The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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November 14, 2008

More on the changing operational face of monetary policy

This week I’m begging your forbearance as we take a bit of a detour into the operational weeds of monetary policy. The geek factor is high, I know, but there truly have been some historic changes afoot over the past months.

To review, effective Nov. 6—as noted in Wednesday’s blog post—the Federal Reserve unwrapped a new approach to its daily operations in overnight interbank markets (in which the federal funds rate is determined). Rather than sending you scurrying down the page, here’s the deal in a nutshell:

1. The federal funds rate is the interest rate at which depository institutions borrow and lend to each other, on an overnight basis, balances (or reserves) deposited with the Fed.

2. The Fed—actually the folks who implement Open Market Operations at the Federal Reserve Bank of New York—manages the federal funds rate to an FOMC-set target by altering the total quantity of reserves available to the banking system.

3. In the old days (pre-October 6 when the Fed first began paying interest on reserves using a different interest-rate regime), these reserves paid no interest. Banks, as a consequence had every incentive to economize on their reserve balances. As a consequence of that fact, depository institutions would respond to an injection of reserves by trying to sell them off. That might work for one bank, but not the banking system as a whole, and in the end the banks would collectively have to be “persuaded” to hold the additional reserve balances. The persuading factor would, of course, be a lower federal funds rate.

4. In the new regime (post-November 6), banks can deposit reserve balances with the Federal Reserve, earning exactly the interest rate they would receive by taking those reserves and lending them out in the federal funds rate market. Beyond some point, then, an increase in reserves should have no impact on the federal funds rate, as banks should simply absorb any injection of reserves into the system. In other words, the Fed can expand the monetary base without changing the federal funds rate.

So, here’s today’s question: Why might it be a good idea, paraphrasing Keister, Martin, and McAndrews, to divorce money from the federal funds rate? Here’s your answer, courtesy of the Board of Governors’ “FAQ sheet”:

The inability to pay interest on balances held to satisfy reserve requirements essentially imposes a tax on depository institutions equal to the interest that might otherwise have been earned by investing those balances in an interest-bearing asset. Paying interest on required reserve balances effectively eliminates this tax…

Paying interest on excess balances should help to establish a lower bound on the federal funds rate by lessening the incentive for institutions to trade balances in the market at rates much below the rate paid on excess balances. Paying interest on excess balances will permit the Federal Reserve to provide sufficient liquidity to support financial stability while implementing the monetary policy that is appropriate in light of the System’s macroeconomic objectives of maximum employment and price stability.

Keister et al. expand on the idea:

The value of the payments made during the day in a central bank’s large-value payments system is typically far greater than the level of reserve balances held by banks overnight…

As a result, banks’ overnight reserve holdings are too small to allow for the smooth functioning of the payments system during the day. When reserves are scarce or costly during the day, banks must expend resources in carefully coordinating the timing of their payments. If banks delay sending payments to economize on scarce reserves, the risk of an operational failure or gridlock in the payments system tends to increase. The combination of limited overnight reserve balances and the much larger daylight demand for reserves thus creates tension between a central bank’s monetary policy and its payments policy. The central bank would like to increase the total supply of reserve balances for payment purposes, but doing so would interfere with its monetary policy objectives.

Monetary policy, in this instance, presumably means manipulating the federal funds rate, and with that the story looks more or less complete: Having removed the opportunity cost to banks of holding reserves, expansion of reserves for payments policy reasons can be accomplished without changing the fed funds rate target, and conversely the funds rate target can be changed without compromising the provision of total reserves.

