Overnight Reverse Repurchase Agreement Rate (ON RRP): Highly simplified, this is the overnight interest rate available to all Federal Funds Market participants.This is the rate that the Fed wants to make sure is always within their target range. Federal Funds Effective Rate: The rate at which commercial banks lend money to each other overnight.This target alone doesn't influence anything. Federal Funds Target Rate: A target range set by the Federal Reserve for what they want the Federal Funds Effective Rate to be.The FFER would naturally be a bit lower than this rate, since the institutions who cannot qualify for IORB will be willing to lend to other banks at a rate below the IORB (but above ON RRP). The IORB acts as an anchor rate, since this is what some (but not all) banks are able to get risk-free from the Fed. In practice, the Federal Funds Effective Rate tends to hover slightly below the IORB rate. Likewise, the Federal Funds Effective Rate will almost always be below the Discount Rate, since if the private rate were higher, any bank could instead borrow from the Fed directly at the Discount Rate. As noted, this should always be above the ON RRP rate since any Federal Funds Market participant is able to get at least that much by lending to the Fed risk-free, and so would require a slightly higher return from a bank, given the slightly higher credit risk. The rate charged is called the Federal Funds Rate, and it is set entirely by the two parties involved, not by the Fed.Īll that's left is to show the actual Federal Funds Effective Rate, the free-market rate set between the banks lending/borrowing money amongst themselves.
The market for these overnight loans between large financial institutions is called the Federal Funds Market. Banks are freely able to lend to each other on an overnight basis in order to efficiently manage their cash reserves. In practice, it is extremely rare for banks to borrow money from the Fed for two reasons: 1) It is usually cheaper to borrow from other banks, 2) There is a stigma that you only borrow from the Fed if no other bank is willing to lend to you, meaning you are desperate and likely insolvent. The interest rate charged by the Fed is called the Discount Rate, which is solely and directly controlled by the Fed. This is called accessing the Fed's Discount Window. Large commercial banks have access to borrow money at any time from the Federal Reserve. Realistically, there are two choices here: If the bank has too little cash, then the only option is to borrow the shortfall from someone else. If the bank has too much cash, then there are many options to loan out or invest the excess cash available to the bankers (largely depending on how long they are comfortable committing to the investment). Every single day the bankers look at their balance sheet and need to decide if they have too much, or too little cash on reserve. Managing this tension is a key balancing act for the bank. Whereas, if they have too little cash on reserve, they risk a liquidity crisis. If they have "too much" cash on reserve, then they are losing out on the potential income of loaning the cash out and receiving a higher interest rate. It is expensive for banks to keep this reserve cash available, since it means that they aren't investing it elsewhere. This is itself a complex and dynamic topic, but suffice it to say that to be a good bank, the bank must have some credible level of liquidity, such that if I am a customer of the bank, I have high confidence that I can walk in and withdraw my cash at any point. Very briefly, a commercial bank needs to carry some amount of reserve cash in order to operate successfully.
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