Session 2 · Monetary Policy FIN310

Monetary policy sets the stance of interest rates and liquidity to achieve the Fed’s dual mandate: price stability (~2% inflation over time) and maximum employment.

• Main lever: Target range for the federal funds rate.
• How it’s steered: Administered rates (IORB, ON RRP) + ample reserves + open market operations.
• When more is needed: Balance-sheet tools — QE and QT.

Plain-English

• Easing = cutting the policy rate or providing liquidity to support demand and employment.
• Tightening = raising the policy rate or withdrawing liquidity to cool demand and reduce inflation.

Quick examples

• Ease (future scenario): Suppose in September 2025 inflation is trending near 2%, unemployment is creeping up, and growth has slowed. → The FOMC might cut 25 bps, lower IORB/ON RRP, and/or buy securities.
• Tighten (recent history): In 2022, inflation surged; the Fed raised the range repeatedly, increased IORB/ON RRP, and began QT.

• The interest rate at which depository institutions lend reserves overnight to each other.
• The FOMC sets a target range for the effective funds rate.
• It influences broader financial conditions (short rates directly; longer rates via expectations/term premia).

Why it moves other rates

Expectations for the path of the funds rate shape borrowing costs. Higher path → yields up; lower path → yields down.

The “floor” framework (today)

• IORB: Interest paid to banks on reserve balances. It’s the anchor/floor for interbank lending.
• ON RRP: Overnight reverse repo facility for eligible nonbanks (money funds, GSEs, primary dealers). Extends the floor beyond banks.
• Ample reserves: With lots of reserves in the system, the market funds rate (EFFR) naturally trades near IORB; ON RRP pins the lower bound for those who can’t receive IORB.

Who can use what?

• Banks: can hold reserves and earn IORB; may also transact in fed funds.
• Money market funds/GSEs/dealers: can invest overnight in the ON RRP facility, but don’t earn IORB.
• Because some big cash lenders aren’t banks, ON RRP gives them a risk-free floor option → prevents rates from drifting below the target range.

Why EFFR “hugs” IORB

• No-arbitrage logic: A bank won’t lend funds below IORB when it can leave cash at the Fed and earn IORB risk-free.
• Spillover to nonbanks: Nonbanks can place cash in ON RRP. If private repo/fed funds dip too low, cash flows to ON RRP instead.
• NY Fed operations: If the fed funds rate drifts away from the target range, the New York Fed can step in with repos or reverse repos to pull it back. Think of this as plumbing work to keep the system flowing smoothly — not a change in overall policy stance.

Old vs. New (implementation style)

Common misconceptions (quick fixes)

• “ON RRP = QE” — No. ON RRP borrows cash from markets (liquidity drain). QE injects cash by buying assets.
• “High ON RRP use = easing” — No. It means lots of cash seeks a safe home at/above the floor; stance comes from the rates (IORB/ON RRP) and the range, not the take-up level.
• “EFFR is set by OMO every day” — In the floor system, EFFR is steered mainly by administered rates; OMOs are for plumbing/backstop.

What they do (day-to-day)

• Buy securities → add reserves (inject cash into the banking system).
• Sell securities (or let them run off) → drain reserves.
• Repos (Fed lends cash against collateral) → short-term reserve injection.
• Reverse repos (Fed borrows cash against collateral) → short-term reserve drain.

Why it matters

Open market operations (OMOs) are the plumbing that keeps the effective fed funds rate (EFFR) inside the FOMC’s target range.

• They transmit stance by aligning short-term rates with the Fed’s policy rate corridor.
• They smooth volatility when reserve demand or collateral supply shifts suddenly.
• They are the Fed’s first line of defense if stress appears in money markets.

OMOs: old world vs. today

• Pre-2008 (scarce reserves): OMOs were central — the Desk had to add/drain reserves every day to hit the point target.
• Today (ample reserves): OMOs are less frequent; administered rates (IORB/ON RRP) do the heavy lifting. OMOs are now mainly for market plumbing or stress events.

