Monetary Policy Operating Frameworks: Are Reforms Heading in the Right Direction?

• Author: Filardo, Andrew

"Monetary policy operations" is one of the topics that capture the imagination of policymakers and academics only once in a blue moon. There is no doubt that those who manage central bank reserves play an important role in the way our modern financial system works. They attend to the financial plumbing that critically links the actions of a central bank to the financial system. They generally beaver away in relative obscurity as long as the financial system is working efficiently. However, just as with household plumbing, the financial plumbing gets our immediate and focused attention when it gets backed up.

It is not surprising then that issues of monetary policy operations have recently attracted renewed interest. In the past year, there have been several episodes--so far mainly temporary phenomena--of monetary markets "getting backed up." Indeed, most market and official commentaries have largely concluded that the acute stress in money markets seen in mid-September 2019 and, for that matter, at the end of 2018, has one main source: the shrinking of the Fed's balance sheet and the concomitant drain of liquidity in the form of reserves. Questions abound about whether these episodes are simply a series of one-off events or whether they are signs of a more fundamental corrosion of the financial pipes that could lead to more persistent and, possibly, larger failures in the future.

In this article, I will argue that recent money market stresses are, in many respects, symptoms of deeper pathologies. While it is true that these stresses have gone hand-in-hand with a smaller Fed balance sheet, the blame lies elsewhere. Namely, private-sector incentives to efficiently reallocate reserves in the financial system have weakened and, hence, undermined the soundness of money markets. At the same time, concerns are growing that the incentives to monitor the actions and motivations of money market participants have eroded. From this "incentives" perspective, many of the solutions generally being considered may be off the mark.

To sketch out the implication of this incentives perspective for reforms of the monetary policy operational framework, the paper is structured as follows. The next section offers evidence supporting the claim that the modestly shrinking Fed balance sheet is not the underlying cause of the money market stresses. I then address the question of why the floor system has not been working as advertised, emphasizing instead the deeper roots of the problem associated with the ways in which monetary policy operations have been adapted to the new financial regulatory environment. Finally, the article turns to some strategic and tactical options for reforming monetary policy operations that move in the direction of strengthening the efficiency of money markets while retaining the financial stability benefits of the new liquidity regulations.

Is the Shrinking Fed Balance Sheet to Blame?

From 2017 to mid-2019, the Fed was in balance sheet normalization mode. Figure 1 (left-hand panel) highlights the inflection point in 2017 as the Fed started running off both Treasury securities and mortgage-backed securities (MBS). In July 2019, it announced an early end to the normalization process and in October decided to resume purchases, at least until the second quarter of 2020.

Supporting Evidence

Over the same two-year period, money markets showed signs of greater volatility. Figure 1 (middle panel) presents several key money market rates: the effective federal funds rate along with the FOMC target rate-band, the general collateral financing (GCF) repo rate, and the secured overnight financing rate (SOFR). The GCF repo rate and SOFR are benchmark financing rates that reflect the price of overnight secured lending, usually involving Treasury securities and other high-quality liquid assets (HQLA). Three features in this graph stand out. First, the general rise in rates reflects the integrated nature of these secured finance money markets with the Fed's policy rate. Second, in a somewhat anomalous fashion, secured financing rates can exceed the unsecured rate (i.e., the effective federal funds rate) and, indeed, have. This suggests money markets may not be fully efficient. Lastly, periodic spikes reflect ongoing vulnerabilities to acute liquidity stresses that the markets have not been able to diffuse before the spikes materialize, and the frequency of outsize moves in SOFR relative to the federal funds rate has increased over the past five years (Figure 1, right-hand panel).

Of particular note, the level of stress in the secured funding markets registered a new extreme in 2019, as GCF repo rates and SOFR spiked (Figure 2, left-hand panel). The size of the spikes is notable. (1) Given that the shadow of the crisis had largely faded, one would have expected to see more normal, not more volatile, conditions (Potter 2018). The timing was also unusual. It has been common to see rate spikes at the end of months, quarters, and years as financial institutions "tidy up" their balance sheets for regulatory and financial window dressing reasons. So the mid-September spike took on greater significance than its mere size. Understandably, the unusual behavior attracted considerable attention.

