On November 16^th, over 200 people gathered in the Hayek Auditorium here at the Cato Institute in Washington, DC, to explore the future of monetary policy at our 35th Annual Monetary Conference.

The all-day affair featured four panels of distinguished speakers — including Stanford economist John B. Taylor, former Federal Reserve Board governor Kevin Warsh, and Charles Calomiris of Columbia Business School. We were honored to have two esteemed keynotes — Loretta Mester, president and CEO of the Federal Reserve Bank of Cleveland, and Rep. Andy Barr, chairman of the House Subcommittee on Monetary Policy and Trade — who circumstances brought to the stage in quick succession. Topics ranged from the potential for a rules-based international monetary system and monetary policy normalization to the future of cash and China’s role in the global monetary system.

In his introductory remarks, Cato president Peter Goettler framed the day’s discussion by challenging attendees to think of a policy area more crucial to an individual’s freedom than monetary policy — remarking with incredulity upon the delegation of discretionary authority over such an important aspect of our society to a few unelected officials. He was also the first of many speakers to acknowledge the leadership of Cato’s vice president for monetary studies, Jim Dorn, who founded the monetary conference 35 years ago and has presided over it ever since — keeping debate on monetary policy alive in DC.

If you missed the live event, here’s a synopsis.

Keynote Address: Loretta J. Mester, President, Federal Reserve Bank of Cleveland

Mester began the conference with a speech about the effects of demographic changes on the economy and the implications of such changes for monetary policy. She commented that there is a strong tradition of studying demography as part of economics. As the world’s economy moves on from a post-financial crisis mindset to one of “normalization,” changes in demographics play a large role in figuring out just what is normal. An aging population — the primary demographic change at present — has deep structural effects on the economy and the data we use to gauge its relative health; for example, long-run unemployment, productivity, and the real natural rate of interest. With specific regard to monetary policy, an aging population effects the monetary transmission mechanism as wealth effects become stronger relative to income effects, savings rates change, and the equilibrium long-term interest rate falls.

Double-Header Keynote Address: Hon. Andy Barr, Chairman, House Subcommittee on Monetary Policy and Trade

While policy discussions are certainly a fruitful use of time, actual governance takes precedent in Washington. As such, Rep. Andy Barr’s luncheon address got bumped by a House vote on tax reform. Fortunately, his speech simply became a double-header keynote, following Mester’s. Barr’s remarks focused on legislative efforts to reform monetary policy, namely the Fed Oversight Reform and Modernization (FORM) Act and updates to it. In particular, he highlighted plans to improve communication from the Fed, create greater transparency as to how the Fed will make their decisions, and force the Fed to participate in an “Annual Adoption of Strategy” in which they would publicly choose reference rules to use in the formulation of monetary policy. Barr lamented the distortions in asset prices caused by the Fed’s balance sheet expansion and criticized its role in the “business of credit allocation.”

Panel 1: Toward a Rules-Based International Monetary System

The first panel of the day was moderated by the Wall Street Journal’s Josh Zumbrun. In addition to John Taylor, it featured George Tavlas of the Bank of Greece, Judy Shelton, author of Money Meltdown: Restoring Order to the Global Currency System, and Charles Plosser, former president of the Philadelphia Fed. Taylor’s presentation established that one way towards a rules-based international monetary system is each country acting in their own interest. He argued that simultaneous implementation of domestic rules-based monetary systems would contribute to global stability. Tavlas discussed three historical periods of rules-based international monetary systems. Of the possible types of international rules-based systems, he speculated that Milton Friedman would opt for a flexible exchange rate system with legislated domestic monetary rules (such as the Taylor rule) that aim at price stability, rather than a system based on international coordination of exchange rates or commodity standards. Shelton, who served as an economic adviser to President Trump’s transition team and was recently nominated to be US director of the European Bank for Reconstruction and Economic Development, lamented the lack of progress toward a rules-based framework for monetary policy that would align currencies and prevent competitive devaluations from distorting global trade balances. Nevertheless, she expressed hope for the future as she urged those in the room to keep trying along with her. The final panelist, Charles Plosser, echoed the views of other panelists, arguing that the difficulty of international rules-based systems is finding the right set of incentives for cooperation between sovereign nations, each of which is primarily concerned with domestic economic performance.

Panel 2: Normalizing Monetary Policy

After nearly a decade of unconventional monetary policy by the world’s major central banks, the second panel was a must-see. Moderated by Mickey Levy of Berenberg Capital Markets, panelists included Martin Feldstein of Harvard University, Kevin Warsh of the Hoover Institution, Hu McCulloch of New York University, and Gunther Schnabl of Leipzig University. Feldstein kicked things off by decrying the Fed’s balance sheet reduction plan as “too little and too late,” commenting that he thought the Fed should have started the process in 2013. Per Feldstein, excessively easy money has inflated asset prices and created an environment for financial instability. Kevin Warsh, drawing from his experience at the Fed during the 2008 financial crisis, spoke about the “false precision” of the Fed’s 2% core PCE inflation target that monetary policy formulation is based on today. He criticized the “caricatured and confused commentary of hawks and doves,” while commenting that “we know far less than we purport about the price formation process” and other key economic concepts. We should therefore reevaluate our standard deliberations about monetary policy. Hu McCulloch presented a six-point plan to normalize monetary policy, the first part of which was to stop paying interest on excess reserves (a topic McCulloch has written about for Alt‑M). Schnabl spoke of the “low interest rate and high debt trap” created by the past decade of unconventional monetary policy, which has resulted in low growth and a variety of redistribution effects: from the private sector to the public sector via financial repression; from the enterprise sector to the financial sector via rising asset prices and sluggish consumption; from the poor to the rich via asset price inflation and financial repression; from young to old via nominal wage repression and reduced future pension claims; and from small and medium enterprise to large enterprise via capital markets–based financing instead of bank-based financing.

Panel 3: The Future of Currency

The third panel was moderated by CMFA’s director, George Selgin, who focused the discussion around whether the “War on Cash” would achieve its stated objectives — increasing tax revenue and decreasing illicit activities — and at what cost. Lawrence H. White of George Mason University, Norbert Michel of the Heritage Foundation, and William Lastrapes of the University of Georgia comprised the panel. White spoke first about the aims of the “War on Cash” that are not openly discussed, such as raising the cost of storing cash so as to enable negative interest rates. He remarked playfully that concerns that banning cash would cut into consumer surplus are futile because those advocating the ban do so from the perspective of the tax collector not the consumer. Michel began his speech with a reminder that although there are more payment options available to consumers than ever before, approximately 40% of transactions by volume are still done in cash. His speech featured several interesting examples of the interest groups and unintended consequences at the heart of this issue. Finally, Lastrapes presented his general-equilibrium model to evaluate the costs and benefits of eliminating or suppressing currency in an economy. He found that eliminating cash would act as an increase in the effective tax rate in his modeled economy.

