A primer on the new era of monetary policy

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.

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27 Comments

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27 responses to “A primer on the new era of monetary policy

  1. “But interest rates are ultimately the key mechanism through which monetary policy affects the economy.”

    Is that really true? Interest rates are just one relative price. Just as a thought-experiment, imagine a world with no borrowing or lending. Or a world where there were binding price controls on interest rates. Or even a world with no assets that one was allowed to trade (except money, of course). Would monetary policy be powerless in such an economy?

    If monetary policy can still work in a world without interest rates, might it work through channels other than just the interest rate channel in a world with interest rates?

    • Monetary policy wouldn’t be powerless in such an economy. In Paul Krugman’s babysitting co-op story, for instance, there are no explicit interest rates or intertemporal markets, yet bad “monetary policy” manages to cause a recession—and better policy improves matters.

      Even in this case, however, I think that interest rates are lurking in the background. In the babysitting co-op story, there is still a convenience yield on money, which for the purposes of determining equilibrium is equivalent to a nominal interest rate. You stimulate the babysitting economy by printing more scrip and decreasing the convenience yield, which makes everyone more willing to spend the scrip today.

      In fact, if you have a dynamic model (even if it’s a resolutely monetarist one), it’s really hard to think about the effects of money without putting the convenience yield at the center of your analysis. MV=PY seems to avoid this, but really it just makes extreme assumptions about the nature of the convenience yield: that it jumps from 0 to infinity whenever the ratio of nominal spending to money exceeds a certain level. (“velocity”)

      Whenever agents are active participants in both the market for money and credit markets, the nominal interest rate equals the convenience yield, which is why I feel comfortable saying that the nominal interest rate is the key price.

      If some agents are participating in only one market, then things are a little different: for these agents, you can imagine the nominal interest rate becoming detached from the convenience yield on money. In this case, my claim that the nominal interest rate is all that matters isn’t necessarily true. But I doubt that this case is very important in practical terms, and regardless I don’t have a good framework for thinking about such a knotty incomplete markets problem (and I don’t know if anybody does).

      • Matt: “Whenever agents are active participants in both *the market for money* and credit markets, the nominal interest rate equals the convenience yield, which is why I feel comfortable saying that the nominal interest rate is the key price.” (emphasis added).

        This is not just a semantic “gotcha!” point that follows. I think it suggests that your whole way of approaching the question, as revealed by the language you use, is problematic.

        What do you mean by “the market for money”? In a monetary exchange economy, *every* market is a market for money (and one other good). So when there’s an excess supply of money, in principle that could affect every single market in the economy. The market for bonds (where the price of bonds and hence the yield on bonds is *proximately* determined), is just one of thousands of markets. Why the emphasis on this particular one? Especially since, in the long run, if money is neutral, that is the *only* price that does not adjust.

        In *every* market, not just the bond market, the marginal benefit of having an extra dollar of money should equal the marginal benefit of holding a dollar’s worth of that other good. (At least, if people are “on” their demand or supply curves in that market.)

      • Sorry I’m responding so late—I’ve been travelling (about to get married) and needed a little time to stew over this comment as well.

        Of course, you’re right: all markets are “markets for money”. When I talk about people being “active participants” in the market for money, I’m not being very precise—everyone who makes a transaction in a monetary economy is “active” in some sense, so this designation is meaningless.

        What I mean is that some people have basically zero holdings of base money (and many even have near-zero holdings of “money” construed more broadly). Sure, they use base money for transactions and paying bills, but this is money that either (1) they take out of an account that is not backed primarily by base money, or (2) they just earned. The gross flow of money for these people is significant, but the stock is close to zero. To the extent that they hold base money, either explicitly by holding paper currency or implicitly by having checking accounts with a reserve requirement, it is either minimal or incidental. They do not make conscious adjustments to their stock of base money, which is why I say that they don’t really participate in the “market for money”.

        I think this matters a great deal. Suppose that the Fed decides to implement a massively contractionary policy and boost interest rates by 5% for a year. Needless to say, this will have a very negative effect on the economy. But how does this happen? In your worldview, as I understand it, it happens because the Fed reduced the supply of base money. People want more, but they can’t do that in the aggregate, so they cut back on expenditures to try to hoard money.

