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Author Spence Hilton examines factors influencing the volatility of the federal funds rate from 1989 through mid-2005 and concludes that the reduced volatility of the past five years was set in motion by accounting and operational changes implemented in the early to mid-1990s.
The early 1990s saw an increase in federal funds rate volatility because reductions in reserve requirements led to a significant decline in reserve holdings. When lower requirements are in place, swings in a bank’s reserve position are more likely to leave the bank either overdrawn or in peril of accumulating unwanted excess reserves, thus placing upward or downward pressure on market rates.
According to Hilton, this rise in volatility set in motion a number of responses both within the Federal Reserve and among banks. These included changes by the Federal Reserve to its accounting framework and a tendency by the Open Market Desk of the New York Fed to execute more frequent temporary operations to adjust the supply of reserves, says Hilton. In addition, banks took measures, including enhancing their information systems, to reduce the uncertainty of payment flows.
The author notes that the low nominal value of the target federal funds rate also has helped reduce rate volatility in recent years. Volatility in the federal funds rate picked up in the second half of 2004, a development that Hilton attributes at least in part to the rise in the target fed funds rate.
Looking ahead, the author observes that if interest rates were to move above current levels, volatility may also increase because the potential range for interest rate movements in the federal funds market will expand, and because higher interest rates tend to set in motion forces that reduce requirements banks have to hold reserves, though he would expect that any increase in volatility would be relatively muted because of the developments of recent years.
Spence Hilton is a vice president in the Markets Group of the Federal Reserve Bank of New York.