Is the interest rate the Fed pays banks on reserves now more important than the Federal Funds Rate?

The Federal Funds Rate is set (maybe influenced is better) by the Fed. It is what banks pay each other when they borrow to meat their required reserves. But this market is smaller than it used to be. So maybe the Federal Funds Rate is not what matters any more. And maybe the sectors of the economy that are most affected by interest rates make up less of the GDP than they used to.

See Has the Federal Reserve Lost Its Mojo? The central bank has less control over market interest rates today than at any time in its history by Phil Gramm and Thomas R. Saving. Excerpt:

"When the Federal Open Market Committee’s meeting concluded last month, reporters focused on the federal-funds rate, announcing that it would be held constant at 2.25% to 2.5%. Unnoticed by even the financial media, and unmentioned in the lead section of the FOMC’s statement, was its decision to cut the interest rate the Federal Reserve pays on bank reserves—a rate that, unlike the fed-funds rate, still has a direct effect on the money supply. The Fed cut the rate paid on reserves because the market yield on one-year Treasurys had fallen below it, inducing banks to build up excess reserves. When banks expand reserve holdings, the money supply contracts—so the Fed was forced to act.

But it wasn’t enough. Because market rates have continued falling since the last FOMC meeting, even the lower rate that the Fed now pays on reserves is 0.35 percentage point higher than Friday’s yield on one-year Treasurys and 0.25 point above the yield on 10-year Treasurys. The return differential has caused banks to increase excess reserves by 5.5%, or $65 billion, over the past month. The size of these yield spreads and the buildup of excess reserves virtually guarantee that the Fed will again cut the interest paid on reserves at Tuesday’s FOMC meeting.

The rate paid on reserves receives too little attention. As a result of the unprecedented monetary easing of the Obama era, when the Fed bought or offset 45% of all federal debt issued—more than five times the amount it bought to support the World War II effort—commercial banks now hold massive excess reserves. By paying interest on reserves, the Fed effectively converted them into income-yielding assets, giving banks an incentive to hold excess reserves instead of expanding credit and the money supply. As banks became awash in liquidity, they all but stopped engaging in borrowing and lending in the overnight fed-funds market. The fed-funds market has contracted 80% since 2008, meaning the fed-funds rate has almost no direct effect on monetary policy."

Related article: Fed Stimulus Just Ain’t What It Used to Be: Federal Reserve may cut rates soon, but its efforts may have less oomph due to changes in the U.S. economy by Justin Lahart of The WSJ. Excerpt:

"A big reason is that the role of some of the most interest-rate sensitive industries in the labor force—the ones that hire like crazy in response to low rates—has been greatly diminished, argue economists at the Federal Reserve Bank of Kansas City. In 1980, construction and manufacturing accounted for about 25% of total U.S. employment. By the time the 1990-91 recession began, that had fallen to 21%, slipping to 18% before the 2001 recession and 15% ahead of the last recession. Now it is at 13%.

Another important difference between this last expansion and previous ones is that housing, after falling by so much in the downturn, had such a modest comeback. Home sales remain below their late 1990s levels, when the U.S. population was lower, and housing’s direct share of gross domestic product is now at levels which in other periods would have been associated with recession. The share of Americans who own the home they live in also has fallen.

Although lower rates might stimulate home sales a bit, a variety of forces are weighing on housing, including out-of-reach prices. This matters because housing is one of the ways that rate cuts have traditionally boosted the economy. Lower mortgage costs prompt people to buy not just a house but many other things—furniture and appliances—that go with it.

Mortgage refinancing—another avenue for lower rates to make their way into consumer spending—also might be lacking. Many homeowners already refinanced during the years coming out of the recession, locking in ultralow rates.

Then, there is the increased caution Americans seem to be taking with their finances since the financial crisis, leaving the saving rate substantially higher than before the recession. Even a decade later, memories of the severity of the downturn may still be too fresh for people to respond exuberantly to lower rates.

It could take more than just rate cuts to get the economy really going again."