        But this just doesn’t seem plausible for most people. When the Fed raises rates, all kinds of people lower their expenditures, even if they hold a minimal amount of cash. Indeed, the change in monetary base is usually minimal itself, and the only people who directly notice the “shortage” are banks borrowing and lending reserves in the interbank market. How does this affect the real economy? I think it’s because interest rates are set in the interbank market, and those interest rates affect the decisions of individuals who have no idea how the interbank reserves market even works. (For instance, they might make a car loan or a credit card bill more expensive.) I don’t really understand your mechanism.

        I know you interpret “money” more broadly than just base money, which is a good approach under our current circumstances. But for a convincing theory of monetary policy, you need to account for the difference between base money and “money” in general: after all, conventional open-market operations work by trading base money for T-bills, even though T-bills are also safe and liquid and can be used to back money market funds or bank accounts that are effectively money. Under a broad view of “money”, they don’t change the money supply much at all. Yet they have tremendous influence.

      • Andrew Rogers

        “I think this matters a great deal. Suppose that the Fed decides to implement a massively contractionary policy and boost interest rates by 5% for a year. Needless to say, this will have a very negative effect on the economy. But how does this happen? In your worldview, as I understand it, it happens because the Fed reduced the supply of base money. People want more, but they can’t do that in the aggregate, so they cut back on expenditures to try to hoard money.

        But this just doesn’t seem plausible for most people. When the Fed raises rates, all kinds of people lower their expenditures, even if they hold a minimal amount of cash. Indeed, the change in monetary base is usually minimal itself, and the only people who directly notice the “shortage” are banks borrowing and lending reserves in the interbank market. How does this affect the real economy? I think it’s because interest rates are set in the interbank market, and those interest rates affect the decisions of individuals who have no idea how the interbank reserves market even works. (For instance, they might make a car loan or a credit card bill more expensive.) I don’t really understand your mechanism.”

        And from our discussion below, we know the Fed doesn’t actually suck out base money to raise the interest rate (I realize there is this ‘long run/short run’ issue we may need to continue hammering out). So banks don’t even notice a shortage.

        I agree it is the interest rate affecting people’s decisions, not the quantity of base money. If people want more loans at 5%, then the Fed will supply the base money to meet reserve requirements/payment needs. So in fact people “can do that in aggregate.”

        Maybe this isn’t Nick’s view though.

  2. Bill Woolsey

    If the Fed wants to keep its balance sheet at current levels?

    What kind of assumption is that? If the demand for the monetary base, chiefly reserves, were to decrease, the the Fed should shrink the size of its balance sheet. Of course, the Fed could instead seek to adjust the interest rate it pays on reserves to keep the amount reserves banks want to hold stable. But why?

    As for this argument that future target rates determine current demand, how does that fit with the fisher effect? A rapidly growing future quantity of base money would be associated with rapid future inflation, and high equilibrium nominal interest rates–including equilibrium future overnight clearing rates. And those high future rates would be consistent with high money expenditures given any current target rate.

    • If the Fed wants to keep its balance sheet at current levels?

      What kind of assumption is that? If the demand for the monetary base, chiefly reserves, were to decrease, the the Fed should shrink the size of its balance sheet. Of course, the Fed could instead seek to adjust the interest rate it pays on reserves to keep the amount reserves banks want to hold stable. But why?

      I agree that is seems a little unnatural. But there are a few situations where it can come up.

      First, it may be logistically difficult to wind down the Fed’s balance sheet sufficiently quickly when tightening becomes necessary, at least without disposing of assets at fire-sale prices.

      Second, it’s possible that the Fed will want to hold the securities to maturity, as a relatively straightforward form of commitment. If the Fed is expected to sell off its longer-maturity securities within only a few years of acquiring them, QE will be even less effective than otherwise. (The natural question, then, is why the Fed doesn’t simply commit to holding interest rates at zero for longer, rather than bizarrely keeping its portfolio intact while using IOR to tighten policy. My only answer is that this might be a less clear form of commitment; “hold until maturity” is very straightforward, and even newcomers to Fedspeak can understand it.)

    • As for this argument that future target rates determine current demand, how does that fit with the fisher effect? A rapidly growing future quantity of base money would be associated with rapid future inflation, and high equilibrium nominal interest rates–including equilibrium future overnight clearing rates. And those high future rates would be consistent with high money expenditures given any current target rate.

