The St. Louis Fed said that research shows that historically checking and savings rates show almost no response to the increase in the federal funds rate and have been near zero since the 2007-09 financial crisis.

 ST. LOUIS–As it is becoming more costly for people to hold not only cash but also bank deposits, new liquidity pressures are being felt by both financial institutions and depositors, creating a “liquidity premium,” according to new research by the St. Louis Federal Reserve Bank.

With the Federal Open Market Committee (FOMC) raising the federal funds rate at its past four meetings, the St. Louis Fed has released new research that investigates the links between monetary policy and its macroeconomic effects, including in the 2022 tightening cycle.

“Imagine a simple world where you can choose between three assets: cash, deposits, or bonds. Cash is the most liquid asset but pays no interest,” the St. Louis Fed stated. “Deposits, such as checking, savings, or time deposits, are less liquid than cash, but they pay rates set by the bank. Bonds are the least liquid among these assets, and assume, for simplicity, that bonds pay the federal funds rate. Banks raise deposits and create loans. Moreover, banks also have market power and set the interest rate on deposits. In this environment, when the FOMC raises the federal funds rate, cash becomes more expensive to hold. How do bank deposit rates respond?”

As shown in the chart, the St. Louis Fed said the research shows that historically checking and savings rates show almost no response to the increase in the federal funds rate and have been near zero since the 2007-09 financial crisis.

‘Hardly Moving’

“In the first two tightening cycles, around 2000-05, the CDs all seem tied to the federal funds rate while it is rising,” the St. Louis Fed stated. “However, if we look at the last two tightening cycles, CDs hardly move at all in response to a rising federal funds rate. In fact, in the current 2022 tightening cycle, between February and June, the monthly average of the effective federal funds rate increased 113 basis points.^”

Checking and savings rates did not increase, and three-, six- and 12-month CD rates increased by 1, 2, and 3 basis points, respectively, the research found.

“These findings mean that the deposit spread—the difference between the federal funds rate and the deposit rate—is increasing,” the analysis continued. “Therefore, it is becoming more costly for people to hold not only cash but also bank deposits. Thus, we expect households and firms to remove their money from deposits and shift their money to other markets with better returns, such as bonds. When deposits are removed from the banks, the banks have less money to lend and liquidity dries up.”

Becoming ‘More Valuable’

The St. Louis Fed researchers further explained that on the one hand, there is a smaller supply of liquidity because households and firms move their money out of cash and deposits to less-liquid assets. But the other hand, they continued, the demand for liquidity continues, as households and firms still find it desirable to have liquid assets in case they need quick access to funds.

“There­fore, in equilibrium, the liquidity provided by financial assets becomes more valuable and investors are willing to accept a lower return on assets that are more liquid precisely because these assets are more liquid.”

To that end, the researchers said to measure the “liquidity premium” they computed the liquidity spread, as seen in the chart below.

“If this spread is positive, then illiquid assets are paying higher rates to compensate for the lack of liquidity and thus there is a liquidity premium,” they explained. “At the start of the COVID-19 pandemic, we see a big jump in the liquidity spread, most of which is gone by July 2020. By July 2020, the FOMC had lowered the federal funds rate to near zero and injected large amounts of liquidity into the market. Consequently, the market was flooded with liquidity and the liquidity premium disappeared; the liquidity spread dropped to around zero.

The ’Premium’

“At the beginning of 2022, when the FOMC started raising the federal funds rate, we see a jump in short-term liquidity spreads, with the commercial paper spread up 50 basis points since the beginning of 2022.

“In conclusion, when the FOMC raises the federal funds rate, cash and deposits become costly to hold because there are higher interest rates available in other markets,” the St. Louis Fed continued. “Thus, firms and households seek out higher-return investments, which are usually less liquid. When liquidity dries up, there is a higher liquidity premium for safe, liquid assets.”