I’ve seen a lot of misleading commentary on how monetary policy will work in the next few years, particularly given the Fed’s enormous balance sheet. Many people seem to think that the Fed’s recent money creation is inherently inflationary—if not now, then eventually.
Once upon a time, this might have been true. Today, however, the Fed has a tool that renders the size of its balance sheet mostly irrelevant as a constraint on monetary policy: interest on reserves. Monetary policy using interest on reserves is almost exactly the same as old-style monetary policy—in fact, the mechanics are maddeningly simple. Yet there is still a great deal of confusion on this issue, and I think it’s helpful to go back to the basics.
Monetary policy works primarily by modifying the riskless short-term interest rate*: at what price can a dollar at time T be exchanged for a dollar at time T+1?
The instrument of choice, the federal funds rate, is determined by banks. If a bank has a dollar in reserves, it can either (1) keep the dollar for itself, earning whatever interest is paid on reserves or (2) lend the dollar in the overnight market to another bank. For most purposes, option (2) is just as good as option (1): there’s (essentially) no default risk, and the bank gets the dollar back the very next day. It shows up on the bank’s balance sheet as a liquid, riskless asset, just like reserves.
But of course, (2) isn’t quite the same as (1), or else banks would be willing to lend reserves at exactly the interest rate the government pays on them. Since that interest rate has traditionally been 0%, this would mean a federal funds rate of 0%, which clearly hasn’t always been the case! There are indeed a few differences between keeping a dollar in reserves and lending it out. First, a dollar in reserves can be used to settle interbank transfers on Fedwire. Second (and more importantly for determining the federal funds rate in practice), holding Fed reserves is the only way to satisfy the 10% reserve requirement on checking accounts. Since these are important for a bank—it’s penalized if its account is overdrawn, or if it fails to meet the reserve requirement—it’s willing to sacrifice some yield to hold reserves. In other words, there’s a premium (sometimes called a “liquidity premium”) on reserves: the rate a bank earns when it holds reserves is less than the rate it earns when it lends them out.
The federal funds rate is the simply the sum of this premium and the interest rate paid on reserves**:
Federal funds rate = (Interest rate paid on reserves) + (Premium on reserves versus overnight loans)
Traditionally, the Fed has worked through the second term on the right side of this equation, the premium on reserves. It changes this premium by adjusting the supply of reserves with open market operations. If it sells bonds for money, it makes reserves scarcer and more valuable, pushing up the premium. If it creates money to buy bonds, on the other hand, it makes reserves less scarce, bringing the premium down. Since the interest rate paid on reserves has traditionally been zero, the premium has been the sole determinant of the federal funds rate.
This is a perfectly fine way to conduct monetary policy. But as the equation above makes clear, it’s not the only way: the Fed can also control the federal funds rate by adjusting the interest rate paid on reserves. In fact, this is arguably a simpler way to conduct monetary policy. There’s no need to bother with open market operations every time you want to change the rate: just pay a different rate on reserves!
Why does this make a difference? Multiple rounds of quantitative easing have left the Fed’s balance sheet far larger than ever before: $2.6 trillion, versus roughly $1 trillion before the crisis. Banks’ reserves at the Fed are now $1.4 trillion, up from only $20 billion pre-2008. If the Fed wants to maintain this large a portfolio, and continue funding it with money***, there’s no way that the premium on reserves will go above zero for a long, long time. There’s simply too much money relative to demand. Banks have far more reserves than they need to execute transactions and satisfy reserve requirements. In this environment, the only way the Fed can control the federal funds rate is by adjusting the first term in the equation above: the rate paid on reserves.
And this is fine! There’s no inherent inflationary risk from having such a large balance sheet—that only happens if the Fed refuses to use its new tool, interest on reserves. The basic principles of monetary policy are exactly the same as before: you adjust the current and future trajectory of the federal funds rate to maintain macroeconomic stability. The only economic difference is the removal of a slight implicit tax on checking accounts, since required reserves now pay market rates of interest—and this is an incredibly, incredibly minor point.
In other words, all the rhetoric surrounding the Fed’s recent money creation is vastly overblown. Looking forward, monetary policy has as much power as ever, regardless of what happens to the Fed’s balance sheet.
*You may have heard from Scott Sumner, among others, that interest rates are a terrible indicator of monetary policy. This is actually true if we’re talking about current interest rates: it’s possible for monetary policy to be effectively tight because the Fed’s policy rule is contractionary, even if the current rate is very low. (Maybe it plans to raise interest rates dramatically in a few years, or whenever the economy shows signs of an expansion.) The key is to remember that monetary policy works through the entire expected path of future interest rates, not just the current rate. But interest rates are ultimately the key mechanism through which monetary policy affects the economy.
**Right now, the “premium” is actually slightly negative, as the federal funds rate is below the interest rate paid on reserves. This is partly due to identifiable factors (i.e. a minor tax on reserves, which lowers the effective rate earned by banks), but to some extent it suggests an unexplained failure of arbitrage. The gap is very slight in absolute terms, however, and there’s certainly no reason to think that it will expand when the Fed decided to raise rates. Barriers to arbitrage are not that large!
*** Since 2008, the Fed has possessed the power to accept term deposits; if it decides to replace reserves with term deposits, most of this discussion is moot. It can also drain reserves using reverse repo.