Remarks on “Floored! How a misguided Fed experiment Deepened and Prolonged the Great Depression,” by George Selgin

Remarks on “Floored!  How a misguided Fed experiment Deepened and Prolonged the Great Depression,” by George Selgin

Let my start by thanking Paul Kupiec for the invitation to discuss George’s new book, a task I take up with pleasure.  George is a keen and passionate intellect, as well as kind and generous with his time, and I always enjoy our discussions.  Moreover, those of us who think the Fed should adopt a corridor rather than a floor system to implement monetary policy are a dying breed and must stick together.

Before diving in, let me state for clarity that when I refer to a “corridor system,” I basically mean the pre-crisis approach to implementing monetary policy with the addition of interest on required and excess reserves, but with the IOER rate 50 to 100 basis points below market rates.

I was amused to read the description of a corridor system in the November FOMC minutes as

…one in which aggregate excess reserves are sufficiently limited that money market interest rates are sensitive to small changes in the supply of reserves…the Federal Reserve actively adjusts reserve supply in order to keep its policy rate close to target.”

By contrast, a floor system was described as one where

…money market interest rates are not sensitive to small fluctuations in the demand for and supply of reserves, and the stance of monetary policy is instead transmitted from the Federal Reserve’s administered rates to market rates—an approach that has been effective in controlling short-term interest rates in the United States since the financial crisis, as well as in other countries where central banks have used this approach.”  p. 3.

The corridor system sound awful!  Market interest rates so sensitive to reserve supply that policy will require active intervention by the Fed! Who could possible support a corridor system?

Well, George provides several good reasons why everyone should.

First, despite the description in the FOMC minutes, a floor system will cause the Fed to have a much greater footprint in the financial system and thus the economy and society than a corridor system.  It is under appreciated how light the imprint was of the Fed under the pre-crisis framework.  The Fed conducted monetary policy by means of relatively small repos with broker dealers; the Fed was a small player in a big market, but it wasn’t committed to fixing rates in that market.  Those small repo transactions allowed the Fed to influence the fed funds market, a relatively small market where the Fed had tight control of both supply and demand but was usually not a counterparty.  Changes in the fed funds rate were transmitted effectively to other money markets, including the repo market and term markets.  Thus, without being an important counterparty to anyone, the Fed still had effective control of interest rates and thereby the economy.

By contrast, a floor system would leave the Fed the financial intermediator of first resort.  As George points out, a floor system “…encourages banks to hold unlimited quantities of excess reserves and…lend a correspondingly large part of the savings they secure from depositors to the Fed.”  Instead of banks holding Treasuries to meet their liquidity needs, the Fed will hold the Treasuries and banks will hold deposits at the Fed.  Instead of the Treasury keeping its deposits at commercial banks, it will just keep its funds at the Fed (more on that in a minute).  Moreover, if the reason the Fed likes a floor system is that it hopes to control money markets broadly, rather than just the fed funds rate, and do so using borrowing and lending facilities, not scarcity, it will inevitably find itself on one side or the other a huge amount of transactions.  And it is not clear the Fed can successfully control the repo market, a massive market for which the Fed controls neither demand nor supply, without massive interventions.  While the corridor system offered good monetary control with a small footprint, a floor system may offer relatively poor control with the Fed counterparty to all.

George also points out that the large interest payments under a floor system will result in horrible political optics.  Currently, the Fed is paying interest at an annual rate of about $37 billion. If excess reserves decline and interest rates rise gradually as projected by the FOMC, then interest payments will slowly decline. However, if the demand for excess reserves remains elevated, or if the Fed needs to increase the fed funds rate quickly to prevent an unwanted rise in inflation, interest payments would rise, possibly sharply. Moreover, as George points out “…the main recipients of interest on reserves are some foreign banks and the very largest U.S. banks.” Congress might see such large payments to banks as unacceptable, and so take away or constrain the Fed’s ability to pay interest on reserves, especially if the rising rates were seen as holding back growth.

I’d add that a large balance sheet will probably reduce the Fed’s income relative to a small balance sheet, which could also have political implications. The Fed’s expected net income is lower, not higher, for each Treasury security it holds in excess of currency outstanding. Treasury term premiums are negative, have been negative for years, and are likely to remain negative. If the five-year term premium remains about minus-fifty basis points, the Fed operates using a floor system, and excess reserves are about $2 trillion, then the Fed will earn and remit to Treasury $10 billion less each year than if the IOER rate were well below the fed funds rate and excess reserves were near zero.