I say more or less complete for a couple of reasons. The first has been highlighted by Jim Hamilton (among others): Thus far, the interest rate on excess reserves has failed to put a floor on the effective federal funds rate. Suffice it to say the puzzle has not yet been resolved:

Effective vs Target Fed Funds Rate

The second issue, which has not yet generated much commentary, is exactly how we should be thinking about this separation of the federal funds rate from the provision of reserves. There is a tendency to think of monetary policy as purely linked to the federal funds rate and its direct influence on the cost of funds and, hence, capital. But as Chairman Bernanke has noted, the issue may be a bit more complicated:

Another area of pressing current interest derives from [Milton Friedman's proposition] that monetary policy works by affecting all asset prices, not just the short-term interest rate. This classical monetarist view of the monetary transmission process has become highly relevant in Japan, for example, where the short-term interest rate has reached zero, forcing the Bank of Japan to use so- called quantitative easing methods. The idea behind quantitative easing is that increases in the money stock will raise asset prices and stimulate the economy, even after the point that the short-term nominal interest rate has reached zero. There is some evidence that quantitative easing has beneficial effects (including evidence drawn from the Great Depression by Chris Hanes and others), but the magnitude of these effects remains an open and hotly debated question.

A natural corollary to that proposition would be that a large expansion of the monetary base might well constitute a change in monetary policy properly construed, even when the federal funds rate target remains unchanged. That is, the separation of money and monetary policy may not be quite as irreconcilable as it seems at first blush.

Of course, as the Chairman said, it’s an open question, and will no doubt be hotly debated. Stay tuned.

November 14, 2008 in Federal Reserve and Monetary Policy | Permalink


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The money supply can never be managed by any attempt to control the cost of credit (e.g., if nominal interest rates are zero, etc.).

The only tool at the disposal of the monetary authorities in a free capitalistic system through which the volume of money can be controlled are "free" legal reserves.

If applied on a large enough scale, the payment of interest on reserves is an indirect method by which the FOMC can raise reserve requirements for the commercial banking SYSTEM. I.e., it will lower the "money multiplier".

The volume of inter-bank lending will be displaced, because of disproportionately larger volumes, of excess-balances:
a. excess reserve balances,
b. excess clearing balances,
c. higher pass-through correspondent balances, &
d. redistributed surplus vault cash,
(inter-bank demand deposits held in the District Reserve banks, owned by the member banks or IBDDs.

The bankers, et. al. are confused. Now the banks have effectively, idle unused lending capacity, i.e, they won't utilize their excess reserves to create new money & credit because they're now getting paid an equivalent market rate of interest (with no risk).

I.e, the commercial banking SYSTEM ends up with a much greater tax, because, as opposed to earning $208 billion dollars in earning assets on the basis of an injection of $1 billion of excess reserves (fractional reserve banking), the individual bankers now earn an interest rate equal to the FFR on $1 billion of reserves (collectively bad business).

The "monetary base" is not a base for the expansion of new money & credit. An increase in currency (trending up ever since the 1920's) drains legal reserves and would contract bank credit, unless offset by other factors supplying reserves, e.g., open market purchases of the buying type.

During 1933-1942 there was a lack of "bankable" loans (like today, not enough credit-worthy borrowers). And net debt was lower in 1939 than it was in 1929 (the essence of a depression). Between 1940-1945 net debt doubled. Virtually all that debt was Federal.

Roosevelt got his “2 percent war” by having the Fed stand ready to buy (or sell) all Treasury obligations at a price which would keep the interest rate on “T” bills below one percent, and long-term bonds around 2-2 1/2%, and all other obligations in between.

This was achieved through totalitarian means, involving the control of total bank credit and the specific rationing of that credit. Plus there were controls on prices and wages that kept the reported rate of inflation down.

Up until now this country has ameliorated its un-necessary, self-imposed, economic hardships (collapsing production), largely through massive transfer payments to non-productive recipients. Deficit financing by the Federal Government provided the principal source of funds. At some unknown point (sooner than later), there is a finite limit to this "remedy".

The future holds the prospect of sharply declining levels of consumption for the vast majority of the American people, who will be facing years of stagflation.

It is probable that we will never be able to dig ourselves out of the present morass of debt and still operate the ecnomy within the framework of a free capitalistic system.

Posted by: flow5 | November 15, 2008 at 12:53 PM

very nice article, thank you!

Posted by: Marius | November 16, 2008 at 02:40 PM

The Fed's paying interest on reserves (required plus excess) is equivalent to allowing the Fed to print and sell unlimited quantities of T-bills. Instead of printing money to pay for assets, then selling T-bills to sterilise the money created, it allows the excess supply of money to flow back as excess reserves. So now the Fed can never "run out of ammunition", and doesn't need loans from the Treasury if it wants to undertake sterilised asset purchases.

