THE FED'S NEW OPERATING FRAMEWORK: HOW WE GOT HERE AND WHY WE SHOULDN'T STAY.

• Author: Selgin, George

Much talk concerning the Fed lately has to do with its strategy for "normalizing" monetary policy--that is, its plans for reversing unconventional policies it pursued during the last financial crisis and subsequent recovery.

Most people are aware of two of the Fed's unconventional policies. One consisted of the relatively low interest rate targets it set during the crisis and for some time afterward. The second consisted of several rounds of large-scale asset purchases it engaged in, generally known as "quantitative easing" (QE). But the Fed's unconventional policies included a third, less well-appreciated component. This was its decision to switch, during October 2008, from its conventional "corridor-type" system for regulating interest rates to a new "floor-type" system. A central bank that uses a corridor-type system influences market interest rates by adding to or subtracting from the available supply of bank reserves. In contrast, one that uses a floor system influences market rates by changing the interest rate it pays on the reserve balances that banks keep with it.

Although the Fed has already begun to undo the more well-known components of its unconventional crisis-era policies by gradually raising its interest rate target and by allowing its balance sheet to shrink, it has chosen not to revert to a corridor-type operating system. I believe that sticking to the present floor system, instead of switching to a corridor system, is a mistake, for reasons I will summarize later. First, however, I wish to quickly review how the Fed's switch to a floor system came about, and some of the consequences of that switch.

From a Corridor to a Floor System

The Fed's October 2008 switch to a floor system was itself the result of two developments. The first consisted of the new policy it inaugurated that month of paying banks a positive rather than zero interest rate on their Federal Reserve account (a.k.a. "reserve") balances. The second consisted of a substantial increase in the total supply of reserves the Fed supplied to the banking system, originally stemming from the Fed's emergency lending, but eventually continued, on a much larger scale, through its various rounds of QE.

Because the Fed paid interest on both banks' required reserves and their excess reserves (i.e., reserves held above minimum legal requirements), and because it soon set the interest rate it paid on both sorts of reserves above prevailing short-term market interest rates, banks became inclined to hold on to any fresh reserves that came their way, even though that meant holding far more reserves than the law required them to. In contrast, prior to October 2008, banks held only very trivial amounts of excess reserves.

The fact that banks could earn more by holding on to Fed balances than they might by lending them to other banks on the federal funds market meant that interbank lending on that market dried up. It also meant that changes to the available quantity of reserves no longer had any influence on the prevailing fed funds rate. Instead, that rate tended to fall somewhere below the rate of interest on excess reserves, or IOER rate, rising or falling as the Fed raised or lowered its IOER rate. Although the Fed continued to express its intended monetary policy stance in terms of a chosen fed funds rate "target" (eventually changed to a target "range"), its IOER rate had replaced its ability to purchase or sell assets as the tool it relied upon to influence short-term market interest rates and thereby achieve its monetary policy goals. This change marked the Fed's transition from a corridor-type operating system, in which the Fed's rate target was always somewhere between its (historically zero) IOER rate and its emergency lending rate (the rate at which the Fed lends reserves to institutions lacking in any other source of credit), to a floor system, in which its IOER rate is always at or above its desired rate target.

As I have noted, the Fed's normalization plans thus far include plans for raising interest rates toward a presumably "normal" rate of close to 3 percent, and for shrinking its balance sheet at least to some nontrivial extent, but not for reverting to a corridor-type operating system. Indeed, "raising interest rates" in the present context means raising the IOER rate, and raising it sufficiently to keep reserves attractive relative to other assets. And that in turn means that the Fed's balance sheet "normalization" must itself be limited, for although that balance sheet can fall substantially from the extraordinary heights it achieved during the recovery, so long as the Fed chooses to maintain a floor system it cannot allow its balance sheet to shrink to the point at which reserves...