      Well, sure—if the expected future trajectory of monetary policy involves (1) high nominal interest rates but (2) even higher inflation, so that real rates are quite low, then the effect on current expenditure will be positive. But I don’t see why anyone would want to do this—a little inflation isn’t nearly as bad as it’s cracked up to be, but it’s still not really a good thing, and if the central bank has the choice between (A) lowering future real rates by directly lowering the future nominal rate and (B) lowering future real rates by raising inflation expectations, I don’t see why it would choose (B) over (A).

      The “credibly promising to be irresponsible” thing comes in when rates are at the zero lower bound, and inflation eases the constraint on real rates. But whenever this constraint is not binding (i.e. after the ZLB episode is over), I don’t see why we would rely on a long-term change to expected inflation when a simple adjustment to the policy rate is possible.

  3. wh10

    Matt,

    I don’t think you’re understanding ‘pre IOR’ central banking correctly. If you will allow me to invoke both orthodox and heterodox research on the subject and refer you to the following primer- http://www.cfeps.org/ss2008/ss08r/fulwiller/Fullwiler%20Modern%20CB%20Operations.pdf

    I think where you go wrong is here: “Traditionally, the Fed has worked through the second term on the right side of this equation…” Or here: “There’s no need to bother with open market operations every time you want to change the rate.”

    I think the research shows that the Fed works through ‘the announcement effect’ in the absence of IOR. The Fed does not use OMO to change the rate, contrary to mainstream belief. That can’t work because not supplying enough reserves at the target rate sends the rate to the IOR (could be zero) or to the discount rate. I’m stealing the following quotes from Fullwiler, taken from a recent debate with Sumner:

    “Not supplying the quantity desired to settle payments at the target rate sends the rate toward one of those two. Too few sends the rate to the central bank’s lending rate; too many sends it to the rate paid (again, could be zero). Reserve requirements reduce the inelasticity on most days, but not all of them. This is all confirmed in numerous empirical studies, even neoclassical research like Borio, Bindseil, Whitesell, and so forth.

    1. The Fed can’t just choose the level of reserve balances it wants to have circulate. Banks are settling $3T/day with reserve balances and you can’t provide them with less than they need to do that without risking the payments system’s stability. But banks can do nothing with any amount beyond that which they need for this purpose. So, as many others have found, the demand for reserve balances is almost perfectly inelastic–providing too many sends the rate to the floor (IOR or 0) and too few sends them to the lending facility. This is de facto interest rate targeting. There’s no such thing as the market setting the rate–as Marting and McAndrews at the NY Fed wrote a few years ago, “The costs of reserves, both intraday and overnight, are policy variables. Consequently a market for reserves does not play the traditional role of information aggregation and price discovery.” RR only reduces the inelasticity a bit on some days, but the basic framework holds regardless.

    2. The Fed can’t not lend at the discount window. Again, the payments system depends on it and they can’t get reserve balances anywhere else but the Fed. And even when banks aren’t borrowing much overnight, they are borrowing over $100B/day on an intraday basis at the peak of payment flows. Overnight holdings are simply a buffer to avoid not clearing these intraday overdrafts given the steep penalty the Fed puts on that.

    ****** 3. Given the inelasticity of the demand for reserve balances, it’s widely reported that the Fed changes rates via an announcement effect. Even prior to 1994 announcements, they would signal via a repo or reverse repo that would necessarily reverse. ******* “

    • wh10

      Here, I am just going to cut and paste an interesting piece from that paper here:

      An understanding of modern central bank operations outlined in the foregoing principles makes clear that there is no liquidity effect related to target rate changes. As Sandra Krieger (head of domestic reserve management and discount operations, New York Fed) put it,

      The conventional textbook view is that the Trading Desk buys and sells securities in response to easings and tightenings [i.e., the liquidity effect]. From the [Trading] Desk’s perspective, however, the supply-demand balance is primarily a function of the demand for required balances, which is almost completely insensitive to small changes in policy. Consequently, any change in the target has no effect on excess supply or demand in the funds market. (Krieger 2002, 74)

      Since there is no change in the supply-demand balance for reserve balances with a target rate change, there is no need for open market operations related to a liquidity effect as defined here. In the case of the Fed, while it might temporarily change the quantity of balances in order to “signal” a new rate to traders or to “nudge” the rate when traders do not move to the new target quickly enough, any changes inconsistent with the given demand for reserve balances—unlike a liquidity effect—are necessarily reversed later in the maintenance period (Krieger 2002, 74). This in fact was the Fed’s operational procedure prior to 1994—after which it began publicly announcing its target changes—which likely accounts for the empirical evidence some have uncovered of open market operations correlated with target changes in this earlier period; note, however, consistent with “signals” or “nudges,” none have found empirical evidence of a change in the supply-demand balance in the federal funds market related to a target change either before or since 1994.

