Photo courtesy of Caleb Martin

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.

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