Falling Reserve Balances and the Federal Funds Rate

The growth of “sweeps”—a banking practice in which depository institutions shift funds out of customer accounts subject to reserve requirements—has reduced the required balances held by banks in their accounts at the Federal Reserve. This development could lead to greater volatility in the federal funds rate as banks try to manage their accounts with very low balances. An analysis of the evidence suggests that the volatility of the funds rate is rising slightly, but not enough to disrupt the federal funds market or affect the implementation of monetary policy. During the past year, required balances held by commercial banks and other depository institutions in their accounts at the Federal Reserve have fallen sharply. This development primarily reflects the spread of “sweep ” arrangements, a banking innovation that allows depository institutions to shift customers ’ funds out of accounts subject to reserve requirements. Recently, questions have arisen about the potential effects of the decline in required balances on the interbank federal funds market in which these balances are borrowed and lent. At issue is whether the interest rate on transactions in this market—the federal funds rate— is becoming more volatile as banks try to manage their accounts with very low balances. Since the Federal Reserve implements monetary policy by influencing the federal funds rate, and the funds rate affects other short-term interest rates, a large increase in its volatility could have broader implications. This edition of Current Issues investigates the drop in reserve balances and its effects on interest rate volatility. After describing the mechanism through which reserve balances influence the behavior of the federal funds rate, we assess the evidence suggesting that lower reserve requirements are leading to larger fluctuations in this rate. Our investigation prompts us to conclude that slightly higher short-term volatility in the federal funds rate may be resulting from the decline in reserve balances to date. Nevertheless, market participants have been adapting well to the drop in reserves and, as Federal Reserve Chairman Alan Greenspan (1997) noted in recent congressional testimony, the Federal Reserve has “not... experienced any specific problem in implementing monetary policy.”