Immediately following its January policy meeting, the Federal Reserve released a Statement Regarding Monetary Policy Implementation and Balance Sheet Normalization. The Statement, which Chair Jerome Powell also referred to in his latest Semiannual Report to Congress, confirms that the Fed will continue targeting interest rates using the new “floor system” first introduced in December 2015. Under that floor system, the Fed adjusts the interest rate it pays on bank reserves to bring about desired changes in its federal funds rate target, while operating with a balance sheet that remains considerably larger than it was before the financial crisis and severe recession of 2007-09.
The floor system has worked well, so far, in re-normalizing the Fed’s policies after the extended period of exceptionally low interest rates made necessary by the financial crisis. There is no reason to replace it right away. Over the long term, however, the Fed should find another approach to policy implementation. The floor system makes monetary policy less effective during severe recessions, exactly when it is needed most. It also exposes the Fed to political risks that threaten its role as an independent central bank.
Since December 2015, the Fed has raised the interest rate it pays on bank reserves in a series of nine steps, from 0.25 to 2.40 percent. By doing so, it has succeeded in pushing the federal funds rate higher as well. To understand how this new floor system works, one must start by recalling that, despite its name, the “federal funds rate” is not controlled directly by the Federal Reserve. Instead, it is a market rate of interest that one bank charges to another bank on very-short term loans of reserves (that is, funds held on deposit at the Fed).
Suppose that the Fed were to increase the interest rate it pays on reserves but that, contrary to the intent of the floor system, the federal funds rate remains unchanged. In that case, any bank could borrow funds from another bank at the low federal funds rate, deposit those funds in its account at the Fed to earn the higher interest rate on reserves, and thereby book instantaneous, risk-free profits. Excess demand for loans between banks would then drive up the federal funds rate. That is why, under the Fed’s new system, the interest rate paid on reserves serves as a “floor” for the federal funds rate: when the Fed increases the interest rate on reserves, market forces push the funds rate higher as well.
Despite the novelty of the floor system used to produce them, the nine increases in the federal funds rate that the Fed has engineered since December 2015 have had the same effects traditionally associated with a monetary policy tightening. Growth in the M1 and M2 measures of the money supply has slowed noticeably. Activity in the most interest-rate-sensitive sectors of the economy, especially the housing sector, has cooled off markedly as well. Most important, inflation appears to have stabilized at a level very close to, but still below, the Fed’s long-run two percent target.
Mechanically, therefore, the floor system has worked, allowing the Fed to remove much of the monetary accommodation applied during and after the 2007-09 recession – accommodation that, with the continued expansion of the US economy, is no longer needed. In addition, as renewed financial market volatility towards the end of last year illustrated, the Fed has good reason to prefer stability in its operating procedures. Changes aren’t needed – not right away.
From a longer-term perspective, however, the floor system has two major flaws. First, by paying interest on reserves, the Fed gives banks an incentive to hold funds on deposit instead of lending them out. For exactly this reason, the large increase in the supply of reserves that the Fed generated through three rounds of “quantitative easing” during and after the financial crisis never produced excessive growth in the broader, M1 and M2 measures of the money supply. Nor did quantitative easing prevent the inflation rate from falling persistently below target. In terms of basic economics, interest on reserves increases the demand for reserves, so even very large increases in the supply of reserves have little effect on inflation.
Thus, quantitative easing would have been more effective without interest on reserves. Smaller, and shorter-lived, bond-buying programs would have provided more monetary stimulus and done a better job of bringing inflation back to target. A recent article by economists Donald Dutkowsky and David VanHoose makes exactly this point. The next time the economy falls into a severe recession, the Fed could provide needed monetary accommodation without quantitative easing. All it would have to do is abandon the floor system by no longer paying interest on reserves. Banks would then have a stronger incentive to lend, an effect that by itself would stimulate money growth and increase aggregate spending.
A second flaw in the floor system is that, by continuing to pay interest on reserves, the Fed retains the ability to conduct large-scale asset purchases without causing inflation. The risk, highlighted in a working paper by Charles Plosser, my colleague on the Shadow Open Market Committee, is that this opens the Fed up to pressures from the president or members of Congress to purchase securities issued by borrowers in politically-favored sectors of the economy. If forced to do so, the Fed would lose its status as an independent central bank, managing interest rates and the money supply to control inflation. Instead, it would be acting more like a fiscal agency, allocating funds to promote specific government projects, but potentially without approval through the formal appropriations process that requires the assent of Congress and the president.
Quite admirably, Chair Powell and his colleagues at the Fed continue to solicit feedback from Congress and the public, seeking ways to make their policies more robust and effective. One important step they should take is to abandon their floor system as soon as possible, and return to a system that implements monetary policy with a smaller balance sheet and without interest on reserves.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee. This commentary is based on a position paper he will present at the SOMC’s March 29 meeting, organized with the help of Economics21 and the Manhattan Institute.
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