The Federal Reserve will soon face a pivotal decision about how it will conduct monetary policy in the future, with significant consequences for the economy. The Fed appears to be on course to assert for itself an unprecedentedly large role in American finance and lose taxpayers money. But there is another way: The Fed could instead simply return to conducting monetary policy essentially how it did before the crisis.
Prior to the crisis, the Fed conducted monetary policy by means of relatively small open market transactions with broker dealers. Those transactions adjusted the quantity of reserves (deposits of banks at the Fed) so as to keep the federal funds rate, the market interest rate at which commercial banks lend reserves to each other, near its target. Using that pre-crisis monetary policy framework, the Fed was able to reliably hit its interest rate target for the federal funds rate, yet leave a small imprint on the financial system. Banks borrowed and lent reserves with each other, not with the Fed. Consequently, the Fed was counterparty to only a small number of relatively inconsequential financial transactions each day.
Because of the extraordinary asset purchases the Fed conducted during and after the financial crisis, it was forced to drastically alter the way it conducted monetary policy. As the Fed’s balance sheet grew, the supply of excess reserves rose more than 2 thousand fold, from pre-crisis levels of about $1 billion to current levels above $2 trillion. With banks bloated with reserves, the fed funds rate is now essentially pinned to the interest rate the Fed pays on excess reserves. Meanwhile, the Fed has created what is effectively a deposit facility for nonbanks (where the “deposits” take the form of overnight reverse repos) to provide additional support to the fed funds rate. In this post crisis framework, the Fed now manages the federal funds rate by changing the interest rate it pays the banks and the rate on its overnight reverse repos instead of by altering the supply of reserves.
The Fed soon will need to choose how to conduct monetary policy going forward, as a projected reduction in its balance sheet will reopen the possibility of using the federal fund market in the same manner it did before. Judging by the discussion in its November minutes, however, the Fed seems to be leaning towards continuing its current course. If so, in large part because of two post-crisis changes to bank regulations, the Fed will have to continue to hold a massive balance sheet and become more directly involved in the financial system than it has ever been.
First, largely to comply with liquidity rules adopted by the Fed, banks now hold about $3¾ trillion in liquid assets –those that can be readily sold to address a destabilizing bank run (primarily, government securities or deposits at the Fed). If the Fed continues to conduct monetary policy so that market rates remain close to the rate paid on excess reserves, banks would choose to comply with the liquidity rules by continuing to hold very large amounts of excess reserves (rather than Treasury securities). The Fed would have to meet that demand; otherwise interest rates would rise above the rate paid on reserves, contrary to the Fed’s objective. It seems likely, therefore, that under this combined monetary and regulatory regime, reserve balances would stay roughly where they are now ($2 trillion). In short, before the crisis, if a bank wanted to hold a liquid asset, it bought a Treasury bill. In the Fed’s new world, the Fed would buy the Treasury bill and the bank would have a deposit at the Fed.
Second, capital regulations, especially a leverage ratio requirement that banks hold a large amount of capital against riskless assets such as Treasury securities, have made it unprofitable for banks and their affiliated broker dealers, to intermediate in the repo market. As a result, whereas before the crisis, if a money fund wanted to invest a shareholder deposit, it executed a reverse repo with a broker dealer, in the Fed’s new world, the money fund would execute the reverse repo with the Fed at the Fed’s new overnight facility.
Taken together, the Fed’s regulatory and contemplated monetary policy framework would leave it counterparty to vastly more financial transactions with a much wider set of market participants than it was before the crisis. As a result, the Fed, instead of private parties, would determine terms and conditions in those markets. And perhaps most importantly, the Fed would be perceived as responsible for developments in financial markets in a way that it never was previously, further increasing the mounting threats to its operating and monetary policy independence.
Relatedly, if the Fed maintains its enormous balance sheet, then it will have to make correspondingly enormous interest payments to commercial banks, with the largest payments naturally going to the largest banks. If reserve balances are $2 trillion and both market rates and the Fed’s interest rate for excess reserves return to a more normal level of 4 percent, the Fed would pay banks $80 billion a year in interest. If the Fed paid only 3 percent on excess reserves when market rates were at 4 percent, banks would return to minimizing their excess reserves, perhaps back down near $1 billion, with the result that the Fed’s interest payments would be much, much lower. The Fed might say that it would make up for the expense on the interest it paid through the interest it earned on its holdings of Treasury securities, pointing to the high earnings it has made in recent years. But those earnings have taken place during a time or falling interest rates; like any institution that invests long and borrows short, the Fed will begin losing money now that interest rates are rising. In fact, the Fed’s own models of term premiums indicate that on average over time, it will lose, not make, money on each additional Treasury security it holds in excess of the amount of currency outstanding because the term interest rates it will earn are lower than expected average short-term rates it will pay.
There is an alternative course. After excess reserves decline, the Fed could go back to conducting monetary policy essentially as before. While the Fed should, like all other major central banks, pay interest on reserves, it should pay a substantially below-market rate so banks choose to hold much smaller levels of reserves and the Fed returns to its traditional more passive role in financial markets. The Fed should hasten its return to its pre-crisis framework by gradually selling its enormous holdings of government securities rather than simply letting them run off. That’s what it said it was going to do when it bought the securities, and there is no reason why it shouldn’t work now.
Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of The Clearing House or its membership.