the two rates. At the May 2019 FOMC meeting, the Fed made an additional technical adjustment, cutting the IOR rate while keeping the policy target range unchanged.

The technical adjustments had the intended effect on money market conditions, as shown in the chart below. Following the introduction of a spread of 5 basis points in June 2018, later widened to 10 basis points in December, the EFFR fell by 5 basis points relative to the top of the target range (see this speech by Simon Potter regarding the June adjustment). Similarly, following a 5 basis point cut in the IOR in May 2019, the EFFR decreased by around 5 basis points. We can also see from the chart that other overnight money market rates changed by similar amounts, even though these other rates are not directly controlled by the Fed. How did that happen?

From Policy Rates to Market Rates—Untangling the U.S. Dollar Funding Market

How Do Changes in Policy Rates Transmit to Other Money Markets?

To answer our question, we need to look closely at the linkages between transactions in the fed funds market and in other money markets, and grasp the broader flows within the U.S. dollar funding market. Using our interactive map as a compass, we select the transaction type “Fed reserve account deposits” to explore the effect of a change in IOR on depository institutions within the onshore wholesale U.S. dollar money market. Noting that the top red arrow reflects the flow of deposits from domestic banks and foreign banking organizations into a Fed liability (“Reserve Balances”), we show how a change in IOR directly influences the rate at which these depository institutions are willing to engage in “Fed funds lending” (light green arrows).

From Policy Rates to Market Rates—Untangling the U.S. Dollar Funding Market

Next, we click on “U.S. dollar repo investments” to illustrate how depository institutions and dealers rely on borrowing cash against securities via repos (black arrows) to finance net securities inventories, creating a linkage between rates in the fed funds market and those in secured short-term money markets. To demonstrate another factor influencing repo transactions, we select “Reverse repurchase agreement facility usage,” which shows how a change in the ON RRP rate reaches a broader set of onshore institutions, including those not eligible to earn interest on reserves, such as the government-sponsored enterprises (GSEs) and money market funds (light blue arrows). Overnight lending to depository institutions comes from a variety of players, such as prime money market funds and corporations, which also invest in term transactions; we can see this by selecting “commercial paper” (dark green arrow) and “U.S. dollar deposits” (yellow arrow).

Other linkages demonstrated by the interactive map include “Securities purchases from Treasury and government-sponsored enterprises” (purple arrows) and “Federal Home Loan Bank advances” (brown arrow), further illustrating the interconnectedness between administered rates and trading in the onshore U.S. dollar funding market.

What about the Offshore U.S. Dollar Money Market?

Another important piece of the puzzle is the offshore U.S. dollar money market, given the key role that the U.S. dollar plays in global trade and finance. Similar to domestic entities, participants located abroad also own U.S. dollar businesses and need U.S. dollar funding. Therefore, an offshore U.S. dollar money market exists and incorporates, among other participants, foreign banks and foreign branches of U.S. banks. By selecting “Eurodollar lending,” we see that these banks may offer deposits (pink arrows) to attract U.S. dollar investments from onshore corporates, money market funds, and hedge funds, and from offshore investors including offshore money market funds, insurers, and corporations. Foreign banks and foreign branches of U.S. banks may also offer commercial paper to a similar group of onshore and offshore entities, further linking the onshore and offshore U.S. dollar funding markets.

An additional linkage comes through “Foreign exchange swaps.” Some offshore entities may use foreign exchange swaps to meet their U.S. dollar funding needs by temporarily swapping their foreign currency balances into U.S. dollars (dark blue arrows), and also to hedge their U.S. dollar exposures. U.S. dollar lending in foreign exchange swaps can come from both offshore and onshore entities.

And so to answer our original question, changes in administered rates reach markets where the Fed does not intervene through the web of interconnected relationships between both onshore and offshore participants and through a host of short-term financial products. These interlinkages and connections are the basis for the efficient pass-through of monetary policy.

Gara Afonso

Gara Afonso is an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

Fabiola Ravazzolo

Fabiola Ravazzolo is an officer in the Bank’s Markets Group.

Alessandro Zori

Alessandro Zori is a senior associate in the Bank’s Markets Group.

How to cite this post:

Gara Afonso, Fabiola Ravazzolo, and Alessandro Zori, “From Policy Rates to Market Rates—Untangling the U.S. Dollar Funding Market,” Federal Reserve Bank of New York Liberty Street Economics, July 8, 2019,


The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.