The Fed's Precrisis Monetary Policy Framework Is Well-Suited for a Free Society.

• Author: Nelson, Bill

In this article, I argue that the Fed's precrisis monetary policy implementation framework is well-suited to a free society. First, I review several of the critical decisions that drove the Fed to its current framework, in most cases because of unintended and unforeseen consequences. Next, I describe how the Fed can return to conducting policy in its precrisis manner.

Monetary Policy Implementation Framework before the Crisis

Prior to the crisis, the Fed conducted monetary policy using Treasury purchases and relatively small repo operations with primary dealers, the large broker-dealers authorized to do business with the Fed. Those transactions adjusted the total quantity of reserve balances so as to keep die federal funds rate--the market interest rate at which commercial banks lend overnight, unsecured to each other--near its target. The dealers were not reliant on the repo transactions with the Fed for funding, and die Fed was largely indifferent to the repo rate. Banks borrowed and lent to each other in the federal funds market, not with the Fed. Consequently, the Fed was counterparty to only a small number of relatively inconsequential financial transactions each day.

Four Decisions That Led to the Fed's Current Large-Balance-Sheet Framework

During the crisis and the anemic recovery that followed, the Fed made a series of decisions that led to the large-balance-sheet implementation framework it uses today.

First, the Fed allowed the Treasury to switch from keeping most of its cash at commercial banks to keeping all of its cash at the Fed. The Treasury initially increased its deposits at the Fed in 2008 to help the Fed finance its emergency lending, but the Treasury ended up keeping all of its cash at the Fed because doing so saved taxpayers money during the six-year period when interest rates were near zero (Santoro 2012). During that period, the Treasury would have earned zero on any funds it kept at a commercial bank. While the Fed also paid the Treasury zero interest on its Fed deposits, a Treasury deposit at the Fed reduces bank deposits at the Fed one-for-one, and the Fed, which remits its income to the Treasury, was paying 25 basis points on commercial bank deposits. But even though market interest rates have been above zero since the end of 2015, the Treasury continues to keep all its cash at the Fed. Whereas before the crisis, the Treasury kept about $5 billion at the Fed, the Treasury's current Fed deposits are currently worth about $300 billion and highly variable. There is no record that I can find in the minutes or transcripts of FOMC meetings of the FOMC actually making the consequential decision to allow the Treasury to keep all its cash at the Fed when rates fell to zero nor revisiting the decision when rates increased.

Although it is beyond the scope of this article to discuss in detail, a similar set of issues was raised by the growth of the foreign repo pool, where foreign official and international holders of accounts at the Fed invest in overnight reverse repurchase agreements (Nelson 2019a). That pool has grown from about $30 billion before the crisis to about $300 billion now. Again, there is no record in the FOMC meeting minutes that I can find of a decision to allow the foreign repo pool to grow.

Second, in late 2012, the Fed embarked on its flow-based asset purchase program, also referred to as QE3 or QE-infinity. (1) While the first two large-scale asset...