Corridor vs. Floor Systems: A Complete Guide for Central Bankers
Navigating the Labyrinth: Demystifying Corridor and Floor Systems in Monetary Policy What is the corridor system? What is the floor system? What are the differences between two system? #Fed #Corridor
Key Takeaways:
The corridor system is based on managing scarce reserves and is controlled by two interest rates in a symmetric corridor, or sometimes by one interest rate in an asymmetric corridor.
The floor system is not based on the amount of reserves and is controlled by a single interest rate.
The corridor system wasn't a part of the Federal Reserve's policy approach until the early 2000s
After the 2008 Global Financial Crisis, with the Federal Reserve's quantitative easing operations, the Fed changed its system from a corridor to a floor.
Overnight reverse repurchase agreements was increased in 2013, creating an alternative floor below the floor rate.
43.8% of central banks operate with a corridor system and 21.9% use a floor system.
Introduction
The Federal Reserve implements monetary policy by choosing a target for the federal funds rate. The Federal Reserve (Fed) defines this rate as “The federal funds rate is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight”. 1]
The Federal Reserve influenced the federal funds rate through open market operations(OMO)2. These operations, involving the buying and selling of securities in the open market by a central bank, are a crucial tool employed by the Federal Reserve in monetary policy. It used OMOs to adjust the supply of reserve balances so as to keep the federal funds rate around the target established by the FOMC.
The total supply of Federal Reserve balances available to depository institutions was determined primarily by open market operations. Through these operations, the Federal Reserve had considerable influence over conditions in the federal funds market.
The Corridor System
The corridor system in monetary policy refers to a framework established by two key interest rates: the discount rate and the interest-on-reserves rate. The discount rate (Primary Credit Rate) is the interest rate at which the Federal Reserve is willing to lend funds, against collateral, to banks in good standing. This rate tends to create an upper bound, or ceiling. The interest-on-reserves rate represents what banks earn on the funds deposited in their accounts at the Federal Reserve. This rate tends to create a lower bound, or floor. 3
The corridor system wasn't a part of the Federal Reserve's policy approach until the early 2000s. Prior to this, from 1955 to 2000, the federal funds rate (the rate at which banks lend to each other overnight) was often higher than the discount rate (the rate at which banks could borrow from the Federal Reserve). This pattern suggests that the Fed's discount rate wasn't effectively setting an upper limit for the market interest rates during that period.
Fed exactly used to start the upper bound in 2003.
Board of Governors approved requests by the Reserve Banks to establish a primary credit rate at 100 basis points above the FOMC's federal funds target rate and the secondary credit rate at a level 50 basis points above the primary credit rate, effective January 9, 2003.4
The Federal Reserve's monetary policy framework did not have a formal lower bound until 2008, leading some authors to describe it as an "asymmetric corridor".
Borio defines the corridor system as scarce reserve system5 Borio statement is as follows: in many cases, the lending facility at the top was never binding, because the management of the reserves was such that they wouldn't really need to go and borrow. The system, as a whole, was never short, so that they wouldn't have to borrow or go into the central bank. So, I think that the key word here is "scarce"”
To highlight how reserve supply influences money market rates, figure shows a stylized depiction of the relationship between the overnight interest rate and banks’ demand for reserves. Prior to the Global Financial Crisis (GFC), the Federal Reserve operated a regime in which just enough reserves were supplied (the red vertical line in the graph) to meet banks’ reserve requirements and payment needs.6
The pre-crisis framework is also depicted as follows. There is a discussion on the elastic and inelastic interest region.
The Floor System
The new monetary policy conducted by the Fed after the crisis is based on the 'floor system.' To understand the floor system, we have to go back to the days of the crisis. In the early days of the crisis, the large amount of liquidity injected into the market by the Fed caused the federal funds rate to fall rapidly.7 This significant deviation showed that, in the absence of a floor rate, the federal funds rate could move towards "0". In response to the current situation, the Fed decided to pay interest on required and excess reserves in October 2008
In November 2008, the target interest rate, the interest paid to required reserves and the interest paid to excess reserves were equalised at 1%. In this way, a transition to the floor system was achieved. In the floor system, the target interest rate is directly equal to the base rate (the central bank borrowing rate). Then the Fed could provide so much liquidity to the financial system.