Posted by: Nick Rowe | November 16, 2008 at 03:05 PM

Payment of interest on reserves creates an option for quantitative easing by eliminating the zero policy rate condition.

One rationale for desiring a QE capability apparently is the difference in demand for daylight and overnight reserves.

But QE also provides an additional mechanism for funding Federal Reserve balance sheet asset expansion, without relinquishing control over the effective Federal funds rate. And it encourages commercial banks to transmit monetary easing more broadly before the funds target rate reaches zero.

As to why the effective funds rate under the new system has deviated from target, you say “Suffice it to say the puzzle has not yet been resolved.”

Should we expect additional changes in reserve architecture?

Will events overtake this problem by further movement of the target rate toward the zero bound?

Posted by: JKH | November 17, 2008 at 06:23 AM

It look's like bank reserve balances at the Fed are headed much higher:

November 17, 2008


Treasury Issues Debt Management Guidance on the Temporary Supplementary Financing Program

Washington - The balance in the Treasury's Supplementary Financing Account will decrease in the coming weeks as outstanding supplementary financing program bills mature. This action is being taken to preserve flexibility in the conduct of debt management policy in meeting the government's financing needs.

Posted by: JKH | November 17, 2008 at 07:45 PM

Dear Dr. Altig,

First, thanks for a great pair of posts. While, as you say, the subject is geeky, such changes in monetary policy are interesting and important.

While I understand _how_ the Fed can "divorce" money from monetary policy, I'd like to return to first principles and ask why would it makes any sense to interfere with a price (the fed funds rate) which presumably is conveying information to market participants. Your second point about Bernanke's view of monetary easing and asset prices is a hint, but begs the question of why the Fed is now in the business of actively influencing asset prices -- the mandate is price stability and full employment.

A second issue is that an important source of price fluctuations is due to the fact that the Fed does not have complete control over the money supply (and therefore price levels) since the ultimate money supply depends both on exess reserves and the public's preferences on deposits and currency. (I think I'm remembering this correctly from Friedman (1959).) Isn't a reserve target well-above the required reserve level (Exhibit 3) essentially introducing a large overhang of excess reserves that is potentially inflationary should the banking system decide to re-leverage?

Thanks for providing the forum for the discussion of such nerdy topics.

-- Rodney

Posted by: Rodney | November 18, 2008 at 02:14 PM

Many thanks for posting this! PLEASE don't worry about the geek factor. The LAST thing this nation needs during this catastrophe is yet another dumbed down financial website.

Keep up the great work!

I'm on vacation right now, but will comment more soon.

Matt Dubuque

Posted by: Matt Dubuque | November 19, 2008 at 09:28 AM

Tell me if I'm right on this:
With interest on excess reserves, the increase in total reserves is likely to lead to banks holding excess reserves, on about a one-to-one basis. So increases in reserves won't increase the money supply. So quantitative easing doesn't really occur.

Maybe the banks feel more comfortable lending when they have extra liquidity at the Fed, but haven't we just precluded any economic impact via monetarist mechanism?

Posted by: Bill Conerly | November 19, 2008 at 10:42 PM

What I don't understand is that it seems to me that this payment of interest has a practical net effect of tightening by the Fed.

I say this because while Bank A previously would have deposited fewer overnight reserves with the Fed to avoid losing the amount of interest they could have charged to Bank B via the Fed funds market, NOW they have a perverse incentive not to do so if certain conditions are met.

In other words, interbank lending is being DISCOURAGED to some extent by this move.

SOME of the funds that Bank A lent to Bank B on the Fed funds market MAY have actually been lent out to the real economy.

But NOW, that is reduced, because Bank A has larger precautionary balances with the Fed.

I think that is harmful, counterproductive and reflects a Fed policy that is unnecessarily tight when we face a surging risk of deflationary bursts.

Posted by: Matt Dubuque | November 24, 2008 at 10:46 PM

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