26/06/2025
How does the Fed control interest rates? HOW DO WE CHOOSE THE VALUATION OF OUR PORTFOLIO?
To understand how the Federal Reserve (Fed) maintains economic stability, it's crucial to understand the role of short-term interest rates. These rates are the heart of monetary policy: they influence the cost of borrowing, the liquidity of the system, and ultimately, inflation. But how does the Fed keep them under control? The answer lies in a set of mechanisms that act as a "floor" and "ceiling" for interest rates, ensuring they move within a predefined range. Below, we explain how these tools work and when they are used.
Interbank market without collateral
This market is based on loans between banks without the need to provide collateral. Here, the Fed establishes a band for interest rates through two facilities that set the floor and ceiling: the Interest on Reserve Balances (IORB) and the Marginal Lending Facility (MLF).
On the one hand, the Interest on Reserve Balances (IORB) is the rate the Fed pays banks for holding their deposits at the Federal Reserve. Because this option is low-risk, no bank would lend money on the market at a rate lower than what it can earn simply by leaving its reserves at the Fed. Therefore, the IORB acts as a floor for Fed Funds.
On the other hand, the Marginal Lending Facility (MLF) is the rate the Fed charges banks when they need to borrow money directly. This rate is higher because it's used in emergency situations, such as when a bank has a temporary liquidity problem and turns to the Fed as a last resort. No bank would pay a higher rate in the market than what it would pay the Fed at this facility, so the MLF sets the ceiling for Fed Funds.
Interbank market with collateral
In this case, the transactions are carried out by providing secure assets as collateral, which reduces the risk for both parties. The Fed uses the Standing Repo Facility and the Reverse Repo Facility to set the limits of the Secured Overnight Financing Rate (SOFR).
In a Standing Repo Facility, participants obtain short-term funds using securities as collateral. In practice, the participant delivers safe assets, such as Treasury bonds, and receives cash in return. This facility is used when immediate and readily available liquidity is needed.
the ceiling for the SOFR, as it provides financing against collateral at a predetermined rate.
In the Reverse Repo Facility, participants deposit short-term funds with the Fed in exchange for securities. Here, the participant hands over cash and receives assets, allowing them to safely invest their excess liquidity and earn a short-term return. These assets can also be used for operations such as short selling. This facility sets the floor for the SOFR, as participants would not accept a rate lower than what they can obtain through this operation.
Why Is This Important?
The use of these facilities—IORB, MLF, Standing Repo, and Reverse Repo—allows for effective control of short-term interest rates. This control is crucial for maintaining economic stability and meeting the Fed's inflation targets. By providing a floor and ceiling for interest rates, these tools ensure that rates remain within the desired range, thus facilitating sound monetary policy management.