Panel 4: The Future of China in the Global Monetary System

Jim Dorn moderated the final panel of the day. Eswar Prasad of Cornell University spoke first and gave a succinct rundown of China’s contributions to the history of money, highlighting the use of paper money in the 7th century Tang Dynasty, and the coercive establishment of legal tender under the rule of Kublai Khan. Prasad said that although the renminbi was recently included in the International Monetary Fund’s SDR basket of currencies — an honor usually restricted to reserve currencies — only the market can really elevate it to such a status. Currently, only 2% of global transactions are settled in renminbi. Charles Calomiris talked about the geopolitical struggle between China and the United States. He applauded the changing perspective on China as a currency manipulator, arguing that productivity growth was the source of China’s economic boom — not an unfairly engineered exchange rate. He also observed that although the renminbi may need depreciation going forward, such an event would have primarily domestic repercussions rather than international ones. David Dollar of the Brookings Institution agreed with Calomiris’s assessment of depreciation risk in China. Drawing on his experience of living and working in China for nearly a decade, Dollar argued that institutional weakness is still a long-term impediment to the renminbi as a reserve currency.

Video:

Check out full video coverage of each panel, along with more information about the conference and speakers, here. Papers presented at the conference will be published in the Spring/​Summer 2018 edition of the Cato Journal.

Fed economists defending interest on reserves have recently called on an unexpected quarter by reviving interest in Milton Friedman’s 1969 essay, “The Optimum Quantity of Money.”[1] As Ben Bernanke and Don Kohn put it, “Before the Fed paid interest on reserves, banks engaged in wasteful and inefficient efforts to avoid holding non-interest-bearing reserves instead of interest-bearing assets, such as loans.”[2] Laura Lipscomb, Antoine Martin and Heather Wiggens make explicit reference to Friedman’s paper in their recent post defending interest on reserves on the New York Fed’s Liberty Street blog.[3]

This discussion takes me back to my graduate student days at Chicago, when Friedman’s essay had just come out, and one witty student had nicknamed it the “Optiquan Model.”  “Optiquan” came out shortly after Friedman’s important 1967 AEA presidential address, “The Role of Monetary Policy,”[4] in which he refuted the notion, popularized by the Keynesians Paul Samuelson and Robert Solow, that positive inflation was beneficial to the extent that it reduced unemployment along a stationary Phillips Curve. Friedman convincingly argued instead that the Phillips Curve shifts up and down with expected inflation, so that the same “natural rate of unemployment” would arise at any sustained inflation rate.

But that paper left open the more academic question, what inflation rate really is theoretically optimal under a pure fiat money regime in which the central bank is not constrained by any parity to gold or silver? (Recall that 1968-71 was precisely when the US government severed the dollar’s external link to gold.)

In Optiquan, Friedman argued that, since fiat money is socially costless to produce, and since optimal inventory management induces money holders to incur real costs to keep down the foregone interest on their money balances, the first best optimum is to have  a real return on money high enough to drive the opportunity cost of holding money balances down to zero. One  way this could be achieved would be by paying interest on all forms of money -- both currency and demand deposits -- at the same rate that could be earned on short-term, riskless non-monetary assets. A second way would be to engineer a negative inflation rate just sufficient to drive the nominal interest rate on non-monetary assets to zero. In either case, agents would in theory hold such large money balances that at the margin they would be savings instruments and provide zero purely monetary services.

One big practical problem with the Optiquan Rule that bothered me at the time, and still does today, is that it would leave the price level indeterminate: Friedman’s Quantity Theory of Money predicts that the price level will gravitate to the level that equates the real value of the nominal money stock to the economy’s real demand for it. But this condition requires 1) that there be a predictable real demand for an appropriately defined monetary aggregate, and 2) that the central bank be able to control its quantity.

Friedman recognized that real money demand responds negatively to its opportunity cost which, assuming money pays zero interest (as was the case for currency and all checking accounts outside New England before the 1980 DIDMC Act), would be the nominal interest rate on safe non-monetary alternatives. He also recognized that nominal rates fluctuate owing to natural changes in real interest rates and also  to changes in expected inflation. However, inventory models of money demand such as the famous Allais-Baumol-Tobin model[5] predict that the money demand schedule is inelastic and therefore relatively steep at moderate nominal interest rates (when i is on the vertical axis and M/P is on the horizontal axis). Real interest rates are normally positive at all maturities, and must be so at most maturities to prevent the price of land from being infinite. While inflationary finance is always fiscally tempting, deflation is fiscally unattractive, and therefore not an important long-run concern under fiat money, even by accident under a zero-inflation target. Therefore, the demand for zero-interest money is reasonably predictable as long as nominal rates are positive and inflationary expectations don’t drive them excessively high. That is, it’s reasonably predictable as long as there’s an opportunity cost to holding money balances.

Figure 1 above illustrates the classical Quantity Theory of Money when money pays zero interest, with moderate uncertainty as to the relevant parameters. The blue line represents the inventory demand for real money balances M/P, with M/P on the horizontal axis and the nominal interest rate on the vertical axis.  Because the money demand function is only known approximately, it is shown as a thick line. In equilibrium, the nominal interest rate will average out to the equilibrium real interest rate r*, plus the inflation π that results from the central bank’s money growth policy. Since neither r* nor π is known with perfect certainty, their sum is depicted as a thick horizontal orange line. The intersection of the two curves determines real money balances and therefore the price level, but only imperfectly: Given a nominal money stock M₀, the price level could be as high as P₂ or as low as P₁. So the price level is not determined precisely, but at least it’s reasonably bounded.

However, inventory models predict that if the opportunity cost of money actually falls to zero, real money demand will be literally unbounded. Of course if the resources of the economy are finite and money is not entirely costless -- due to the risk of theft, loss, bank failures or unanticipated inflation -- money demand will never actually reach infinity, but the point remains that the money demand schedule becomes virtually indistinguishable from the M/P axis over a wide range of values. Such a horizontal demand schedule for money  implies  an equally wide range of price levels capable of equating the supply and demand for money. In that case, the Quantity Theory would no longer predict either the price level or inflation.

Figure 2 above illustrates the inventory demand for money as a function of its net opportunity cost -- net of any interest paid on money or real return from deflation -- again as a thick blue line. As the opportunity cost approaches zero, this schedule coincides with the horizontal axis, for all practical purposes. The thick horizontal orange line depicts the approximately zero opportunity cost under the Friedman Optiquan deflation rule. Because the neutral real rate r* is uncertain and because the central bank cannot precisely control any deflation it engineers, this line again incorporates some uncertainty. Given a nominal money stock M₀, the  price level is now indeterminate at any level between P₂ and P₁, and could be even lower than P₁.

