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August 15, 1991

Federal Reserve Bank of Cleveland

Federal Funds Rate Volatility
by Diana Dutnitru and E. J. Stevens

M. he federal funds rate was unusually
volatile for several months starting in late
December 1990. Day-to-day changes
over this period were far greater than in
previous years, although the difference
seems to have disappeared recently
(figure 1A).
The federal funds rate is the interest rate
banks charge one another for unsecured
overnight loans of their deposit balances
at Federal Reserve Banks. Borrowers
and lenders in the funds market are
almost exclusively depository institutions, who see the funds rate as the
market price at which Fed deposits can
be acquired to make payments or to
meet reserve requirements. The rate is
also a short-run indicator of the monetary policy intentions of the Federal
Open Market Committee (FOMC),
which controls the supply of reserve
assets. Volatility would be a serious concern if confusion about FOMC policy
intentions caused market participants to
make bad decisions.
Sharp changes in the funds rate are
typical near the end of a year, when
financial institutions make temporary
balance-sheet adjustments, a practice
known as "window dressing." Because
these adjustments usually last only a
few days, they cannot explain the recent protracted period of funds rate
volatility. Easing of monetary policy
during this unstable period, which allowed a number of downward adjustments in the rate, also fails to account
for much of the variation. More important are two effects of an unrelated substantial cut in reserve requirements in
December. The first is that until banks

and the Fed learned to managcsmaller
reserve positions, the funds rate moved
sharply on final, settlement days of
reserve maintenance periods. The second effect is that the lower quantity of
required reserves prevented borrowers
and lenders from responding to day-today funds rate movements in the way
that normally dampens variations. This
Economic Commentary examines the
role of policy easings and reduced
reserve requirements in the recent episode of funds rate volatility.
• Policy Easings
Neither actual changes in monetary policy nor potential market uncertainty
about policy intentions appears to have
contributed significantly to the increased
funds rate volatility. The FOMC implements monetary policy by specifying a
desired degree of reserve restraint to be
maintained by open-market operations,
normally reflected in the size of the rate
spread between the discount rate (the
rate banks pay to borrow directly from
the Fed) and the funds rate. The lower
the degree of restraint, the lower will be
the funds rate relative to the discount
rate. Market participants and analysts
("Fedwatchers") read public announcements of discount rate changes and are
quite adept at recognizing independent
FOMC adjustments of reserve restraint.
Deducting market estimates of occasional policy-intended changes from
actual changes in the level of the funds
rate has little effect on the volatility
comparisons, as shown in figure IB.1
Increased market uncertainty about current and impending policy also can

A cut in reserve requirements late in
1990 apparently contributed to increased federal funds rate volatility
early this year. Legal reserve requirements are the principal source of
demand for holding deposits at
Federal Reserve Banks. This article
suggests that although the recent
episode of funds rate volatility was
short-lived and did not cloud market
perceptions of Federal Reserve policy
intentions, the effect of dwindling
reserve deposits on banking, payment,
and monetary policy practices should
be examined more extensively.

affect the funds rate. The less certain
the perception of policy, the greater
will be the range within which interest
rates might trade without inducing borrowers or lenders to enter the market to
take advantage of low or high rates.
However, market commentary reported
through wire information services and
in newspapers during this episode contained no hint of unusual, or unusually
wide, differences of opinion about the
funds-rate level thought to be consistent with FOMC directives. Moreover,
increased volatility was restricted to
markets for instruments with the
shortest maturities. For example, the interest rate on overnight repurchase
agreements, a widely traded form of
secured overnight loan, showed a comparable increase in volatility; no increase emerged in markets for threemonth or long-term Treasury securities.
In large part, uniform perceptions of policy can be traced to consistent signals
emitted by routine operations of the
"Desk," the domestic securities trading
department of the Federal Reserve Bank
of New York, which conducts openmarket operations on behalf of the
FOMC. Fedwatchers make daily estimates of the amount of reserves they
think the Desk must add or drain to
maintain the perceived degree of
reserve restraint, indexed by a level of
the funds rate. Actual open-market
operations are then scrutinized for their
consistency with preserving the funds
rate at, or returning it to, that perceived
target. Comparing the three-month
periods before and after the December
reserve requirement reduction indicates
no change in policy implementation.2
• Reduced Reserve Requirements
In December 1990, the Board of Governors reduced reserve requirements from
3 percent to zero on Eurocurrency liabilities and on nonpersonal time deposits
of less than 1 x/i years maturity. Half the
reduction took effect on December 13,
and the full reduction began on December 27. All else equal, the change
would have produced a decline of almost $14 billion in the quantity of
reserve assets (deposits at the Fed plus


