According to the minutes of their late-October meeting, Federal Open Market Committee members discussed the possibility of lowering the interest rate the Fed pays on reserves held on deposit by commercial banks
, as a way of adjusting the stance of monetary policy. This idea has considerable merit. To see why, let us remember how monetary policy actually works.
During normal times, the Federal Reserve conducts monetary policy by adjusting its target for the federal funds rate. It lowers the target when it wants to ease monetary policy and raises the target when it wants to tighten.
But the federal funds rate is the interest rate one bank charges another on a very short-term loan of reserves. It is an interest rate that adjusts freely, at every moment, to clear the market for interbank loans, not a rate that is directly controlled or regulated by the Fed. Thus, when the Fed shifts its funds rate target, it cannot just dictate that bankers suddenly become willing to borrow and lend at a new interest rate. Instead, it must adjust the supply of reserves so as to bring about the desired change in the equilibrium funds rate.
In particular, when the Fed lowers its federal funds rate target, it must conduct open market operations in which it uses newly-created reserves to purchase previously-issued U.S. Treasury securities. This increase in the supply of reserves puts downward pressure on the actual federal funds rate, so that it falls to meet the Fed’s new, lower target. Conversely, when the Fed raises its funds rate target, it must conduct open market operations in which it sells back to the public U.S. Treasury securities that it bought before, thereby draining reserves from the banking system and putting upward pressure on the actual funds rate.
These open market operations then initiate the circular process of multiple deposit creation that most college freshman learn about in their Principles of Economics classes. When the Fed expands the supply of reserves, each individual bank holds some of the new dollars, but lends the rest out. The money lent then gets re-deposited in another bank, continuing the process and leading, in the end, to an expansion in the money supply that can be much larger than the size of the original open market operation. This same process works in reverse when the Fed contracts the supply of reserves.
Thus, while financial market participants, newspaper reporters, and even Federal Reserve officials themselves prefer to think of monetary policy in terms of interest rates, it is really open market operations, which change the supply of reserves and then overall money supply, that allow the Fed to do its job of controlling the rate of change of prices or inflation.
These same mechanisms continue to work when the federal funds rate is constrained by the zero lower bound on interest rates, as it is today. Indeed, despite their peculiar name—“Large Scale Asset Purchases”—the Federal Reserve’s repeated rounds of bond buying really amount to nothing more than standard open market operations, which increase the supply of reserves and then the money supply, and are intended to bring the rate of inflation back up towards the FOMC’s two percent target.
By continuing to pay interest on reserves at a rate that not only matches, but exceeds the rate banks can earn on comparable risk-free assets such as short-term U.S. Treasury bills, the Fed has been working against itself, perversely sending deflationary impulses through the economy at a time when inflation is already too low. This is because a higher interest rate on reserves induces banks to demand more excess reserves. The Fed must then either conduct even larger open market operations simply to accommodate additional demand, or accept downward pressure on the money supply and inflation rate as the circular process of deposit creation gets curtailed by what, again, any college freshman should recognize as a decrease in the money multiplier.
Reducing the interest rate it pays on reserves would allow the Fed to provide additional monetary stimulus, even as the federal funds rate remains at zero, so as to more effectively defend its two percent inflation target. Usefully, this same step might also allow the FOMC to scale back on its asset purchase programs, so that they focus solely on U.S. Treasury bonds and eschew the mortgage-backed securities the Fed has also been buying. This is important, since it would make clear that allocating credit to the housing sector, or any other specific area of the U.S. economy, is a task that is best left to private financial institutions, which profit when they make the right decisions and fail when they are wrong. The Fed, meanwhile, should concentrate on stabilizing prices. Paying a lower interest rate on reserves would allow it to do so more effectively.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.