      • wh10

        Also, on the FFR < IOR, more from Fullwiler:

        "There are a few non-bank institutions with reserve accounts that do not earn interest–namely the GSEs. Given all the ER out there, these institutions aren't able to find a bank willing to hold them at 0.25%. This is a quirk in the way the Fed does IOR (covered in the NY Fed's annual reports on open market operations, by the way)–if the Fed tried to raise the fed funds rate by raising IOR, this could be an issue… I can't recall exactly if this is the Fed's doing or Congress's–either way, if the Fed raises IOR to raise the target, it should raise it for the GSEs or petition Congress for the ability to do so if necessary. Otherwise, they will possibly have to drain the ER in order to raise the target rate (don't know for sure, as I don't know how significant the GSE actions in the market would be relative to other market activity at a higher target rate)."

    • I agree that the short-term demand for reserves is highly inelastic—in fact, I’ve mentioned this myself on occasion. This is one of the reasons why a true quantity target can never really be implemented… you’d see the rate wildly oscillating back and forth between zero and the discount rate.

      But it’s not sufficient to say that the Fed changes rates merely via an “announcement effect”—there needs to be some actual policy underlying that announcement.

      Here is how I interpret the Fed’s implementation of policy. Pre-2008, the binding constraint determining the marginal demand for reserves was the reserve requirement (as is evident from the fact that the level of “excess reserves” was almost always zero). Banks have to satisfy a reserve requirement that covers a two-week maintenance period. Although the demand for reserves is (mostly) inelastic across the entire period, it is not inelastic within the period: if banks know that the federal funds rate is going to be lower later in the period, they will try to dispose of reserves now and hold them later, which pushes down the federal funds rate to the correct level. Inversely, if banks know that the federal funds rate is going to be higher later in the period, they will try to accumulate more reserves now, which increases the federal funds rate. In both cases, the federal funds rate today depends on its expected level later in the maintenance period, and thus the “announcement effect” is a key tool for making sure that the short rate stays at the right level throughout the period, rather than oscillating around.

      But an announcement alone isn’t enough to make this work: the Fed has to eventually back it up with open market operations that make the target interest rate the equilibrium price. I’m curious how it could possibly be otherwise—why would an announcement completely disconnected from the supply of money (or any tangible action by the Fed) change the rate at which banks are willing to lend to each other?

      In general, though, I agree: it is easy to understand why the demand for reserves is so inelastic, and why setting the nominal interest rate involves a little more than moving along some idealized demand curve. I didn’t go into the details in the post because (1) it was already long and boring enough, (2) the “open market operations change the scarcity of money” story gets the basic mechanism right, and (3) in general I don’t think that these kinds of technical details matter much to anyone except the central bankers tasked with implementing them.

      BTW, I’ve also heard the story about how the GSEs lending in the federal funds market. Presumably this has something to do with the divergence of IOR and the federal funds rate. It doesn’t explain, however, why banks don’t conduct the obvious arbitrage: borrow reserves in the federal funds market and earn interest on them. This arbitrage should, in principle, equalize the FFR and IOR rate, regardless of what the GSEs are doing.

      • JKH

        “why would an announcement completely disconnected from the supply of money (or any tangible action by the Fed) change the rate at which banks are willing to lend to each other?”

        anticipatory arbitrage

        because banks know that the Fed will take immediate action to correct the market trading level if it deviates materially from the new target rate

        the Fed uses such fine tuning tuning when required with respect to any given target level

        so it will be expected to be prepared to do so immediately at a new target level

        therefore banks will not trade materially away from that new target level knowing that the Fed will come in against them

        and there is no reason to believe that the demand for reserves will be any different at a target level of say, 2 1/4 per cent, than it is at 2 per cent , so there is no reason to materially change the stock of excess reserves

        Fullwiler, who is very correct, acknowledges that the occasional “nudge” may be required in terms of reserve levels, but it is generally not critical to establishing the new trading range in conformity with the new target level

      • JKH

        re the GSE effect

        the failure of perfect arbitrage may be due to the effect of nominal balance sheet expansion on unweighted nominal capital ratios, which are still watched

      • Andrew Rogers

        Matt, I do want to acknowledge that you have noted the interest inelasticity in the past; so sorry if my post came off as unfairly accusatory and insulting.

