The Interplay of Policy Interest Rates

Repurchase Agreement (Repo) rate is based on the Reverse Repo agreement which is the purchase of securities with the agreement to sell them at a higher price at a specific future date. For the party selling the security (and agreeing to repurchase it in the future) it is a Repo while for the party on the other end of the transaction (buying the security and agreeing to sell in the future) it is a reverse repo. The difference between the sale price and the repurchase price is effectively the "interest" on the loan. While the interbank market is largely limited to banks, the repo market includes a broader range of participants, including broker-dealers, hedge funds, and money market funds.

Interest on Reserves is the rate central banks pay on reserves that banks hold in accounts at the central bank. By setting the Interest on Reserves, the central bank provides banks with a risk-free option for the use of their funds. Interest on Reserves creates a floor to the interbank rate.

Interbank rate is the rate at which banks lend reserve balances to other banks overnight on an uncollateralized basis. A central bank sets a target range for the Interbank Rate, and the actual rate is determined by supply and demand in the open market. Changes to the Interbank Rate have a broad impact on other interest rates and on the overall economy.

Discount Rate is the interest rate charged to banks on loans they receive from the central bank. The discount rate is typically higher than the Interbank Rate because the central banks prefer banks to borrow from each other rather than from the discount window. It serves as a ceiling for the Interbank Rate, discouraging banks from borrowing directly from the central bank unless they have no other option.

COMPARISON

In terms of why the rates aren't the same, each rate serves a different function and gives the Fed more flexibility in implementing monetary policy. For example, the Repo rate, Interbank Rate and Interest on Reserves work together to manage short-term interest rates and control monetary policy. The discount rate serves a different purpose, acting as a lender of last resort to troubled banks.

If all rates were identical, it could potentially cause instability in financial markets. For instance, if the Discount rate was the same as the Interbank Rate, banks might choose to borrow directly from the central bank instead of from each other, which could disrupt the interbank lending market. Conversely, if the Interest on Reserves was the same as the Discount rate, banks might not have enough incentive to hold reserves at the Fed. This distinction among the rates provides the central bank with a broader range of tools to control liquidity, manage banking stability, and influence monetary conditions.

Repo versus Interest on Reserves

Financial institutions outside the umbrella of central banks (like homeloan unions) cannot earn Interest on Reserves from central banks by putting reserves there. However, they can offer lending money to the banks for lower than the Interest on Reserves to still earn money. Central banks use Repo rate to set the floor rate for banks they can earn from reserves since this is the rate other financial institutions can earn from the central bank. Repos give the financial institutions another place to put its money and earn interest on it at a rate set by the central bank. As a result they are willing to lend to banks for the rates above the repo rate.

Interest on Reserves versus Interbank Rate

There is a risk that a bank might take on more risk than is prudent, because lending to other banks or entities in the open market can expose a bank to counterparty risk, which is higher than the risk associated with keeping reserves at the central bank. Banks would require a premium for the counterparty risk they take on when lending to each other in the interbank market, as opposed to parking their excess reserves at the central bank and earning the Interest on Reserves rate risk-free. Therefore, under normal circumstances, we might expect the Interbank Rate to be higher than the Interest on Reserves to compensate for that risk.

Interest on Reserves creates a floor to the interbank rate which would keep the Interbank rate from going any lower than the Interest on Reserves. Banks are not going to lend out at a lower rate than the Interest on Reserves when they could have that money sit at the central bank and collect the higher Interest on Reserves.

Interbank Rate versus Discount rate

In terms of the Discount Rate, it is typically set higher than the Interbank Rate and Interest on Reserves to discourage banks from borrowing directly from the Federal Reserve, except in times of stress when they have no other options. The Discount Rate is set intentionally higher than the Interbank Rate to incentivize banks to meet their short-term funding needs through the market under normal circumstances.

However, there might be situations where a bank might choose to borrow from the central bank at the Discount Rate. One such situation is during a financial crisis or period of significant stress in the banking sector, when other banks might be unwilling or unable to lend in the federal funds market, even at elevated interest rates. In this scenario, the central bank serves as a lender of last resort, providing liquidity to banks that can't obtain it elsewhere.

Another situation might be if a bank is facing short-term liquidity needs that it can't meet through the market for some reason, even if there's no broader crisis in the banking sector.

In these cases, the ability to borrow directly from the central bank at the Discount Rate can be a valuable lifeline for a bank.

Coupon Rate and yield curve control

Since government bonds carry a longer term, the coupon rate of government bonds would generally be higher than these short term interest rates to compensate for the additional time risk.

The Bank of Japan also uses a policy known as "yield curve control," where it aims to control both short-term and long-term interest rates.

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