Various hypotheses have been put forth to explain this behavior. A dominant theme in market commentaries is the shrinking Fed balance sheet. The argument is that a smaller Fed balance sheet squeezed available reserves and left market participants scrounging around for liquidity. The policy conclusion from this line of thinking is that an increase in the Fed's balance sheet will help financial institutions sort out their financial needs, calm markets, and reduce the likelihood of overreactions in the future.

Contradictory Evidence from Money Markets

Is it obvious that the shrinking Fed balance sheet is to blame? Figure 2 (right-hand panel) presents striking visual evidence of a structural change in the relationship between money market rates and the size of the Fed's balance sheet. Before the end of 2014, the light gray dots show a negative relationship between the secured money market rates relative to the floor rate of the Fed (i.e., the interest rate on excess reserves, IOER). As the Fed's balance sheet grew (moving from left to right), competition led to a smaller gap between the secured money market rates and the IOER. That empirical relationship changed in the middle of the sample, as the earlier relationship represented by the light gray line twisted clockwise in the later period represented by the dark gray line. The newer relationship was still negative but much more steeply sloped.

Casting doubt on the shrinking Fed balance sheet hypothesis is the evidence on the timing of the structural break in the statistical relationship. It is clear that the structural break at the end of 2014 occurred several years before the Fed began implementing its normalization plan (i.e., the run-off of its Treasury and MBS assets starting in late 2017). The stability of the relationship since the break has been remarkable and covers both the balance sheet pause and the normalization.

The evidence of this relationship just before and after the September 2019 market turmoil casts further doubt. Figure 2 includes weekly balance sheet data around the time of the September rate spike. The circles (*) represent data from early August to mid-September; the plus signs (+) represent data in the first half of October. Other than the two diamond shapes (**) representing the third and fourth weeks of September, the statistical relationship appears unchanged since late 2014. The data for the second half of September look in retrospect like a few outliers in an otherwise stable structural relationship.

What happened during the period of these September 2019 outliers? The markets and the Fed were taken by surprise. Repo markets experienced extreme stress, as reflected in the rate spikes (one day hitting 10 percent!), which then kept markets on edge. It appears that the proximate cause of the higher volatility was the drying up of liquidity in the secured money markets. In response, the Fed reacted by supplying reserves in the market via open market operations. On the first day, the Fed faced some technical difficulties performing the reserves-supplying operations and only supplied about $53 billion out of the $75 billion in Treasuries and MBS securities. Significantly, this was the first time since the financial crisis that the Fed conducted major market interventions to calm stresses in money markets. The stresses finally subsided after a couple of weeks and multiple rounds of large Fed interventions.

So, what did we learn from this September episode of market turmoil? Clearly, the rate spikes were a visible sign that the U.S. financial plumbing had become clogged. The sharply wider gap between secured money market rates and the federal funds rate indicated that banks were unwilling or unable to recirculate reserves efficiently from those with excess reserves to those with need. It also showed that the Fed's plumbers are good at clearing the clogs but can get caught off guard. And the Fed's initial technical difficulties while ramping up its emergency actions raised questions about the ability to respond nimbly after sitting on the sidelines of these markets for such a long time.

This September 2019 episode also highlighted the fragile nature of money markets. They appear to have grown highly vulnerable to a virulent form of liquidity illusion: that is, liquidity buffers that appear ample when not needed but prove insufficient just when they are needed. Indeed, despite liquidity buffers appearing ample in 2019, the unwillingness of banks to release their liquidity buffers at the whiff of stress resulted in the outsized reaction in rates. This experience demonstrated that interconnected money markets subject to liquidity illusion risk can very quickly turn a...