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The liquidity effect is the negative relationship between the supply of federal funds and the overnight federal funds rate. Deviations of the federal funds rate from its target can be interpreted as demand innovations for federal funds. Permanent adjustments to demand are modeled as an unobserved component and estimated using the Kalman filter to identify liquidity effects. The demand-based approach for identifying the liquidity effect contrasts previous work which concentrates on errors forecasting the supply of federal funds. This paper finds a liquidity effect several times larger than that from previous studies, indicating the market for federal funds is less liquid than previously thought. The effect of a $1 billion increase in open market operations over a 1-week period is a decrease of the federal funds rate by about 12 basis points.

The federal funds rate, the price negotiated between depository institutions (banks hereafter) for overnight loans between accounts at the Fed, serves as a primary instrument for the implementation of monetary policy and, thus, is an integral link in the transmission process of policy to the economy. In the context of the federal funds market, the liquidity effect refers to the specific relationship between the supply of federal funds and the overnight lending rate; an increase in the supply of reserve balances brings about a lower federal funds rate. The elusiveness of an accurate and non-controversial estimate for the magnitude and properties of the liquidity effect can be attributed to the difficulty isolating exogenous policy activity of the Federal Reserve from the effect of the Fed’s anticipation of the expected funds rate, the market’s anticipation of the Fed’s future actions, or other endogenous factors.

The unique structure of the federal funds market allows the behavior of the Fed to be modeled in an adaptive expectations framework. The Trading Desk enters the market by buying and selling bonds in an attempt to equalize the funds rate with a FOMC determined target. This structure allows for the identification of the liquidity effect of open market operations. In a departure from the previous studies of Hamilton, 1997, Carpenter and Demiralp, 2006 and Judson and Klee, 2010 this paper measures the elasticity of demand for additional reserves in terms of the observed open market operation, not through use of supply forecast errors unavailable to market participants. The unobserved demand component accounts for a misspecification of the demand for funds found in previous studies which yield conspicuously small liquidity effects.