In order for the value of a fiat money to be determinate, therefore, some appropriate monetary aggregate must have a clear and positive opportunity cost relative to non-monetary assets. With all due respect to Milton Friedman, his “Optiquan” rule is therefore just an interesting academic exercise that is not implementable in practice. Its reasoning does argue against high-inflation policies, and does make a case for reducing the opportunity cost of at least the deposit component of M1 through interest on checking accounts. However, in order for the Quantity Theory to determine the price level, there must be a substantial aggregate controlled by the central bank that pays zero or at least greatly reduced interest. It certainly does not make a case for interest on excess reserves.

If the central bank believes it has better knowledge of the “natural rate of interest” (the real interest rate at which the non-monetary supply and demand for credit are equated [6]) than it does of the demand for real money balances, or if it has given up on trying to measure the narrow money supply (as when Sweep Accounts are not included in official M1), it may prefer to use a Taylor-type rule to manipulate the price level through short-term nominal interest rates. However, this only works to the extent that low or high real interest rates create an (albeit unobserved) excess supply or demand for money -- but this is again indeterminate if no form of money has a clear and positive opportunity cost.

So long as currency pays zero interest, it has a clear opportunity cost (at least since early 2016 as nominal rates return to normal positive levels), and the price level must eventually equate the real value of its nominal quantity to its real demand. However, when banks are awash with zero-opportunity-cost excess reserves as at present, the Fed has no control over how much base drains from bank reserves into currency in circulation. Lately this currency drain has been steady, though lethargic, so that currency in circulation has almost doubled since 2007, while the nominal economy has only grown about 33%. This huge growth in currency should be a great cause for concern. However, more readily controllable bank excess reserves have a much more immediate impact on banks’ ability and willingness to lend, but only provided they likewise have a clear and positive opportunity cost.

While it is true that banks’ aggressive efforts to minimize zero-interest excess reserves are “wasteful” in the sense implied by Friedman’s “Optiquan” model, there is a flip side to this observation: If banks are being paid not to make loans they will be in no hurry to make (or cut back on) loans and thus to permit borrowers to engage in (or cut back on) the spending that stabilizes the price level on target as the Fed expands (or contracts) the base and therefore reserves. As I argued in my previous post on Alt-M, “The Rudderless Fed,” [7] the Fed has rendered itself essentially rudderless in its conduct of monetary policy as a result of its misguided policy of paying interest on excess reserves.

_____________

h/t George Selgin for the title of this post.

[1] Published in his collection, The Optimum Quantity of Money and Other Essays, Chicago 1969.

[2] Ben S. Bernanke and Donald Kohn, “The Fed’s Interest Payments to Banks,” Brookings blog, Feb. 16, 2016.

[3] Laura Lipscomb, Antoine Martin and Heather Wiggens, “Why Pay Interest on Required Reserve Balances?,” Liberty Street Economics blog, Federal Reserve Bank of New York, Sept. 25, 2017; see also Lipscomb et. al., “Why Pay Interest on Excess Reserve Balances?,”  Liberty Street Economics blog, Sept. 27, 2017.

[4] Published May, 1968 in the American Economic Review 58: 1-17.

[5] Willliam Baumol and James Tobin (1989). “The Optimal Cash Balance Proposition:  Maurice Allais’s Priority,” Journal of Economic Literature ,1160-2.

[6] See J. Huston McCulloch, “The Theory of Money and Credit,” class notes dated Sept. 2012.

[7] J. Huston McCulloch, “The Rudderless Fed,” Alt-M, Aug. 9, 2017.

More from Alt-M on Interest on Reserves:

• Interest on Reserves, Part 1
• Interest on Reserves, Part 2
• Interest on Reserves, Part 3
• Interest on Reserves and the Fed's Balance Sheet
• On Shrinking the Fed's Balance Sheet
• IOER and the Banks' Demand for Reserves, Yet Again
• Our Unhinged Fed
• The Rudderless Fed 

The Cat's Out of the Bag

In September, when current Fed chair Janet Yellen held a press conference announcing details of the Fed's normalization plan, yours truly insisted that that plan reflected the Fed's "determination to maintain its current, bureaucratically advantageous operating system," in which monetary policy is mainly implemented by altering the rate of interest the Fed pays on banks' reserve balances. Yellen never said so explicitly, however. On the contrary: she chose her words so craftily that she might be understood to be saying just the opposite. In particular, I noted then,

in reply to questions about the Fed's future plans for monetary control, Yellen says that the Fed intends to use changes in "the fed funds rate" rather than adjustments to its balance sheet as its chief means of monetary control. This reply could be taken to mean that it won't be engaging again in Quantitative Easing, and that it plans to return eventually to pre-2008 style fed funds rate targeting. The interpretation squares well, after all, with the Fed's claim that it is intent on "normalizing" monetary policy.

But that interpretation is wrong. What Yellen's words really mean is that the Fed plans to keep its current IOER-based operating system going. The changes in the "fed funds rate" to which Yellen refers are really changes to the Fed's IOER and ON-RRP rates, which define the upper and lower bounds, respectively, of the Fed's current fed funds rate "target range." It follows that when Yellen says that the Fed won't be implementing monetary policy by means of balance sheet changes, she doesn't just mean that it will no longer engage in post-2008 style Quantitative Easing. She also means that it won't be making use of conventional (that is, pre-2008 style) open-market operations to influence an otherwise market-determined federal funds rate. All this in turn requires that banks be kept flush with excess reserves, and that the Fed maintain a correspondingly enlarged balance sheet.

How do I know this? Do I have a specially-made Enigma-type machine designed to crack Fed code? I do not. But I have talked to Fed officials, and kept up with Fed publications, and all indications from those support my understanding, as does the theory of bureaucratic behavior to which I've referred.

In other words, I might be wrong. But who wants to bet on it?

Alas, no one did, which is too bad, because on November 21st -- the day after she announced her plan to retire from the Fed -- Yellen finally settled all doubts concerning the Fed's intentions, and did so in a way that would have allowed me to score some easy money.

The occasion was Yellen's appearance that day in the "In Conversation with Lord Mervyn King” series hosted by NYU's Stern School of Business. Although the first hour of the event was mainly devoted to affable reminiscing about her life as a Fed chair, the last half hour of Yellen's appearance was devoted to audience Q&A. It was then that some clever NYU undergrad (bless his heart!) asked Chair Yellen point-blank: "Do you see interest on reserves as the new normal, or something that will come to an end?"

To her credit, Chair Yellen did not equivocate this time. Interest on reserves, she said, "is our key policy tool. We absolutely need it."

There has been discussion in Congress about taking that power away, and I've argued very strenuously against it. We would not be able to control short-term interest rates, now, if we did not have that power. If it were to disappear we would really have to change our monetary policy strategy and probably start quickly selling off assets to gain control of short-term interest rates. That would be very disruptive. So I think the question said something about the new normal. I think the new normal needs to be that we will retain that power and keep it as our main monetary policy tool.

At which point Lord King interjected, "And that is in line with what most other central banks do," to which Chair Yellen replied, "That is."

