Higher Fed funds rate may raise arbitrage

The U.S. Federal Reserve is holding more bonds; as a result, total USD reserves in the Fed funds system have increased to USD 2,500 billion, which is more than reserve requirement. The depository institutes, who have reserve accounts with the Fed, are earning the interest rate on excess reserve (IOER) at 0.25%.

The Fed rate hike may increase a scope for the depository institutes to arbitrage out the spread between Fed fund rate and the IOER. They will barrow in the Fed funds market and save in IOER. Therefore, Fed should fix the funds rate at a margin to the IOER, suggests Danske Bank.