Examples

• Buy operation: Fed buys $10B Treasuries → banks’ reserve balances ↑ by $10B → more liquidity.
• Repo: Dealers need overnight cash; Fed lends with Treasuries as collateral → reserves ↑ for 1 day.
• Reverse repo: Money market funds have spare cash; Fed takes it overnight with Treasuries as collateral → reserves ↓ for 1 day.

Analogy

Think of the Fed’s balance sheet as a reservoir:

• QE/QT = raise or lower the dam (long-term water level change).
• OMOs = daily gates/valves adjusting the flow in or out (short-term stability).

Definitions

• QE: Buy Treasuries/MBS to lower term premia, ease credit, reinforce guidance at/near ZLB.
• QT: Let assets run off or sell to withdraw liquidity and reduce accommodation.
• State-dependent: Effects stronger in stress or with credible guidance.

Historical examples

• QE1–3 (’08–’14), QE4 (2020 pandemic), QT (’17–’19; ’22–present).

Main channels (what moves & why it matters)

• Expectations — Policy signals shape beliefs about future inflation and rates.
  Forward guidance lowers expected path of rates → firms bring investment forward; households refinance/spend sooner.
• Interest rates — Administered rates (IORB/ON RRP) steer short rates; expectations transmit to longer maturities.
  ↑ Policy rate → ↑ loan/mortgage/auto rates → ↓ consumption & capex; the reverse for cuts.
• Credit conditions — Availability and terms of credit change, not just the price.
  Tighter policy → stricter underwriting, wider spreads, lower risk appetite → fewer approvals & smaller credit lines.
• Asset prices & FX — Valuations and the dollar respond to discount rates and risk appetite.
  Cuts → lower discount rates → equities/real estate up (wealth effect); dollar tends to weaken → net exports up.

One-liners for class

• Expectations: “Tell me where rates are going, and I’ll act now.”
• Rates: “Change the short end; the curve and loans follow.”
• Credit: “Banks don’t just change price, they change yes/no.”
• Assets & FX: “Lower r → higher P and softer $.”

Quick classroom examples

• Expectations: Fed signals cuts over the next year → firms pull forward equipment orders.
• Rates: +25 bps hike → mortgage rates nudge up → home sales cool.
• Credit: Stress + higher policy rate → banks tighten lending standards in surveys → fewer small-biz loans.
• Assets & FX: Easing + QE talk → yields down, equities up, dollar dips → exporters get a boost.

10-second summary

Cut → easier expectations, lower rates, looser credit, higher asset prices & weaker $ → demand up.
Hike → the opposite → demand cools.

• Statement — decision day.
• Press conference — Chair Q&A.
• Minutes — ~3 weeks later.
• SEPs — projections/dots (selected meetings).

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• ECB — MRO, DF; symmetric 2% target. Policy implementation
• BoE — Bank Rate; APF (QE/QT). Monetary policy
• BoJ — Short-rate target + (recent) YCC. Policy

• IORB — Interest on Reserve Balances Administered rate

  Interest paid to banks on reserves; anchors the floor for interbank rates.

• ON RRP — Overnight Reverse Repo Facility Administered rate

  Overnight investment option for eligible nonbanks; extends the floor.

• EFFR — Effective Federal Funds Rate

  Volume-weighted mean of overnight fed funds transactions; targeted inside an FOMC-set range.

• OMO — Open Market Operations

  Day-to-day buys/sales and (reverse) repos run by the NY Fed’s Desk.

• QE / QT

  QE lowers long yields by buying assets; QT withdraws liquidity via runoff/sales.

📊 Monetary Policy — Quiz 1

Covers stance (easing vs tightening), fed funds rate, IORB/ON RRP, and QE/QT basics.

🏦 NY Fed OMOs — Quiz 2

Focuses on daily operations: buy/sell securities, repos, reverse repos, and market plumbing.

Tasks

1. Open the H.4.1 balance-sheet release and summarize the latest asset changes (3–5 bullets).
2. Skim NY Fed Domestic Market Operations and Monetary Policy Implementation ; list two day-to-day instruments with a 1-sentence explainer each.
3. Explain (5–7 sentences) when to add QE vs. stick to rate policy.