Floors and Corridors

Well, yes and no. While it's true that many other, if not "most," central banks possess the power to pay interest on reserves (IOR), most use that power to support "corridor"-style operating systems, in which the IOR rate is usually a below-market rate that serves as the lower-bound of a policy-rate band (the rate "corridor"), the upper bound of which consists of a central bank lending rate corresponding to the Fed's discount rate. In corridor systems, bank reserves are scarce, overnight interbank lending markets remain active, and overnight rates are kept at their target values by means of open-market operations. In short, the corridor systems in wide use among central banks today most closely resemble, not the Fed's present operating system, but its pre-October 2008 -- that is, pre-IOR -- system. Indeed, the Fed's pre-2008 system was itself a corridor system, albeit one in which the IOR rate, and, hence, the lower-bound of the policy-rate corridor, was constrained to be zero.

The Fed's current operating system, in contrast, is a type of "floor" system -- what I have elsewhere referred to as a "leaky" floor system. In a floor system, the IOR rate (which is also, in the Fed's case, the interest rate on excess reserves) is an above-market rate, the purpose of which is to encourage banks to retain excess reserves. Once satiated with reserves, banks have no reason to borrow overnight for the sake of keeping liquid, so the overnight interbank market shuts down. The IOR rate itself, rather than open-market operations, thus becomes the central bank's chief means of implementing monetary policy, with a higher IOR rate serving to tighten, and a lower one serving to loosen, policy.

In the Fed's "leaky" system, GSEs that keep balances at the Fed, but are not entitled to interest on those balances, lend their balances overnight to banks for a share of the interest to which those banks are entitled. Consequently the fed funds market is still somewhat active, and the effective fed funds rate trades below, rather than at, the IOR rate. To limit the extent to which the funds rate can decline, the Fed makes overnight reverse repurchase (ON-RRP) agreements with the GSEs, as well as some other counterparties, thereby rewarding them the equivalent of interest on their Fed balances, albeit at a rate below the IOR rate. Between them the IOR and ON-RRP rates define the Fed's fed funds rate target "range." Although the range superficially resembles a corridor, notice that in this case the IOR rate defines the top rather than the bottom of the range.

Keeping IOR vs. Keeping a Floor System

It should be perfectly evident that, when Yellen says that the Fed intends to continue using interest on reserves as its "main monetary policy tool," she doesn't simply mean that it intends to use that tool to operate a corridor system of the sort used by many other central banks. Were that the Fed's intent, instead of planning to "normalize" its IOR rate by eventually raising it to about 300 basis points, it would be contemplating lowering that rate to get it below corresponding market rates. It might even be contemplating setting a negative IOR rate, as several other central banks have done, on the grounds that "natural" short-term rates have themselves gone negative. (No I am not endorsing that step.) By the same token, critics of the Fed's current IOR-based regime, myself included, are not opposed to IOR as such. What we oppose is the Fed's policy of paying IOR at above market rates, together with the floor-type operating system that this policy serves to establish.

Besides confusing arguments against the Fed's leaky-floor operating system with arguments against any sort of IOR-based regime, Yellen's defense of he Fed's leaky floor system proceeds as if the sole policy alternatives consisted of either retaining that system or abruptly ending it by suddenly depriving the Fed of its power to pay interest on reserves. If the Fed did not have the power to pay above-market IOR, Yellen observes, the Fed would be unable to control short-term interest rates "now."

Of course suddenly preventing the Fed from paying interest on reserves "now" would pose serious problems. In the short-run, and so long as reserves remained abundant, it would leave the Fed without any basis for monetary control.  Ultimately, though, it would inspire banks to shed their excess reserves, reviving the money multiplier, and re-establishing a corridor-type operating system in which monetary control could once again be achieved by means of conventional open-market operations. The problem is that, while the transition is taking place, it could indeed necessitate the "disruptive," large-scale asset sales Yellen worries about.

But there are other, less disruptive ways to get back to a corridor system. Most obviously the Fed's assets, and the outstanding quantity of excess reserves, can be allowed to decline gradually (though perhaps not so gradually as the Fed presently intends) in anticipation of an eventual reduction of the IOR rate, and subsequent revival of the base-money multiplier, so that the latter revival will itself require proportionately fewer offsetting asset sales. The Fed can also make use of its Term Deposit Facility to sterilize released reserves, as an alternative to asset sales. I'm not saying that the transition back to a corridor system, with or without IOR, will be easy. But it needn't be severely disruptive. And once the transition was complete, modest asset sales (and occasional purchases) -- that is, old-fashioned open-market operations -- would once again suffice to implement monetary policy.

Down with the Floor!

And make no mistake: the transition will be worth it, because no matter what Yellen and other apologists for it claim -- and setting aside its doubtful legality -- the Fed's current operating system stinks. It stinks in part because it places the Fed in command of an excessively large share of the public's savings, which it steers towards the government and housing market and whatever other markets its administrators choose to favor, depriving other borrowers of that much potentially productive credit.

The present system also stinks because, by separating monetary control from balance-sheet policy it turns the Fed's balance sheet into a fiscal Trojan Horse -- one that Treasury officials and other special interests alike will try to have the Fed employ in their favor, further aggravating the squandering of scarce savings that has already taken place.

Even more disconcertingly, precisely because it can only be maintained by keeping IOR rates above their "natural" counterparts, the Fed's present operating system harbors a built-in deflationary bias which, if you ask me, is the main reason why the Fed keeps undershooting its inflation target.

Finally, the last-mentioned bug of the present arrangement also means that, unless it wants to risk a "disruptive" revival of the money multiplier, the Fed can only lower its IOR-based policy target so much to combat a liquidity crisis. That's true, by the way, regardless of the absolute height of the IOR rate when the crisis occurs. Maintaining a floor system therefore means, in practice, having to resort again to Large-Scale Asset Purchases ("Quantitative Easing") to combat any serious liquidity crunch.

I hope, for this last reason, that Chair-Elect Powell would rather not like to be remembered as the "The Six-Trillion Dollar Chairman." Assuming he wouldn't, he can avoid that fate by taking steps to get the Fed from its leaky floor system to a true corridor system.

Avoiding disruptive change is all very well, when maintaining the status-quo is itself unlikely to prove dangerous. But there are times when a little disruptive change today is a price well-worth paying for the sake of avoiding future turmoil; and this happens to be one of them.

_________________________

More from Alt-M on Interest on Reserves:

• Interest on Reserves, Part 1
• Interest on Reserves, Part 2
• Interest on Reserves, Part 3
• Interest on Reserves and the Fed's Balance Sheet
• On Shrinking the Fed's Balance Sheet
• IOER and the Banks' Demand for Reserves, Yet Again
• Our Unhinged Fed
• The Rudderless Fed 
• Operation SNAIL
• The Strange, Official Economics of Interest on Excess Reserves
• The Fed's Mispricing of Liquidity: Nothing New Under the Sun

(Originally appeared November 27, 2014)

Happy Thanksgiving to all of my fellow free bankers out there!