vault cash) demanded by banks to meet
reserve requirements.
The FOMC must match any reduction
in demand for reserve assets with an
equivalent reduction in supply in order
to maintain its desired degree of reserve
restraint. This is because individual
banks have no incentive to hold noninterest-bearing excess reserves overnight as long as the funds rate is above
zero. Allowing a $14 billion decline in
required reserve demand to be translated
into an equivalent excess supply initially
would have sent the funds rate plunging
to zero until the excess supply had been
eliminated by excessive expansion of
money and bank credit. That is, if banks
were to work off a $14 billion excess
supply of reserve assets in the long run
by investing in earning assets, the excess funds would not be completely absorbed by increased requirements until
transactions deposits rose at least $ 117
billion ($14 billion is 12 percent — the
highest marginal reserve requirement —
of $117 billion). This increase would
have exceeded the cumulative growth
in transactions deposits over the entire
preceding four-year period.

The Desk's job of reducing supply had
to focus on reserve deposits rather than
on vault cash. Banks' demands for vault
cash are largely determined by operating needs, not by reserve requirements,
and vault cash applied to required reserves increased by a normal seasonal
amount over the first four biweekly
reserve maintenance periods following
December's cut in requirements.
Actual holdings of reserve deposits, on
the other hand, plummeted over the
same period, from $34 billion to less
than $19 billion. This enormous contraction in the supply of reserve deposits
was almost, but not entirely, equal to
the combined reduction in demand
stemming from 1) the increase in vault
cash applied to reserve requirements,
2) the cut in reserve requirements, and
3) a normal seasonal decline in reservable transactions deposits. Any remainder — whether more or less than demanded — would have been included
in measured excess reserve deposits.4


Basis points



Dec. Jan. Feb. March April


Nov. Dec. Jan. Feb. March April


Basis points


Basis points



Dec. Jan. Feb. March April


SOURCE: Board of Governors of the Federal Reserve System.



Basis poi

Billions of dollars

Federal funds rate


10/31 11/28 12/26 1/23


3/20 4/17



a. Deviation on settlement day from the average level over the previous
13 days of the period.
b. Deviation of maintenance-period average from April-September
1990 average.
SOURCE: Board of Governors of the Federal Reserve System.


Basis points




Basis points


Dec. Jan. Feb. March April




Nov. Dec. Jan.

Feb. March April


SOURCE: Board of Governors of Ihe Federal Reserve System.

Settlement-Day Rate Volatility. One
source of increased funds rate volatility
can be traced to the Desk's inability to
determine the exact amount of reserves
to supply in order to cover transitional
increases in involuntary demands for excess reserve deposits. The cut in reserve
requirements meant that some banks no
longer had to hold any reserve deposits
because their operating needs for vault
cash became more than adequate to
satisfy their reduced requirements. In
fact, between mid-December and early
February, such surplus vault cash holdings grew about $2 billion more than in
the same period of the two previous
years. Until the additional banks holding surplus vault cash (as well as those
with substantially reduced needs to hold
reserve deposits) developed methods
for operating with zero or very small
reserve deposit balances, their "demand"
for excess reserve deposits could be
said to have increased.
Desk "errors" in offsetting excess reserve "demand" by increasing the
reserve deposit supply would be expected to show up in the funds rate,
especially on the last, settlement day of
a maintenance period. Because banks
must hold required reserves only on
average over a 14-day maintenance period, they have more tolerance for unwanted or deficient holdings of reserve
deposits before the last day, intending
to offset them later.

Excess reserve deposits averaged slightly less than $ 1 billion over the six
months prior to December's cut in reserve requirements. Although the supply doubled in the first period of
reduced requirements, the total was insufficient to prevent the settlement-day
funds rate from rising almost 200 basis
points above its average level on the
previous 13 days of the period. Thereafter, the amount of additional excess
reserves supplied and the deviation of
the settlement-day funds rate from its
average over the prior 13 days moved
in an exaggerated inverse pattern
through successive maintenance periods
in January and February (see figure 2).
This inverse relationship continued
through May, but was far less pronounced, suggesting that the demand
and supply of reserves began to stabilize close to the previous average level
of excess reserves.

