Interest on Reserves and Segmentation in the Federal Funds Market

To combat the financial crisis that intensified in the fall of 2008, the Federal Reserve
injected a substantial amount of liquidity into the banking system. The resulting increase
in reserve balances exerted downward price pressure in the federal funds market, and the
effective federal funds rate began to deviate from the target rate set by the Federal Open
Market Committee. In response, the Federal Reserve revised its operational framework
for implementing monetary policy and began to pay interest on reserve balances in an
attempt to provide a floor for the federal funds rate. Nevertheless, following the policy
change, the effective federal funds rate remained below not only the target but also the
rate paid on reserve balances. We develop a model to explain this phenomenon and use
data from the federal funds market to evaluate it empirically. In turn, we show how
successful the Federal Reserve may be in raising the federal funds rate even in an
environment with substantial reserve balances.