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Research Highlights

A New Way of How Monetary Policy Works

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Because deposits are the primary source of funding for banks and are well-suited to funding risky and illiquid assets due to their stability, the deposits channel has important implications for credit supply, the prices of risky assets, and the macroeconomy.

The impact of monetary policy decisions on the real economy can be analyzed through many channels. A new such channel was recently proposed by a trio of NYU Stern finance professors, who showed how an increase in the Fed funds rate affects deposits and thus the credit supply, asset prices, and the macroeconomy.
 
In “The Deposits Channel of Monetary Policy,” Professors Itamar Drechsler, Alexi Savov and Philipp Schnabl took a branch-level look at banks across the US to chart what happens to interest spreads on deposits when the Fed funds rate goes up. They showed that when the rate increases, banks widen the interest spreads they charge on deposits, which causes deposits to flow out of the banking system and into other financial intermediaries. The aggregate effect is so large, they write, that monetary policy has a significant, causal effect on how the financial system is funded.
 
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Deposits are critically important to banks, as their single largest source of funding and, through interest spreads, an important revenue source. Deposits are similarly important for households, representing their main haven for easily accessible savings. Therefore, any change in monetary policy that affects deposits ripples throughout the system, because when spreads widen, households look elsewhere for higher returns, deposits flow out, and banks have less money to lend.
 
The authors conclude: “Because deposits are the primary source of funding for banks and are well-suited to funding risky and illiquid assets due to their stability, the deposits channel has important implications for credit supply, the prices of risky assets, and the macroeconomy. Moreover, because deposits represent the main source of liquidity and safety for households, the deposits channel also implies that monetary policy drives the supply of safe and liquid securities produced by the financial system and the price of liquidity in the economy.”