THE FED'S OPERATING FRAMEWORK: HOW DOES IT WORK AND HOW WILL IT CHANGE?

• Author: Williamson, Stephen D.

In September 2008, during the global financial crisis, the Federal Reserve commenced an unprecedented program of asset purchases. At that time the Fed's total assets were about $925 billion, and when the balance sheet expansion ceased in October 2014, total assets stood at about $4.5 trillion. Before the financial crisis, the Fed's asset portfolio was financed primarily by circulating currency, but by October 2014 currency outstanding was about $1.3 trillion and interest-bearing reserves were about $2.6 trillion.

The intention of the Federal Open Market Committee (FOMC) was to use the balance sheet expansion as an accommodative tool to supplement its zero interest rate policy, under which the target for the fed funds rate had been reduced to a range of 0-0.25 percent in December 2008. However, the Fed's balance sheet expansion created the necessity for important changes in how the policy directives of the FOMC were implemented in the postfinancial crisis period. Moreover, in ultimately winding down its experiment with unconventional monetary policy--that is, large-scale asset purchases and zero interest rates--the Fed was, and is, sailing in uncharted territory. Therefore, careful evaluation and adjustment along the way was and is critical to the Fed's success in managing the experiment and potentially repairing any damage.

What are we to make of the Fed's experiment with a large balance sheet expansion (also known as quantitative easing or QE) ? Was the experiment worth it? Has policy implementation been handled correctly during QE? Was the move toward normalization handled in a timely way? What will normalization ultimately entail, and what should it entail? What lessons should we have learned that permit better policymaking in the future?

Fed Intervention before the Financial Crisis

Prior to the large balance sheet period that began in September 2008, the Fed effectively implemented monetary policy in a channel or corridor system. In countries in which interest is paid on reserve balances held with the central bank, channel systems have been formalized as part of central bank communications and implementation. For example, in Canada, the Bank of Canada's policy interest rate is a secured overnight interest rate. The Bank sets a target for that interest rate, and the target falls in a channel. The upper bound on the channel is the interest rate at which the Bank stands ready to lend to financial institutions, which is 25 basis points higher than the target. And the lower bound on the channel is the interest rate at which interest is paid on overnight deposits (reserves) with the Bank, which is 25 basis points below the target. Financial arbitrage dictates that the policy rate must fall between these upper and lower bounds, though typically the Bank achieves the overnight target interest rate with a very small margin of error.

Before the financial crisis, most central banks in rich countries (with some exceptions due to idiosyncratic institutional arrangements) implemented monetary policy in a corridor system that worked similar to Canada's. But monetary policy in the United States worked somewhat differently. First, the Fed targeted an unsecured overnight rate--the fed funds rate. In other countries, unsecured overnight markets may exist, but the target rate--as in Canada--is typically an interest rate on overnight repurchase agreements (repos), that is, a secured rate. Second, the Fed did not pay interest on reserves. This made the effective lower bound on its policy rate zero. However, like other central banks, the Fed conducted lending through the discount window at interest rates higher than the fed funds interest-rate target, so the fed funds rate was bounded in a channel demarcated by zero on the low side and the discount rate on the high side.

Though the Fed's pre-2008 target interest rate was the unsecured fed funds rate, the Fed did not intervene directly in unsecured credit markets to peg the fed funds rate (nor does it do so currently). In managing its asset portfolio, the Fed focused on an essentially all-Treasury portfolio consisting of bills, notes, and bonds--assets that, for the most part, were held until maturity. Day-to-day intervention to achieve the fed funds rate target occurred in the market for repos. At any given time the Fed was active on both sides of the repo market. That is, it would lend in the repo market, and borrow in terms of reverse repos. Typically, most of the variation in the Fed's repo market intervention occurred through variation in repo activity, rather than reverse repo activity. This intervention procedure is often framed (see Potter 2018) as a process by which the Fed managed the supply of excess reserves, so that the market for excess reserves would clear at an interest rate as close to the fed funds rate target as possible.

It is perhaps more helpful to think of the overnight credit market as involving substitution between secured and unsecured credit. Financial arbitrage between the overnight repo market and the fed funds market is somewhat imperfect because of different timing in these markets during the day (details concerning when the funds go to the borrower one day, and when the debt is settled the next day), friction due to the time it takes to find a counterparty for a particular transaction, and counterparty risk. However, imperfections in arbitrage between secured and unsecured overnight markets did not prevent repo rates from moving together with the fed funds rate. Thus, the Fed's pre-2008 implementation procedure effectively involved influencing repo rates with the goal of pegging the fed funds rate. Sometimes this could be a quite noisy process, particularly during the financial crisis when the fed funds market became contaminated with counterparty risk and...