Arbitrage Breakdown. The most unusual aspect of this episode was that, even
after deducting policy-related changes
and eliminating settlement days from
the comparisons, the funds rate still was
more volatile than in previous years (figure 1C). Normally, with a clear market
expectation of a funds-rate level consistent with the FOMC's desired degree of
reserve restraint, arbitrage between days
within a maintenance period can maintain a reasonably stable effective rate.
When the rate comes under upward
pressure, banks lend funds, postponing

their accumulation of reserve deposit
holdings to take advantage of the anticipated future opportunity to borrow
when the rate has declined to the expected level. Similarly, when the rate
comes under downward pressure, banks
borrow funds, accelerating their accumulation of reserve deposit holdings to
take advantage of the anticipated future
opportunity to lend, or to avoid borrowing, when the rate has risen to the expected level.
Arbitrage became less effective in
smoothing the funds rate because lower
reserve requirements reduced borrowers' and lenders' need for reserves. This
dampened their ability to respond to
pressures on the daily rate emanating
from variations in the daily supply and
distribution of reserve deposits. That is,
lower reserve requirements reduced
banks' demand for reserve deposits that
could be postponed (limiting rate increases) or accelerated (limiting rate
decreases). Initially, the decline in
demand was even greater than the cut
in requirements because it was augmented by seasonal shrinkage of reservable transactions deposits and seasonal
increases in vault cash. With an unchanged, stiff penalty for overnight
overdrafts, arbitrage became more
restricted. And with banks' apparent unwillingness to rely more heavily on the
discount window than on the funds
market, more limited arbitrage resulted
in wider movements in the funds rate.



Federal funds rate volatility died down
after February for the reverse of some

fusion about FOMC policy intentions
and lead market participants to make
bad decisions.

of the reasons it had increased. Bounds
on arbitrage widened, as required reserves increased from seasonal lows
and were augmented by increased holdings of clearing balances at a number
of banks.

In addition, banks gained ex-

perience in managing smaller deposit
balances, while the Desk became more
adept both at matching supply to demand for excess reserves and at offsetting day-to-day demand and supply variations that otherwise might have moved
the funds rate.
The brief episode of substantial interest
rate volatility in the overnight markets,
while perhaps initially puzzling, turned
out to be no cause for immediate concern: Volatility did not seem to cloud
market perceptions of the FOMC's
desired degree of reserve restraint.
However, this incident should serve as
a reminder that legal reserve requirements are the major source of demand
for holding deposits at Federal Reserve
Banks. Reductions in these requirements and a long-term trend toward
satisfying them with vault cash eliminate that demand. Thus, we need to pay
greater attention to the effect of dwindling reserve deposit balances on banking, payment, and monetary policy practices. Otherwise, recurring episodes of
funds rate volatility may create con-

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

Address Correction Requested:
Please send corrected mailing label to
the above address.

Material may be reprinted provided that
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of reprinted materials to the editor.

• Footnotes
1. We obtained the morning rate, perceived
target, and Fed watchers' interpretations from
Knight-Ridder's MoneyCenter service . If, for
example, market analysts believed that the
perceived target was lowered by 25 basis
points, but the day-to-day change was 27
basis points, the actual change plotted was
two basis points because the other 25 points
resulted from a policy shift.
2. The morning funds rate deviated from
the market-perceived target range on 23
days between September 4 and December 4,
1990, and on 26 days between December 4,
1990 and March 4, 1991 (omitting the days
before, of, and after each perceived policy
change). The Desk conducted policy operations consistent with moving the funds rate
back into the market-perceived range on 20
days during the first period and on 23 days
during the second period. On the remaining
days, Fedwatchers attached no policy significance to the possible inconsistency.
3. The cut took effect on January 17, 1991
for small institutions holding reserves on a
quarterly basis.
4. Biweekly reserves data are published
regularly in the Federal Reseive Bulletin,
table 1.12.
5. To a limited extent, banks might have
wanted to reduce vault cash rather than to hold
excess reserve deposits, but they could not
have done so immediately because the cut in
reserve requirements was not announced soon
enough. Vault cash eligible to meet reserve requirements is the amount held during a two-

week period ending 30 days prior to the end
of a two-week reserve maintenance period.
The cut in reserve requirements was announced on December 4, 1990; vault cash for
the first maintenance period, ending December 26, was the amount held during the twoweek period ending November 26.
6. The breakdown in arbitrage was evident
within, as well as between, days. Volatility
within days increased sharply, as measured
by deviations of the effective rate from the
morning and closing rates, and by deviations
of the morning from the closing rate.
7. Clearing balances are deposits at Federal
Reserve Banks that yield earnings credits used
to offset charges for priced services. A bank
enters into an agreement to hold a predetermined average clearing balance for a reserve
maintenance period. A bank meeting all or
most of its required reserve with vault cash is
likely to find a clearing account useful. Targeting a positive clearing account balance reduces
the chance that an unexpected debit will tip the
bank into an overdraft position subject to

Diana Dumitru is a senior research assistant
and E. J. Stevens is an assistant vice president and economist at the Federal Reserve
Bank of Cleveland. The authors thank
Jagadeesh Gokhalefor helpful comments
and suggestions.
The views stated herein are those of the
authors and not necessarily those of the
Federal Resen'e Bank of Cleveland or of the
Board of Governors of the Federal Reserve

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