Today is our biggest secular national holiday. Not everyone celebrates Christmas or Easter much less other national holidays like Memorial Day or Labor Day, but I don’t know anyone who doesn’t like Thanksgiving. So, as we sit around eating turkey or some other dinner of thanks, remember also that we acknowledge the beginning of native currency competition in America. While there was always competing use of different national currencies (basically different denominations and weights of gold and silver) in what would become the American colonies — and in that sense America was founded on free banking principles — Thanksgiving gives us a time to remember the birth of a truly American free banking experience.

Wampum!

Yes, wampum was, arguably, the first native American free banking episode. Here is the description of the birth of the first native American currency, wampum, from the 1883 Ancient Landmarks of Plymouth by William T. Davis, a former president of the Pilgrim Society (pp. 57–9):

No legal-tender scheme, in these later days, has been bolder in its conception, or more successful in its career than that of the Pilgrim Fathers, which, with the shells of the shore, relieved their community from debt, and established on a permanent basis the wealth and prosperity of New England. Many of the Indian tribes not acquainted with the use of wampum, were instructed in its use and before the enterprise could be successfully carried out, and adopted it greedily when it was fully understood. This currency of the early days was made from purple and white parts of the quaw-haug shell, round, about a sixteenth of an inch in thickness, and a quarter of an inch in diameter, with a hole in the middle for stringing on strings of bark or hemp, the purple and white alternating on the string, the purple of double the value of the white, and the whole value at five shillings per fathom. (p.58–59)

[caption id=”” align=“aligncenter” width=“375”] Quahog and whelk wampum made by Elizabeth James Perry (Aquinnah Wampanoag/​Eastern Band Cherokee), c. 2009 [/​caption]

Unfortunately, the success was relatively short-lived. Here is a follow up to that development in the Rhode Island colony by Oliver Payson Fuller, The History of Warwick Rhode Island: Settlement in 1642 to the Present Time published in 1875 (pp. 59 and 70) explaining,

The currency of the colony, wampum paege [sic], which had been in use from the earlier settlement, had fallen so low in value that it was declared to be no longer legal tender. The other colonies had abandoned it some time previously. Massachusetts had commenced the coining of silver ten years before. …

As there was no restriction in relation to the manufacture of peage, a large amount came early into circulation, and as early as 1649, a law was passed lowering the standard of black peage one third, and four instead of three per penny was made the legal rate. (p. 59)

There were even differences between new Coke currency and classic English currency even of the same name, explains Fuller, “Forty shillings of the New England currency was equivalent to thirty shillings of English currency.” (p. 70)

I guess this shows that inflation is as American as apple pie — though some things are definitely sweeter than inflation.

On Friday, the Treasury Department released a report on Financial Stability Oversight Council (FSOC) designations. This report could have addressed the problem underlying FSOC’s designation authority: the fact that it makes explicit which financial institutions are “too big to fail,” paving the way for more bailouts of the kind we saw in 2008. Sadly, the report flew wide of the mark, focusing on the minutiae of the designation process and all but ignoring the glaring bailout problem.

A little background. FSOC is an entity created in 2010 by Dodd-Frank, the sweeping financial reform legislation passed in the wake of the 2008 crisis. It is comprised of the heads of various financial regulatory agencies, and is chaired by the Secretary of the Treasury. One of its purposes is to facilitate communication among regulators, helping to give them a complete picture of the financial sector beyond their own territories.

FSOC’s other purpose — and arguably its primary one — is to identify systemic risk and designate certain entities as “systemically important financial institutions” (SIFIs). These SIFIs are then subject to heightened oversight by the Federal Reserve. The idea is that increased oversight will reduce the chances of these companies running into trouble, and thereby obviate the need for bailouts.

But the government has not shown itself to be adept at identifying systemic risk. Not in 2008. Not in any of the last eight financial crises, in fact. Even if the coordination among regulators facilitated by FSOC improves the government’s ability to see trouble brewing, it will never have perfect foresight.

When one of these SIFIs stumbles — as one eventually will given a long enough timeline — how will the government avoid a bailout? In the past, large firms understood with a wink and a nod that Uncle Sam was backstopping their bets. But there was at least some ambiguity. And in the case of Lehman Brothers, the government did not ultimately provide a safe landing. Could the government have let Lehman fail if it had already branded it “systemically important”? I tend to think not.

Back to the new report. The report does a good job of identifying the problems that FSOC and SIFI designation present:

Designation by the Council…should not imply that the government will rescue the designated firm in the event of failure. A market expectation of such a rescue could cause inefficient investment decisions and increased risk-taking. Nor should government discipline be substituted for the market discipline of investors, counterparties, and clients as a result of the designation process.

I couldn’t have said it better myself. Later, the report states that “a company subject to a Council designation should not receive a financial advantage from any perception that the government may rescue the company in the event of its failure. Such a perception could give the company an unfair competitive advantage in funding markets.” Again, an excellent point.

Unfortunately, while the report accurately identifies and describes some of the chief problems with the SIFI designation, it completely fails to identify any corresponding solutions.

As to market advantage, the report does note off-hand that the market may adjust once the regulatory effects become more clear. But this explanation makes little sense. Yes, the market will incorporate the advantage by pricing in the government backstop a company is likely to enjoy as a SIFI. That doesn’t mean the effect goes away. Instead, the company’s position in the market will reflect the costs and benefits of being designated as systemically important.

As for the SIFI designation potentially forcing the government’s hand if a bailout is needed, the report simply outlines the problem and then never mentions it again. The report does recommend using an activities-based approach to regulation, although it is not clear whether this is intended to address the specific problem of creating moral hazard by designating certain firms as SIFIs. In the past, while FSOC has been troublingly opaque about its designation process, it does seem that firm size has been the most salient concern. The report notes that focusing on activities may reduce the need to designate firms, principally because firms will likely avoid activities that might trigger designation. And yet, the report provides little detail about how FSOC will evaluate activities to determine their systemic risk or even what “risk” in this context means. Given the government’s poor track record in predicting crises, it would be helpful if the report had explained how FSOC’s analysis will be different going forward. Finally, the report suggests using designations sparingly. But as long as any firm is designated as a SIFI, the specter of government bailouts remains.

It is worth noting that the report is written as a memorandum to President Trump, and comes in response to a request he sent to the Treasury Department earlier in the year. In that request, the president asks Treasury principally about the process for designating SIFIs — a process that has left much to be desired.

But the request also asks Treasury to assess whether FSOC and its SIFI designations align with the objectives laid out in the president’s February executive order establishing principles for financial regulation. Among those objectives is to “prevent taxpayer funded bailouts.” Addressing whether SIFI designation itself might lead to more bailouts was squarely within the four corners of the president’s request. And Treasury completely ignored it.

