In some previous posts, I’ve taken Federal Reserve officials, including former New York Fed President William Dudley, to task for continuing to insist that the Fed’s post-2008 “floor” operating system is a “simple” means for keeping overnight interest rates on target. Whatever the floor system’s merits may be, simplicity isn’t one of them.
But in weighing the advantages of the Fed’s floor system compared to those of a “corridor system,” Fed officials haven’t just put their thumbs on the floor-system scale by exaggerating its merits. They’ve also exaggerated the drawbacks of a corridor system. In particular, they’ve framed the choice as one between the current floor system (or rather an idealized version of it), and a revival of the Fed’s pre-2008 arrangement, with zero interest on reserves, a relatively wide (but variable) corridor, and heavy reliance upon open-market operations.
In fact, none of the “pro-corridor” economists I know —and there are more than a few of us—favors a return to the pre-2008 set-up, or anything like it. Instead, we mostly have in mind a symmetrical corridor, with the (usually though not always positive) interest rate on reserves as its lower limit, and the rate charged by some Fed lending facility—it could be the proposed standing repo facility—as its upper limit. Finally, most of us would argue for a relatively narrow corridor of 50 basis points or so, with its correspondingly limited role for open-market purchases and sales.
I had intended to elaborate upon this point. But thanks to Sir Paul Tucker, a former Bank of England Deputy Governor and author of Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State, I don’t have to. For Paul argued the same point, very eloquently, at a Hoover Institution conference last year, in commenting on a presentation by Fed Vice Chair Randy Quarles. The conference proceedings, including Quarles’ contribution with Paul’s comments, are available online, so you can read the whole thing. Still, I can’t resist sharing some substantial excerpts, the better to tempt you to read the rest.
Paul begins by repeating a central argument of his book, to wit, that central banks should “live by a principle of parsimony in order to aid public comprehensibility and accountability”:
Central banks are very powerful bodies, led by unelected technocrats who are insulated from day-to-day politics. In our democracies, the delegation of government power can be legitimate only if we can track what the legislature’s agents are doing. Central banks should make that as straight-forward as possible. And, in jurisdictions that have chosen to have a market economy, they should distort market mechanisms no more than required to achieve their objectives.
This precept entails that central bank balance-sheet operations should at all times be as parsimonious as possible consistent with achieving their objectives. Thus, if price stability can be achieved using only interest rate policy, it should be; and if banking system resilience can be maintained without a permanently enormous central bank balance sheet, it should be.
In view of this Paul concludes that, “if there are other options, a floor system violates the principle of parsimony as it involves the central bank choosing to have a larger balance sheet than is necessary for monetary policy.”
But according to officials at the New York Fed (which is responsible for overseeing monetary operations), a corridor system is no longer a practical option. Their claim, Paul notes, rests upon two propositions. The first holds that, to manage a corridor the Fed would have to be capable of forecasting banks’ demand for reserves very accurately. The second asserts that it would have to engage in frequent open market operations.
Paul’s response, boiled down, is “rubbish.”
Conceptually, neither proposition is true in general. Nor, for what it’s worth, are they true in practice other than in rather particular circumstances.
Those circumstances are, broadly, where banks are set a reserves
target; they have to meet it very precisely; the spread between the lending rate and deposit rate is large; and the maintenance period is effectively short (so that there is little or no inter-temporal arbitrage across days). As it happens, nearly all those conditions held in the Fed’s pre-crisis operating system, but they were choices. Having to conduct frequent open market operations and to strive for precision in their forecasts of reserves-demand were consequences of those choices, nothing to do with corridor systems as such.
There are, instead (Paul goes on to say), all sorts of corridor systems, “with none having an exclusive right to the label.” These differ according to the width of the corridor, whether it is symmetrical or not, the length of the “reserve maintenance period” to which any reserve requirements refer, and various other specifications. (Readers wishing to learn more about the many choices and their pros and cons should start with this excellent Ulrich Bindseil article.) It is even possible, Paul notes, to have a corridor system that “does not require any open market operations at all or, indeed, any forecasting of the demand for reserves.”
What all this means, Paul concludes, is that “when the governors debate the merits of floor versus corridor systems, they do not need to be constrained by the Fed’s rather idiosyncratic pre-crisis system.” The Fed is therefore “not condemned …to stick with a giant balance sheet and a ‘floor system’ for rates forever.” Not condemned, that is, so long as those governors will allow themselves to revisit the floor-vs.-corridor question, with all the possible alternatives in mind, and without pretending that the present system has worked according to plan.