        However, as JKH explains, the announcement effect can be sufficient, and the Fed doesn’t necessarily have to “back it up with open market operations.” Is our logic wrong, and is this not what the research shows?

        “in general I don’t think that these kinds of technical details matter much to anyone except the central bankers tasked with implementing them.”

        Honestly, I am not so sure about that. For example, a lot of economists and non-economists believe the Fed lowers rates by supplying more reserves, and banks then use these reserves to create more loans. It’s part of the money multiplier fallacy and poorly taught Econ 101. This has implications on policy making or at least how policies are perceived. Politicians and markets interpreting the influx of excess reserves courtesy of QE2 as ‘fuel for loans’ is a real-world case in point.

        Agreed, the FFR<IOR story is still suspicious.

      • wh10

        BTW, thanks for engaging these ideas in an even-keeled, thoughtfully critical, and open manner. You’re pretty much the only intelligent, prominent, mainstream econ blogger who does so.

      • I think we essentially agree. The threat of open market operations to correct a rate that deviates from its target needs to be there, but it’s possible that the change in demand for reserves at 2% versus 2.5% is so tiny (relative to the total supply of reserves, and all sorts of other idiosyncratic factors) that no such open market operations will be perceptible. I’m just saying that there needs to be something that makes this arbitrage worthwhile (even if it’s basically a threat), and that open market operations adjusting the supply of reserves are really the only candidate.

        Note, however, that we’re talking about short-term adjustment here; in the longer-term, higher rates presumably do decrease the fraction of deposits held in checking accounts (which are now costlier), and the total supply of reserves declines relative to where it would have been in the absence of a rate hike. Thus in the longer term we do get something that resembles the clean, classical story about supply-and-demand, even though the short term operational details are quite different.

        Honestly, I am not so sure about that. For example, a lot of economists and non-economists believe the Fed lowers rates by supplying more reserves, and banks then use these reserves to create more loans. It’s part of the money multiplier fallacy and poorly taught Econ 101. This has implications on policy making or at least how policies are perceived. Politicians and markets interpreting the influx of excess reserves courtesy of QE2 as ‘fuel for loans’ is a real-world case in point.

        I agree—this is a function of poorly taught Econ 101. Both economists and non-economists get a certain intuition into their head (like the money multiplier) and can’t quite manage to shake it, even though closer logical scrutiny reveals that it is at best a deeply incomplete story. This is true even though the concepts involved are quite simple: my posts about it are essentially basic microeconomics. I’m still not sure whether the operational details of Fed adjustment are so important, though the fact that the demand for reserves is so inelastic in the short-term is useful in building a conceptual model of what’s going on.

      • re the GSE effect

        the failure of perfect arbitrage may be due to the effect of nominal balance sheet expansion on unweighted nominal capital ratios, which are still watched

        This is a very interesting suggestion, and it rings more true than anything else I’ve read. Thanks!

      • Andrew Rogers

        Cheers Matt. I love your style of discussion and debate.

        Regarding the long run/short run, I hear you, but I am just not sure. I have a feeling people like Fullwiler might say we are missing the point (maybe). I have to do more reading. In the meantime, I will keep both perspectives in mind.

  4. David Pearson

    The Fed’s balance sheet is relevant independent of the IOR in the presence of chronic high fiscal deficits. In this case, the level of ER’s represents the amount of financing of deficits contributed by the Fed. The higher this level goes, the more “trapped” the Fed will be in financing fiscal deficits.

    Imagine a case where markets expect 10% of gdp fiscal deficits for ten years, and for the previous five, the Fed has financed similar deficits. Now the Fed wants to tighten by raising the IOR. The effect would be to raise Treasury’s real borrowing costs. Significant changes in initial real borrowing costs have out-sized effects on out-year deficit projections. Markets would respond by blowing out real term premiums. The Fed would likely reduce the IOR in an attempt to lower those same rates. Thus, the Fed could be trapped in to more-or-less permanent deficit monetization.