George discusses some of the flaws in the process by which the Fed ended up in a floor system, including the fact that the decision not to sell assets as part of normalization was driven in part by a desire to avoid recognizing losses.  But the process was actually even worse than he describes.  For one thing, the Fed backed into a floor system in large part because it made time-inconsistent plans in order to forge an internal consensus to provide more accommodation, only to later conclude that those plans were unworkable. For example, when considering the flow-based asset purchase program, the Committee based its decision on a staff balance sheet forecast in which the purchases would end in six months even though the staff economic forecast showed no decline in the unemployment rate over that period. The forecast for a limited purchase program was based in part on an implausible plan that, if necessary, the FOMC would simply announce that the program wasn’t working. In the event, the program continued for twenty-one months.

Moreover, there was a roach motel element to the process – you can check in but you can’t check out.  Specifically, the Fed has taken actions that have left it in a floor system for an extended period, and those actions make a floor system look attractive and a corridor system look implausible. With excess reserves topping $2.75 trillion, the fed funds market should have died entirely and today mostly consists of GSEs (government- sponsored enterprises) lending to FBOs (foreign banking organizations). Now floor system advocates ask, “How could the Fed target the interest rate in such an illiquid and odd market?”

With interest rates at zero, commercial banks were no longer able to provide the Treasury interest on its deposits, so the Treasury switched its deposits entirely to the Fed.  The resulting increase in volatility of that account which causes corresponding volatility in the supply of reserves, hasn’t troubled the Fed in a floor system but would make a corridor system unworkable.

There have been some important market developments this year that suggest a floor system could be even worse than George imagined.  While the Fed had projected that excess reserves would need to be about $500 billion in a floor system, starting this spring, with excess reserves about $1¾ trillion, some signs of reserve scarcity began to show up in money markets raising the prospect that the Fed would need to have an even bigger balance sheet than anticipated.  For my part, I think the episodes of scarcity are temporary phenomena as banks adjust their asset-liability mix in light of changing market signals, but the truth will out as the balance sheet continues to decline.

Year-end could be particularly interesting as tax payments boost the Treasury balance at the Fed, pushing excess reserves down further.  Moreover, because GSIB surcharges are calculated on a year-end basis, large broker dealers will shrink their balance sheet.  Plus, European banks’ leverage ratios are calculated on a quarter-end basis, adding further to the pressure.  Perhaps market participants have all secured the funding they need, and year-end will turn out to be a snooze.  But if it is a train wreck, and the Fed intervenes, it will cast doubt on the claim that a floor system is a set-it-and-forget-it way to conduct monetary policy.

I will note for the record that there are several reasons to oppose a floor system that George discusses that I do not agree with.  Most significantly, the Fed’s large-scale asset purchases successfully stimulated economic growth by lowering long-term interest rates.  The associated added reserves balances had no impact on growth, at worst, and provided a little stimulus, at best. I don’t want to try to resolve the 50-year disagreement between monetarists and Keynesians on how monetary policy works this evening.  That said, reading the monetarist parts of George’s book felt similar to arriving at a college in the South in the 1980s having grown up in a liberal northern suburb.  I had no idea people still held such views.

Lastly, it is important to recognize that the floor versus corridor decision is far from a no-brainer.  There are some strong arguments for a floor system.  Last week I asked those leading supporters of a floor system to list their top reasons.  Here are the ones I found most compelling:

  • There could be large swings in reserve demand as banks switch between Treasuries and excess reserves to satisfy their LCR in reaction to small differences in Tbill rates.
  • Banks could need $800 to $900 billion on hand to meet immediate outflows if there is another crisis.
  • If banks pass on IOER to their depositors, the Friedman rule will be closer to being satisfied.
  • Banks will be less likely to throttle their intraday payments, reducing the associated systemic risk.
  • Just as it is more efficient for intraday liquidity to be freely available, not scarce, it is more efficient for overnight liquidity to be freely available, not scarce.

These are all good points.  On the other side, though, I think the overarching question those who think a corridor system is unworkable must answer is “The Fed operated a corridor system successfully for decades, why can’t it do so again?”

Thank you, and congratulations George.


Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Bank Policy Institute or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.