The report makes some worthwhile suggestions about the designation process. For example, it recommends that FSOC notify companies earlier in the process, so that they can take measures to address FSOC’s concerns and avoid SIFI designation entirely. Of course, to assume that addressing these issues is a good thing is to assume that FSOC has correctly identified problems in the first place. And that may be a big assumption.

The report also recommends that FSOC “should only designate a company if the expected benefits to financial stability from Federal Reserve supervision and enhanced prudential standards outweigh the costs that designation would impose.” This is a good recommendation but I’m fairly disheartened that it’s one that must be made. Should regulators need to be told that they should only act to make things better, not worse?

Then there’s the report’s recommendation that, before making a SIFI designation, FSOC should consider whether a company is actually likely to face financial trouble: “Material financial distress at a nonbank financial company does not pose a threat to U.S. financial stability if the company will not experience material financial distress.” Indeed: things that do not happen rarely cause distress. Again, I’m disappointed this must be explicitly stated.

It might be less distressing if the report had simply failed to mention the risk that SIFI designation could give rise to more bailouts. That would leave open the possibility that alerting Treasury staff to this danger would spur some action. Instead, the report’s authors, aware of the risk and explicitly stating the need to address it, offer no explanation of how that might be accomplished.

The bottom line is that there is probably no way for the government to designate firms as “systemically important” without simultaneously creating the guarantee of bailouts later on, should the need arise. As has been argued in several other places, the SIFI designation process not only fails in Dodd-Frank’s stated mission of ending “too big to fail,” but explicitly enshrines it in law.

The FSOC itself need not be disbanded, but if we’re serious about eliminating taxpayer-funded bailouts — and I hope we are — its power to name SIFIs should end.

[Cross-posted from Alt‑M.org]

In his recent post exploring the welfare implications of the Fed paying interest on reserves, George Selgin observed that if banks failed to maintain optimal reserves, the problem was either incorrect remuneration of reserves themselves, or the Fed’s mispricing of short-term (intraday or overnight) credit. Regarding the latter, he claimed mispricing was once serious, but has since been partly rectified.

I agree that the problem of mispriced Fed intraday credit was once serious, and that it has been “partly rectified.” The Fed made several attempts to improve its overdraft policies, and more recently, the vast increase in banks’ excess reserve holdings has made daylight overdrafts unnecessary.

Yet important questions remain concerning the extent to which the Fed continues to misprice its services, and to thereby violate the spirit and letter of the 1980 Depository Institutions Deregulation and Monetary Control Act (DIDMCA, or MCA for short). These questions, along with Selgin’s concerns about the legality of the Fed’s above-market interest rate on bank reserves, suggest a need for heightened scrutiny of the Fed by Congress.

Here I survey the Fed’s post-MCA payments-pricing practices. I hope to show that, even though the mispricing of some of these services may have been “partly rectified,” there are still good reasons to doubt that the Fed has complied with the MCA’s provisions calling for it to fully recover “all direct and indirect costs” of the payment services it provides to banks.

Some History on the Fed-Subsidized Services

The Fed has published financial statements for its priced payment services ever since the MCA was passed. The statements report the Fed’s revenue, expenses, and cost recovery for those services under accounting standards set not by an independent standard setter, but by the Federal Reserve itself. Unsurprisingly, the Fed’s standards have allowed it to report that its revenue has fully recovered its costs over time, even when conventional standards would not have.

The Fed has thus been able, using its own financial statements, to defend itself when outside parties (and some rival, private suppliers of payment services) have accused it of subsidizing its payment services. For example, in a 1997 Congressional hearing, Alice Rivlin, then-vice chair of the Federal Reserve Board of Governors, testified:

The MCA requires the Federal Reserve Banks to charge fees for their payment services, which must, over the long run, be set to recover all direct and indirect costs of providing the services. In addition, the MCA requires the Federal Reserve Banks to recover imputed costs, such as taxes and the cost of capital that would have been paid and imputed profits that would have been earned if the services were provided by a private firm.

…

Over the last ten years, the Federal Reserve has fully recovered the total costs of its priced services, including imputed costs as required by the Monetary Control Act. … Shortly after the MCA was enacted, the Board of Governors adopted pricing principles that are more stringent than the requirements of the MCA and that require the Federal Reserve Banks to recover priced service costs, not just in the aggregate, but for each major service category. Our check service, for example, has fully recovered its costs over the last ten years.[1]

In turn, in an appendix to the body of this testimony, Rivlin reiterated that

Taxpayers do not subsidize the cost of the Federal Reserve’s check transportation. It is understandable that whenever a public entity competes with the private sector in providing services, the issue of subsidies arises. The Monetary Control Act of 1980 (MCA) addressed that issue by requiring the Federal Reserve, over the long run, to set fees for its priced payment services to recover all direct and indirect costs of providing those services. [Emphasis original.]

Rivlin’s remarks had been anticipated by then-Fed chairman Alan Greenspan, who in his 1996 testimony to the Senate Banking Committee insisted that the Fed’s

priced services are subject to the inherent discipline of the marketplace as the Federal Reserve must control costs in order to meet the statutory directives for cost recovery in the Monetary Control Act. The risk-management decisions that we make concerning the way we provide payment services to depository institutions are tested directly in the marketplace. These services comprise more than one-third of the Federal Reserve banks’ total budget and the Monetary Control Act requires that, over the long run, we price these services to recover their costs, as well as costs that would be borne by private businesses, such as taxes and a return on equity. If we provide these services inefficiently, we price ourselves out of the market.

Over the past decade, our track record has been good. The Reserve Banks have recovered 101 percent of their total cost of providing priced services, including the targeted return on equity. I should also note that, by recovering not only our actual costs but also the imputed costs that a private firm would incur, the Federal Reserve´s priced services have consistently contributed to the amount we have transferred to the Treasury. During the past decade, priced services revenue has exceeded operating costs by almost $1 billion.[2]

Yet even with the help of their special accounting practices, Fed officials weren’t able to consistently maintain that its payments services weren’t subsidized. Just two months before Rivlin assured Congress that “Taxpayers do not subsidize the cost of the Federal Reserve’s check transportation,” Greenspan, in making a case for the Federal Reserve Board to serve as lead regulator for new financial holding companies, had been claiming just the opposite:

a number of observers have argued that there is no subsidy associated with the federal safety net for depository institutions — deposit insurance, and direct access to the Federal Reserve’s discount window and payment system guarantees. The Board strongly rejects this view.

…

While some benefits of the safety net are always available to banks, it is critical to understand that the value of the subsidy is smallest for very healthy banks during good economic times, and greatest at weak banks during a financial crisis. … What was it worth in the late 1980s and early 1990s for a bank with a troubled loan portfolio to have deposit liabilities guaranteed by the FDIC, to be assured that it could turn illiquid assets to liquid assets at once through the Federal Reserve discount window, and to tell its customers that payment transfers would be settled on a riskless Federal Reserve bank? [Emphasis added.][3]

Although Greenspan refers generally to subsidies offered by the Fed’s safety net, that net includes access to Fedwire as well as to the discount window.