    The above scenario is plausible if monetary stimulus leads to more inflation but relatively little real growth. It would be familiar to anyone with experience in Latin America.

    • I don’t understand. When the Fed’s balance sheet is large, and IOR essentially equals the FFR, IOR also be more-or-less equal to the rate on T-bills. At this point, it really doesn’t matter whether debt is financed by the Fed creating reserves or the Treasury creating T-bills; they both pay the same rate.

  5. Abraham

    HI,

    Too much technical wording for basic issues. First. FED fears interest rates reach zero bound. Well, they have. If the FED is therefore precluded from further lowering the FED funds rate, then easing monetary conditions further implies some mechanism to provide liquidity to a fragile financial system. That is QE. If this is irrelevant, why bother and for what purpose? Why is the Treasury issued so many T-bills? Why is the US deficit so large? Why does the international investment position deteriorating further? Why are other cebtral bank accummulating so much dollar reserves? Please do not tell me this is just misleading.

  6. Manfred Leone

    Matt; your spate of posts on monetary policy has been both substantive and informative.

    I fully understand how the IOR can prevent undue lending of excess reserves by setting a floor on the Federal Funds Rate. But there is potential long term flaw with the instrument which I have always been disturbed; could not the continued payment of Interest on Reserves lead to unduly high / potentially inflationary buildup of bank reserves down the line, when it comes time to loosen policy again? If, in some scenario, the Fed pays interest rates on reserves for a time at some level which discourages excessive reserve lending, but then decides to lower the fed funds rate again, couldn’t the reserves in the banking system, which by now have accumulated to large volumes since interest is being paid on them, be so large that too many reserves would now be available to be lent out? I realize that this scenario may not apply to the present situation; nonetheless, couldn’t it theoretically apply to one in the future.

    • Hi—sorry I’ve been so late in responding. I’m travelling and won’t be around much for the next few weeks.

      The reserves on the liability side of the Fed’s balance sheet were used to purchase interest-paying assets (longer-term Treasuries, etc.) As long as the Fed earns roughly as much from these assets as it pays out in interest on reserves, it will be “fully capitalized”, and have enough assets to claw back its liabilities if necessary. In this case, there is never really any worry that the Fed will be left with too many reserves in the future: it can always just sell back its assets, draining reserves from the system.

      If interest rate the Fed pays on reserves rises much more rapidly than we currently expect, it’s possible that the Fed will suffer losses on its portfolio: it’ll pay more on reserves that it earns from its assets. (And if it tries to sell the assets, it’ll suffer capital losses because their prices will have declined.) Perhaps these losses would be large enough to make the Fed temporarily undercapitalized — meaning that its liabilities are greater than its reserves, and it doesn’t have the unlimited ability to soak up reserves if necessary. But even in this case, I don’t think that the Fed’s balance sheet would be in any serious danger: there is $1 trillion in paper currency in circulation, and when interest rates are significantly above zero the Fed earns healthy seignorage revenue by investing that $1 trillion in positive-yield assets. It would take some pretty serious losses to overcome the Fed’s expected stream of seignorage revenue and put it in fiscal trouble.

      And, of course, the Fed controls the interest rate on reserves, so that it doesn’t have to raise the rate if it doesn’t want to—though this drives a wedge between the “optimal” rate for the economy and the optimal rate from the perspective of the Fed’s balance sheet. Again, I doubt this would come into play when with the Fed’s current portfolio, but it’s possible that further interventions would make the balance sheet large enough that undercapitalization is a real possibility. In fact, in another post, I mentioned this as a possible commitment device for the Fed: if it makes itself financially vulnerable enough, we can expect it to hold interest rates low for a little longer than otherwise.

      Incidentally, I’m not very fond of discussion about reserves being “lent out”, though I recognize that it’s ubiquitous, and I’ve probably used this phrasing myself on occasion. Although reserves sit on banks’ balance sheets, there is really nothing special about them that is conducive to lending: their only roles are (1) some transactions between banks (for which there are plenty) and (2) satisfying the reserve requirement on checking accounts, which is usually the binding constraint. (2) might make it seem like more reserves encourage lending, but checking accounts comprise only a very small fraction of bank deposits, and even in normal times the implicit cost of reserves is extremely low: banks are coughing up (10% reserve requirement)*(federal funds rate), which at a FFR of 4% is only 0.4%… not a big deal, especially since it’s imposed on only such a small fraction of deposits.

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