Fed Funds Rises to 1.92%; Spread to IOER Tightest Since 2010 (Large Banks Hold Most of Excess Reserves at The Fed)

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Large banks hold the most excess reserves in the US. But will continued Fed rate increases lead to further withdrawal of excess reserves by these giant banks?

(Bloomberg) — The effective fed funds rate rose Wednesday to 1.92% from 1.91%, further narrowing the gap to the Fed’s interest on excess reserves (IOER) rate.

Wrightson ICAP economist Lou Crandall said in Thursday note that he expected fed funds to set higher given that “rates in the broker market continued to trend north.” Now that fed funds has set at 1.92%, the rate should remain unchanged through the end of June. Longer-run trend in fed funds is “clearly to move closer to (and eventually perhaps above) IOER. At 3bp, the fed funds/IOER spread matches the tightest level since April 2010.

Before the spread narrowed to 4bp on Tuesday, the gap between interest on excess reserves and the fed funds rate remained at 5bp, even after the Fed’s hike last week, which included the technical change of only lifting the IOER by 20bp; spread was at 8bp at beginning of year.

Two theories about the rise in fed funds rate: First is that the rise of overnight rates following the surge in T-bill supply is the culprit behind the move; second, that reserve draining is hitting a critical threshold for bank demand for funding to rise.

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Here is a chart of excess reserves against the interest rate paid on excess reserves.

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Its the large banks that are holding most of the excess reserves at The Fed.

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This is not surprising given the consolidation of the banking industry since 1990.

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