Fed Funds Market Explained

In my previous post, I explained the difference between dollars created by The Fed and dollars created by banks. Dollars created by The Fed do not act as money.

In this post, I will briefly describe the Funds Market.

I realize this is pretty boring stuff, but you need to understand some of this stuff before I explain the problems with public statements made about The Fed and the influence of Fed Funds.

The Fed Funds Market

The Fed Funds Market has a very simple structure, but based on the comments I hear, it seems misunderstood. In simple terms, it consists of a market in which institutions that have accounts with The Fed can lend and borrow the funds in their reserve accounts. Because of the limitation as to which institutions trade in this market, we must consider it a closed market.

Pre-2008

Although operating as a closed market for many years, prior to 2008, the market had more significance to banks because of the limitation of excess reserves, which consisted of reserve balances held in excess of required reserves.

Post-2008

During the “financial crisis” in 2008, The Fed increased bank reserves by a staggeringly large amount. Based on the reserve ratio at the time (10% on-demand accounts), “excess reserves” became essentially meaningless. As a matter of fact, The Fed quit reporting “excess reserves.”

Then in March 2020 The Fed eliminated required reserves. They made my beautiful diagram useless, except that the depiction of The Fed Funds Market remains accurate.

Summary

I have tried to keep this post short and simple because you need to know only one thing:

The Fed Funds Market is a closed market.

I will explain the importance of this fact in the near future.