First, we'll get up to speed on the state of monetary policy implementation in the United States of America, in case you haven't been paying attention. After the financial crisis, the Fed substantially increased the size of its balance sheet, primarily through the purchase of long-maturity Treasury securities and mortgage-backed securities. On the liabilities side of the balance sheet, the Fed has seen a steady increase over the last 10 years in the quantity of Federal Reserve notes (currency) outstanding, but the primary source of funding for the increase in securities-held-outright by the Fed is an increase in the reserve balances held by financial institutions. This increase in reserves outstanding necessitated a floor-system approach to targeting overnight interest rates. That is,
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Well, normalization never happened, either with respect to interest rate policy or balance sheet policy. The Fed backed off its interest rate hikes, reversed direction, and certainly does not seem on the road to pegging short term interest rates in the ballpark of what would be commensurate with sustaining 2% inflation. Remember, sustained low nominal interest rates just creates sustained low inflation. Just ask the Bank of Japan. On balance sheet policy, there was a modest reduction in the Fed's total assets between late 2017 and this August, of about $600 billion:Fed balance sheet snapshot, those liabilities included $293 billion in the foreign repo pool - that's effectively reserves held at the Fed by foreign central banks and other foreign institutions - and $378 billion in the Treasury's general account held with the Fed. More about that later.
How does the FOMC think about overnight interest rate determination in a floor system? Typically, they're relying on this:
You can see how, if this is your view of how overnight markets work, then the mid-September episode when the overnight repo rate spiked well above IOER would be interpreted as a symptom of reserves being less than Q*. As a reminder of what has happened to overnight interest rates in the US since interest rate hikes began in December 2015:
When the repo market went crazy on September 17, much to everyone's surprise, the Fed intervened by lending in the repo market. That intervention has continued. Here's the Fed's overnight repo activity since then:
The FOMC's model of overnight credit market intervention, in the third figure, is misleading for a number of reasons. First, it's not a good idea to think that there's some stable demand for reserves in the financial system. Reserves are necessary for clearing and settlement of interbank transactions during the day, but intraday velocity is so high, basically, that a small quantity of reserves can support a very large quantity of intraday transactions. For example, before the financial crisis $10 billion in reserve balances could support a volume of intraday transactions on the order of annual U.S. GDP. So, issues related to reserve balances in excess of $1 trillion, as is the case currently, relate to the role reserves play as overnight assets, and we can safely ignore issues to do with the functioning of intraday wholesale payments. How useful banks find overnight reserve balances is determined by regulation, and by the stocks of other assets, particularly Treasury securities, which play an important role as collateral in the repo market, and as a liquid asset in banks' asset portfolios. A possibly superior way to look at the overnight market is to think in terms of the demand and supply of overnight credit. For example:
We can then think about all systems for pegging overnight interest rates in exactly the same way as in the last figure. The Fed has to intervene in such a way that either overnight credit demand, or overnight credit supply, is perfectly elastic at the target interest rate. For example, in this context, the operating regime for the Fed before the financial crisis looks like this:
But there's more to it. The Econ 101 approach to the overnight market in the last couple of figures isn't a good way to analyze a market with substantial frictions. For example, if there were no significant frictions in the overnight credit market, then it would make no difference whether the Fed permanently swapped, say, $100 billion in reserves for $100 billion in T-bills, or intervened by lending $100 billion in the repo market every day forever, taking T-bills as collateral. Clearly, the Fed thinks there's a difference, as they're now planning to buy about $60 billion in T-bills every month until the second quarter of next year, which looks like a potential planned purchase of $300 billion or more in T-bills. Somehow the Fed thinks that's better than continuing to intervene in the repo market at the current intensity - note that current repos outstanding, including term repos, amounts to about $191 billion.
So what's the Fed up to, and why? For more information, let's go to a recent speech by John Williams, President of the New York Fed. Williams says:
The key benefit of this approach is that it’s a simple, effective way of controlling the federal funds rate and thereby influencing other short-term interest rates.Well, in my book, "simple" means easy to explain. It's actually quite complicated to explain features of the current floor system, such as the ON-RRP facility, and why it's there, or why the repo market went phooey on September 17. A lot of people are spending valuable time trying to figure this out. Nothing simple about it. Further, "effective," I think, means it works. The floor system definitely does not work as advertised. Simply setting IOER should peg overnight rates, but that only happened (roughly) for just over a year. Before early 2018, the ON-RRP facility was holding up overnight rates from below, and after mid-September 2019 the Fed was lending in the repo market to hold down overnight rates from above. The floor system does not work, except in some sweet spot. And that sweet spot isn't determined only by reserves outstanding. There is a host of other poorly understood factors that matter for whether the floor can work on its own.
Here's something else Williams said in his speech:
In light of these events, we have learned that the ample reserves framework has worked smoothly with a level of reserves at least as large as we saw during summer and into early September. Although temporary open market operations are doing the trick for the time being, anticipated increases in non-reserve liabilities would cause reserves to decline in coming months without further actions.The "events" he's referring to are all included in the charts above. It's certainly not correct to say that everything worked smoothly prior to September. As I've pointed out, things were creaky before 2018, even given the ON-RRP intervention, and month-end spikes in the repo rate were apparent before the blowup on September 17. But, the key problem with Williams's statement here is that he doesn't tell us why the Fed prefers to buy T-bills rather than to intervene in the repo market every day - as he says, that's "doing the trick," so what's the problem?
1. If the answer to the problem of overnight interest rate control is more reserves, that can be achieved by reducing the size of the foreign repo pool and the Treasury's general account, which together currently come to a total of about $672 billion. That's a lot larger than the $300 billion in T-bills the Fed plans on purchasing. The size of the foreign repo pool and the Treasury's general account are purely discretionary, and both were tiny before the financial crisis. None of the communications coming from the Fed have explained what these items are about. Why is it important to the Fed's goals that foreign entities, including central banks, hold what are essentially reserve accounts at the Fed? How does it help monetary policy that the Treasury carries a large and volatile reserve balance with the Fed? Why can't foreign central banks park their overnight US dollars elsewhere? Why can't the Treasury park its accounts with the private sector, as before the financial crisis?
2. Experience with a floor system in the U.S. since December 2015 should tell us that it's ineffective for the Fed to attempt to intervene in overnight markets by narrowing their engagement with the financial sector to commercial banks. The fed funds market is a small market, and reserve accounts are held by only a fraction of financial institutions. The repo market is a large market, and intervention by the Fed in that market reaches all the nooks and crannies of the financial sector. A more effective approach, as many other central banks have discovered, is to peg a repo rate - stop worrying about the fed funds market - and intervene in the repo market, either on the lending or borrowing side, depending on circumstances.
3. The only advantage reserves have over Treasury securities, as a liquid asset, is that reserve balances can be transferred among financial institutions with reserve accounts, on Fedwire during the day. Otherwise, Treasuries are more widely held, and they're the primary form of collateral in the repo market. In general, if the Fed takes Treasuries out of financial markets and replaces those assets with reserves, that will make the financial sector less efficient. Some people have tried to argue that post-financial crisis banking regulations somehow make banks prefer reserves to Treasuries. I don't buy it. Treasuries and reserves are equivalent as high-quality liquid assets in banking regulation. And I've never seen a bank "living will" that articulates a special role for reserve balances. And if regulators are encouraging banks to hold reserves rather than Treasuries as liquid assets, there's no good reason for them to do that, given what seems to be written in the law.
So, the Fed seems to be floundering on this issue. Balance sheet policy seems to be more about the FOMC sticking to what they decided in early 2019, than with responding to what they should have learned since then.