Basic, lesson 1 of 3
Central banks and how they move markets
A central bank has three tools: the overnight rate, its balance sheet, and its words. Markets trade the reaction function, the rule the bank seems to follow, more than any single decision.
10 min, 3 checks
1The corridor: how the Fed holds a rate it does not trade
The Fed announces a target range for the fed funds rate, 25bp wide. It does not trade fed funds itself. It keeps the market rate inside the range with two administered rates: interest on reserve balances (IORB), which it pays banks on money parked at the Fed, and the overnight reverse repo rate (ON RRP), which it pays money market funds and others for lending to it overnight.
No bank should lend reserves overnight for less than it earns leaving them at the Fed, so IORB acts as a strong pull near the top of the range. ON RRP sets a floor for the wider set of lenders who cannot earn IORB. Market overnight rates settle between the two.
| Rate | Level | What it does |
|---|---|---|
| Target range | 4.25% to 4.50% | The announced policy stance |
| IORB | 4.40% | Banks will not lend reserves for much less |
| ON RRP | 4.25% | Floor for money funds and other non banks |
| Effective fed funds | About 4.33% | Where overnight trading actually prints |
Check 1
The Fed raises the target range by 25bp. What does it actually change to move market rates?
2The balance sheet: QE and QT
Quantitative easing means the central bank buys long bonds (Treasuries and agency mortgages in the US) with newly created reserves. It removes duration from the market, so investors who sold must buy other assets, and the term premium on long bonds falls. Quantitative tightening is the reverse: the bank lets bonds mature without reinvesting, so private investors must absorb more duration and the term premium tends to rise.
The policy rate works through the front end; the balance sheet works mostly through the long end and through liquidity. That is why a central bank can cut rates and run QT at the same time without contradiction: one sets the price of overnight money, the other the amount of duration the market must hold.
Check 2
A central bank announces it will slow QT sharply while leaving its policy rate unchanged. Which move is most consistent?
3Forward guidance and the reaction function
Words move markets before rates do. Forward guidance is what the bank says about the future path: data dependent, on hold for some time, prepared to move faster. The market prices the path, so a speech can move the 2 year as much as a hike.
The reaction function is how the bank seems to respond to data: how much a hot inflation print or a weak jobs report changes the path. A trader's job is to estimate it better than the market. A common starting point is a Taylor style rule.
Policy rate = neutral real rate + inflation + 0.5 x (inflation - 2%) + 0.5 x output gap
A rule of thumb, not what any central bank mechanically follows. The output gap is actual minus potential output, in percent.
Worked example
A Taylor rule, worked
- 1Neutral real rate 0.5%, inflation 3.0%, output gap -1.0% (the economy is running a little below potential).
- 2Inflation gap: 3.0% - 2.0% = 1.0%, times 0.5 = +0.5%.
- 3Output gap term: 0.5 x -1.0% = -0.5%.
- 4Rate = 0.5% + 3.0% + 0.5% - 0.5% = 3.5%.
The rule suggests 3.5%. If policy is at 4.4%, the rule says policy is tight, and a desk would expect cuts if inflation keeps falling. The useful part is the sensitivity: each extra point of inflation adds 1.5 points to the rule.
Check 3
Neutral real rate 1.0%, inflation 4.0%, output gap +1.0%. What rate does the Taylor style rule above give, in percent?
Terms in this lesson: Federal funds rate, Repo, Quantitative easing, Treasury securities, Duration, Nonfarm payrolls.
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