In related 1997 testimony, Greenspan noted explicitly how the safety net (including Fedwire access) shifted risk to the government, and how, because that risk constituted a cost, the practice amounted to a subsidy provided to banks. “The use of sovereign credit in banking,” Greenspan said,

even its potential use — creates a moral hazard that distorts the incentives for banks: the banks determine the level of risk-taking and receive the gains therefrom, but do not bear the full costs of that risk. The remainder of the risk is transferred to the government. This then creates the necessity for the government to limit the degree of risk it absorbs by writing rules under which banks operate, and imposing on these entities supervision by its agents — the banking regulators — to assure adherence to these rules.[4]

Fedwire — the Fed’s wholesale funds transfer system — is one of the largest payment services the Fed provides. Prior to the recent crisis, banks paid one another more than $1 trillion every day using this service. The funds being transferred consisted of bank reserve account balances — balances on which the Federal Reserve now pays banks billions of dollars a year in interest.

Before the present “abundant reserves” era began, banks settled huge Fedwire payments volume on a relatively thin aggregate cushion of excess reserves, with the extension of intraday overdraft credit from the Fed a key enabler. Only a thin cushion sufficed because banks that ran short of reserves with which to meet either their settlement needs or their minimum legal requirements could, for a price, borrow both either from the Fed or, for overnight loans, from other banks, to avoid shortfalls. The Fed provided billions of dollars of intraday credit daily, the result of the fact that the Fed guaranteed Fedwire payments to receiving banks, notwithstanding that the sending bank might be short funds at the end of day — thereby exposing the Fed itself to credit risk.

The Fed’s fee schedules for Fedwire transfers have evolved over time, but they have consistently been based on a fee-per-transfer basis, with “volume” discounts available not for the dollar size of the transfer(s), but the number of transfers. In the scarce-reserves era, fees were generally a fraction of $1 per transfer, even for large dollar transfers utilizing large amounts of overdraft credit. For many years after 1980, the Fed didn’t even charge fees for intraday credit utilization, only beginning the practice in 1994 — with effective interest rates a small fraction of market interest rates. In turn, the Fed didn’t include daylight overdraft fees as revenue in its cost recovery calculation for pried services — despite acknowledging that the new payment system risk policy (in 1985) and overdraft fees (in 1994) were developed “[t]o reduce the risks that depository institutions present to the Federal Reserve through their use of daylight credit and to address the risks that payment systems, in general, present to the banking system and other sectors of the economy …”[5]

With the progress in the Fed’s payment system risk policies in the late 1980s and the development of overdraft fees in the mid-1990s, some Fed leaders claimed to have addressed the subsidy issue. However, they didn’t appear to have convinced the Fed Chairman, given that he was identifying Fedwire access as a subsidy in the late 1990s.

In light of the low fees being charged, even allowing for some improvements here and there, Fedwire sure looked like a subsidy. But for many years, the Fed was also asserting that Fedwire was not a subsidy, given that the Fed priced the services to fully recover “all direct and indirect costs.”

In 1999, Congress passed the Financial Services Modernization Act. This law established the Federal Reserve Board of Governors as the lead regulator and supervisor for financial holding companies. In making their case to Congress for the lead position, Fed leaders acknowledged, like Greenspan did in that 1997 testimony, that the Fed’s assumption of risk on Fedwire constituted a subsidy. The Fed was very concerned about the risk it was exposed to, the story went, and so the Fed had to be in the lead position as a regulator (and supervisor).

The Fed’s case for a lead supervisory role was (and is) ironic in another sense. Greenspan asserted that the shifting of risk to the government from safety net features like Fedwire drove the need for costly government supervision. So it could have been argued that the costs of this supervision were another element of the “direct and indirect costs” to be recovered by Fedwire pricing. But they were not.

Yes, Fedwire was subsidized. The Fed knew it, but didn’t account for it. And Congress stood idly by, as the Fed’s accountants and lawyers resorted to window-dressing to feign compliance with the law.

How About the New “Reserve-Abundant” Era? 

In 2007 and early 2008, reserves at the Fed were running about $40–45 billion, with Fedwire accomplishing more than a $1 trillion a day in funds transfers. In those “old” days, some Fed officials actually argued that high Fedwire volume on a thin reserve base was evidence for how “efficient” the system was.

With the massive easing of monetary policy amidst the blooming financial crisis and arrival of IOR, reserves at the Fed mushroomed from $46 billion in August 2008 to more than $800 billion at the end of the year. And from there, reserves reached new heights, rising to nearly $3 trillion in 2015. Not surprisingly, as excess reserves ballooned, daylight overdrafts dropped to record low levels.

Let’s take a closer look at what was going on as the 2007–2009 financial crisis intensified. In the weeks leading up to mid-September 2008, peak daylight funds overdrafts were running at about $130 billion. From September 10 to September 24, however, peak overdrafts jumped to $200 billion, and higher still to $245 billion in the reserve period that ended October 8. The September 10 — October 8 period coincided with the onset of the burgeoning reserve balances — and rising fears (and failures) in the financial markets.

In other words, in the first weeks of sharply higher reserves, daylight overdrafts were actually still growing dramatically, with large financial firm failures exploding around the payment system minefield. It was only later, after the acceleration in QE, that daylight credit began falling.

In making their recent case for the efficiency of paying interest on reserves, Fed economists have praised the reduction in risk to the Fed, and the public, from the reduced utilization of intraday credit. For example, in a 2012 FRBNY article “How The High Level of Reserves Benefits the Payment System,”[6] Fed economists praised the new system: “we can document an important and overlooked benefit of the high level of reserves: a significantly earlier settlement of payments on Fedwire.” They continue, “[a]t the same time, the Fed has been extending less intraday credit, which reduces the public’s risk exposure.”

Can the Fed have it both ways? Was the Fed truly recovering “all direct and indirect costs” from 1980 until the financial crisis? Was Fedwire efficient back then, and even more efficient today?

Nothing New Under the Sun

A strong case can be made, and Selgin has made it, that in paying above-market interest on banks’ reserves, the Fed is not just subsidizing banks, but subsidizing them illegally.

But far from being an exceptional, new development, this practice is only the latest instance of the Fed’s longstanding practice of offering subsidized payments services, which it mainly did in the past by helping banks fund trillions of dollars in Fedwire payments with risky overdraft credit, without pricing that risk to fully recover the cost of providing Fedwire as required by law.