Fed’s researchers called this system as “Divorcing Money from Monetary Policy”. The key feature of this system is immediately apparent in the exhibit: the equilibrium interest rate no longer depends on the exact quantity of reserve balances supplied. Any quantity that is large enough to fall on the flat portion of the demand curve will implement the target rate. In this way, a floor system “divorces” the quantity of money from the interest rate target and, hence, from monetary policy. 8
Despite the floor system equalizing the targeted interest rate with the floor rate, the market interest rate has not necessarily converged to this point. In practice, the federal funds rate has generally remained below the IOER( After change as IORB). The effective funds rate was below the IORB rate because the typical fed funds transaction then (as now) consisted of GSEs lending to a bank. The overabundance of reserve balances had made interbank transactions uncommon. GSEs earned nothing on deposits at the Fed so lent the funds to banks that earned the IORB rate and the two parties essentially split the difference, resulting in a fed funds rate that was well below the IORB rate.9 As a solution to this issue, the volume of overnight reverse repurchase agreements was increased in 2013, creating an alternative floor below the floor rate. Williamson defined it as the floor-with-subfloor system.10
Interest on Excess Reserves (IOER)(new IORB) serves as the upper limit, while Reverse Repurchase Agreements (RRP) represent the lower limit for the Effective Federal Funds Rate (EFFR).
In this regime, the supply curve intersects the demand curve on the flat portion of the demand curve. In this region, the Fed has chosen to offer a sizable level of reserves to the banking system and, since small shifts of the supply curve have little or no effect on the FFR rate, the level does not need to be monitored as closely.
Fed no longer relies on OMOs as the principal policy tool to target the policy rate in its day-to-day, normal operations because small shifts in the supply of reserves have no impact on the FFR, by design. Instead, the Fed would lower its IOER rate and RRP rate, shifting the bottom of the demand curve down, which induces market rates, including the FFR, to move in the same direction and by a similar amount. To be clear, the lowering of the IOER rate and RRP rate puts downward pressure on the federal funds rate and other market rates by lowering the incentive to hold reserves at the Fed.11 This system is called the abundant reserve regime because the Fed has created significantly more reserves. You can see from the following graph how the reserves are growing in this period 12
Monetary Policy Benchmarks 2023 shows 43.8% of central banks operate with a corridor system and 21.9% use a floor system.13
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Note:
1- Fed’s statement:
Prior to the crisis, this regime maintained good monetary control, albeit with a high degree of operational complexity. The Federal Reserve’s Long-Run Operating Regime Page 4
2- Staff’s statements:
The floor system, there is generally little need for detailed information on the demand curve for reserves, and the regime is robust to shifts in demand and shifts in supply….”
If you had a corridor system, reserves added by QE and special liquidity programs would have to be drained in order to maintain monetary control, and we saw in 2008 that this can be difficult to do”
Sources:
FED Effective Federal Funds Rate, (2024), https://fred.stlouisfed.org/series/FEDFUNDS (01.10.2024).
The Federal Reserve Bank of New York publishes a detailed explanation of OMOs each year in its Annual Report.
Todd Keister, Antoine Martin, and James McAndrews, (2008), Divorcing Money from Monetary Policy, Link
Revising teaching materials to reflect how the Federal Reserve implements monetary policy,(2020), Link
Gara Afonso, (2023), Scarce, Abundant, or Ample? A Time-Varying Model of the Reserve Demand Curve , Link
I enjoyed your post. Please keep generating more content! I have a question about the RRP rate. What's the mechanism that prevents the funds rate from declining below the RRP rate? How exactly does it serve as the lower limit for the funds rate? I understand that a bank wouldn't lend reserves at a rate that's below IORB, which creates the upper limit, but don't understand completely how the RRP rate creates the lower limit.