The Federal Reserve Bank of New York recently published a Liberty Street Economics blog entitled, "Explaining the Puzzling Behavior of Short-​Term Money Market Rates." They write, "​Since 2008, the Federal Reserve has dramatically increased the supply of bank reserves, effectively adopting a floor system for monetary policy implementation. Since then, the behavior of short-​term money market rates has been at times puzzling. In particular, short-​term rates have been surprisingly firm in recent months, despite the large increase in reserves by the Fed as a part of its response to the coronavirus pandemic. In this post, we provide evidence that both the supply of reserves and the supply of short-​term Treasury securities are important factors for explaining short-​term rates." The blog explains, "​In a Staff Report updated last year, we showed that the theory focusing solely on reserves and balance sheet costs isn'​t sufficient to explain the behavior of short-​term rates. In reality, it is also important to consider how the supply of Treasury securities affects rates. Specifically, our model showed that short-​term Treasury securities and reserves have opposing effects on short-​term rates." It continues, "​However, wholesale bank deposits are not the only investment option for institutions seeking to invest in short-​term instruments. Money market mutual funds (​MMFs) offer an investment alternative to bank deposits and hold a large amount of short-​term Treasury securities as assets. When the supply of Treasury securities increases, everything else being equal, Treasury yields tend to increase to attract investors. MMF shares become more attractive than bank deposits and investors reduce the amount of such deposits they hold.... This reduces the size of banks' balance sheets (​banks may reduce, on the asset side, their investments in repos, for example), and induces banks to raise their wholesale deposit rate to remain competitive." It adds, "In this post, we showed that the quantity of short-​term Treasuries, in conjunction with the quantity of reserves, assists in explaining the evolution of short-​term rates such as the fed funds rate. In particular, by enriching our understanding of how short-​term rates are determined, we are able to explain why these rates have remained elevated in recent months, despite the Fed'​s very large increase in the supply of reserves. Put another way, whether reserves are scarce can only be judged in relation to the amount of short-​term Treasuries. Because Treasury issuance of short-​term securities is expected to remain high, upward pressures on the federal funds rate are likely to continue in the coming months, even in the face of a large supply of reserves."

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