Daylight overdrafts have declined to next to nothing since 2008, while the problem of mispriced overdrafts, though seemingly in abeyance, has not actually been addressed. The Fed’s pricing of Fedwire and funds overdrafts continues to be at odds with the spirit, if not the letter, of the MCA’s cost recovery provisions. While daylight overdraft risk no longer poses the direct problem it used to, in “eliminating” it the Fed has created an even more serious problem (and indirect cost) of balance sheet risk for itself, and ultimately for taxpayers. In short, the Fed is now paying banks billions of dollars a year for the “privilege” of “reducing” the risk they pose to the Fed, and shifting it to the taxpaying public!

New Congressional hearings should explore these developments, with the aim of helping the Fed comply with the law, at long last.

_______________

[1] Alice M. Rivlin, “Role of the Federal Reserve in the Payment System,” testimony before the Subcommittee on Domestic and International Monetary Policy of the Committee on Banking and Financial Services, U.S. House of Representatives. September 16, 1997.

[2] Alan Greenspan, “Recent reports on Federal Reserve operations,” testimony before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate. July 26, 1996.

[3] Alan Greenspan, “The Financial Services Competition Act of 1997,” testimony before the Subcommittee on Finance and Hazardous Materials of the Committee on Commerce, U.S. House of Representatives. July 17, 1997.

[4] Alan Greenspan, “Modernization of the Financial System,” testimony before the Subcommittee on Financial Institutions and Consumer Credit of the Committee on Banking and Financial Services, U.S. House of Representatives. February 13, 1997.

[5] Stacy Panigay Coleman, “The Evolution of the Federal Reserve’s Intraday Credit Policies,” Federal Reserve Board of Governors Bulletin (February 2002)

[6] Morton Bech, Antoine Martin, and Jamie McAndrews, “How the High Level of Reserves Benefits the Payment System,” Liberty Street Economics, Federal Reserve Bank of New York. February 12, 2012.

Members of the House Financial Services Committee made some progress on monetary reform this past week by introducing three new bills in the House on November 7th and 8th, to be marked-up in Committee on Tuesday — along with a host of other financial services related bills. The monetary measures serve as free-standing counterparts to similar provisions and goals of the comprehensive Financial CHOICE Act passed by the House earlier this year.

The Independence from Credit Policy Act (H.R. 4278), introduced by Rep. French Hill (R‑AR), is intended to restrict the Fed’s asset holdings, apart from gold, foreign exchange, and IMF-issued SDRs, particularly by requiring it to swap its current MBS holdings for Treasury obligations. In future emergencies the Fed could temporarily acquire certain non-Treasury assets in connection with its 13(3) lending operations (concerning which see below); but it would be allowed to hold such assets for no more than a year, after which it would also have to trade them in for Treasury securities.

The Monetary Policy Transparency Act (H.R. 4270), introduced by Rep. Andy Barr (R‑KY), is a variation on a core aspect of the Fed Oversight Reform and Modernization (FORM) Act, which was originally introduced in 2015. The FORM Act required the FOMC to adopt a specific, formal monetary policy rule, of the FOMC’s own choosing, and report to Congress when and if monetary policy deviated from the rule — although such a requirement was not to be “construed to prevent” the FOMC from such deviations. The new measure adds a step, calling for the FOMC to announce a particular monetary policy “strategy” each year, specifying, not mathematically but “in plain English,” its policy targets and the instrument or instruments it plans to employ to achieve them. And again, report to the appropriate House and Senate Committees concerning any deviations.

Finally, Rep. Scott Tipton (R‑CO) introduced the Congressional Accountability for Emergency Lending Programs of 2017 Act (H.R. 4302). That Act would further restrict the Fed’s 13(3) lending operations by requiring that they be approved by at least two-thirds of the FOMC (as opposed to the present 5‑member requirement); by disallowing the use of equity as collateral for 13(3) loans; by requiring that loans be approved not only by the Federal Reserve Board but by all Federal banking regulators having jurisdiction over the prospective borrowers; and by allowing emergency lending to be extended beyond a term of 30 days only by means of a joint resolution approved by Congress.

There’s no question that these measures, if adopted, would help to impose some much-needed discipline on the Fed — especially by preventing the Fed from propping-up markets for particular securities, save those issued by the U.S. Treasury — and by making it harder for it to bail-out insolvent firms. But crucial steps toward reforming the Fed’s current system of monetary control, with its reliance upon interest payments on banks’ excess reserve holdings as an alternative to conventional open-market operations, still need to be taken.

As I’ve stressed on numerous occasions, the current system involves a far less reliable “monetary transmission mechanism” than the old one — because it divorces changes in the Fed’s policy rate settings from any corresponding changes in the quantity of bank reserves, and also because it encourages banks to hoard reserves that come their way, instead of using them to support corresponding growth in the nominal quantities of money and credit. By encouraging banks and other financial institutions to direct funds to the Fed rather than to private-market borrowers, thereby increasing the Fed’s size relative to that of the commercial banking system, the new system also limits growth by employing savings less productively. Finally, by allowing the size of the Fed’s balance sheet — formerly a crucial determinant of the Fed’s monetary policy stance — into a “free parameter,” the new set-up makes the Fed vulnerable to the Treasury’s importuning, if not to that of other borrowers.

So, while I wish the sponsors of the present legislation good luck with their efforts so far, I hope they’ll follow them up with some reforms specifically aimed at replacing the present, unreliable, and inefficient monetary control system with a more old-fashioned, but nonetheless better, alternative.

The good news is that, legislatively-speaking, the fix is relatively easy. To compel the Fed to switch from its current “leaky floor” monetary control system, based on paying banks an above-market return on their excess reserves, to a more orthodox system in which the interest rate on excess reserves defines the lower bound of a fed funds rate “corridor,” all that’s needed is a slight clarification of existing law.

According to the statute that grants the Fed authority to pay interest on reserves, the rate it pays is “not to exceed the general level of short-term interest rates.” Unfortunately, Congress left it to the Fed to interpret “the general level of short-term interest rates” however it liked. By choosing to interpret it so loosely as to refer to the Fed’s own discount rate (or “primary rate”), among other proxies, the Fed has managed to pretend to conform to the statute, while actually thumbing its nose at it.

To put a stop to that, Congress just has to amend the law to make the “general level of short-term rates” mean what it was originally supposed to mean, to wit: the level of any of several reasonably comparable short-term market rates. Here is one way Congress could do just that — call it the Undo the Fed’s Abuse of Interest on Reserves Act:

Section 19(b)(12) of the Federal Reserve Act (12 U.S.C. 461(b)(12)) is hereby amended by inserting after Subparagraph (C)

‘(D) General level of short-term interest rates defined.—

For purposes of this paragraph, the term “general level of short-term interest rates” shall be defined as the average value over the preceding six-week interval of the Federal Reserve Bank of New York’s benchmark Broad Treasury financing rate on overnight repurchase agreements’

So, what do you say, FSC? As long as you’re tidying-up the Federal Reserve Act, a little clarification here could go a long way.

[Cross-posted from Alt‑M.org]