Conduct Monetary Policy with
EFFR Above IORB

The Floor System: How the Fed Currently Operates

Since 2008, the Federal Reserve has operated a floor system for monetary policy implementation. In this system, the Fed sets the Interest on Reserve Balances (IORB) rate at or near the top of the federal funds rate target range. Because banks can earn IORB by simply parking reserves at the Fed, IORB sets a floor for the effective federal funds rate (EFFR) — banks won't lend overnight at a rate below what they can earn risk-free at the Fed.

In a floor system, monetary policy can be implemented effectively even with superabundant reserves, because the IORB rate controls the short end of the yield curve regardless of how many reserves are in the system. This is convenient — the Fed can maintain large asset holdings without losing control of the policy rate. But the floor system also makes the size of the balance sheet less consequential for policy, inadvertently reducing the discipline to shrink it.

The Problem: FBO Arbitrage

A key structural feature of the current floor system is that EFFR consistently clears slightly below IORB — typically 5–10 basis points below the IORB rate. This spread exists because certain entities — most importantly, Foreign Banking Organizations (FBOs) — cannot earn IORB directly on their reserve balances (their reserves are held at the Fed through U.S. bank affiliates) and therefore lend in the federal funds market at below-IORB rates.

Domestic banks then borrow from FBOs in the federal funds market at these below-IORB rates and deposit the proceeds as reserves to earn the IORB spread — a straightforward arbitrage. This arbitrage transaction is profitable precisely because it creates demand for reserves: banks want to hold more reserves to capture the FBO-IORB spread, inflating aggregate reserve demand structurally beyond what would otherwise exist.

Moving to a Corridor System

In a corridor system, the EFFR clears above IORB rather than below it. Banks must borrow reserves from the Fed (via open market operations) to meet their demand; the interest rate they pay on this borrowing sets the ceiling of the corridor, and IORB sets the floor. The EFFR clears somewhere within the corridor based on supply and demand for reserves at the margin.

Operating above IORB eliminates the FBO arbitrage: if EFFR > IORB, there is no profit from borrowing from FBOs in the federal funds market and depositing at the Fed. FBO reserve hoarding becomes unprofitable, reducing the structural demand for reserves from this channel. The paper estimates this channel alone accounts for $150–550 billion in excess reserve demand.

Historical Evidence and the Scarce-Reserves Regime

Before 2008, the Fed operated a scarce-reserves (corridor) system. The banking system held only about $10–15 billion in excess reserves — the Fed managed the supply of reserves through daily open market operations to keep the EFFR near target. This system was operationally demanding but proved that policy can be implemented effectively with far fewer reserves than the current system requires.

The challenge of transitioning back to a corridor system is determining the appropriate "scarce" level of reserves — too few, and the Fed loses control of the EFFR; too many, and the benefits of the transition are not fully realized. The paper suggests the transition could be managed gradually, with the Fed allowing EFFR to drift above IORB over time as QT reduces the supply of reserves.

Operational Risks

The transition carries real risks. If reserves become too scarce before the banking system has adapted — through the adoption of the discount window, SRP usage, and other backstop mechanisms developed in Options 01–06 — the EFFR could become volatile, complicating monetary policy communication. The paper therefore recommends implementing Option 07 only after the full suite of supporting options (particularly those reducing precautionary reserve demand) are in place, so that banks have viable alternatives to hoarding reserves when the supply falls.