The Federal Reserve's floor system: immediate gain for remote pain?

Author:Mueller, Paul D.
 
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"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater illfor the future. "

--Ludwig von Mises ([1953] 2009, p. 14)

  1. Introduction

    Before the recent financial crisis, US monetary policy was equivalent to "interest rate policy," meaning that the policy stance was defined exclusively in terms of a short-term interest rate. The Federal Open Market Committee (FOMC) set a target for the policy rate: the federal funds rate. The open market desk at the Federal Reserve Bank of New York then conducted open market operations to maintain the effective federal funds rate at or close to its target. The Federal Reserve, therefore, expanded or contracted its balance sheet in response to banks' shifting demand for reserves. Central bankers refer to this manner of implementing monetary policy as a "channel system."

    During the financial crisis, the Federal Reserve lowered its policy rate repeatedly until it ultimately reached the zero lower bound. These actions failed to stabilize prices and to maximize employment. To remedy that ill, the Federal Reserve sought and obtained the legal authority to begin paying interest on reserves immediately. (1) Shortly after that, the Federal Reserve's implementation of monetary policy switched to a "floor system." The interest rate on reserves establishes a floor for the price of reserves. A floor system entails the Federal Reserve purposefully supplying the banking system with more than enough reserves to push the effective federal funds rate down to the interest rate on reserves. A floor system, therefore, allows the Federal Reserve to target a positive price and quantity of reserves simultaneously while holding reserve requirements constant (see, e.g., Goodfriend 2002). (2) In other words, the floor system "divorces" interest rate policy from changes in the size and composition of the Federal Reserve's balance sheet--that is, from "balance sheet policy." (3)

    Given the floor system's relatively immediate and seemingly positive effects, the Federal Reserve shows few signs of returning to a channel system. One effect was eliminating the implicit tax on reserves, which Milton Friedman (1959) initially recommended over fifty years ago. A second effect of the floor system was reducing the credit risk associated with daylight overdrafts, which are a function of the Federal Reserve's settlement system, Fedwire. The third and most significant effect is that the floor system provides the Federal Reserve with another policy tool: the size and composition of its balance sheet.

    While the Federal Reserve's ability to implement balance sheet policy, independent of interest rate policy, yields potentially large short-run benefits, it also yields potentially large long-run costs. More specifically, the Federal Reserve's balance sheet policies may reduce longer-run economic growth by reallocating capital to less efficient financial and nonfinancial institutions. Separately, the Federal Reserve's balance sheet policies risk the institution's independence by increasingly blurring the line between monetary and fiscal policy. This article therefore seeks "to foretell the remoter effects" of implementing monetary policy with a floor system, so that central bankers can avoid "sowing the seeds of a much greater ill for the future" (Mises [1953] 2009, p. 14).

    Section 2 briefly describes the history and mechanics of Federal Reserve operating systems, particularly the channel and floor systems. Section 3 highlights the immediate and beneficial effects of switching monetary policy implementation from a channel to a floor system. Section 4 attempts to foretell the remoter effects of implementing monetary policy with a floor system. Section 5 concludes with a suggestion of how to implement monetary policy using a floor system that maintains the present benefits while protecting against future costs.

  2. History and Mechanics of Federal Reserve Operating Systems

    The explicit objectives of US monetary policy, since an amendment to the Federal Reserve Act (section 2A) in 1977, are "to promote maximum employment, stable prices, and moderate long-term interest rates." The consensus on monetary policy, prior to the financial crisis, held that interest rate policy was sufficient to achieve these goals. In the words of monetary theorist Michael Woodford (2002, p. 88), "All that matters is that the [Federal Reserve] be able to control overnight interest rates; this gives it the leverage that it needs in order to pursue its stabilization objectives." Accordingly, the FOMC conducted monetary policy by setting a target for the federal funds rate.

    The FOMC's announcements of monetary policy were, however, generally insufficient to ensure that the effective federal funds rate remained at or close to its target. Responsibility for implementing monetary policy, therefore, lay with the open market desk at the Federal Reserve Bank of New York (hereafter "the desk"). Prior to the financial crisis, the desk implemented monetary policy using a channel system, which contains two standing facilities that form a "channel" around the target rate. The discount window--the lending facility--allows banks to borrow reserves freely, against acceptable collateral, at a fixed interest rate above the target rate. If the Federal Reserve provides too few reserves through open market operations, individual banks compete to borrow reserves until either the excess demand is satisfied or the effective federal funds rate reaches the lending facility rate. The discount window sets a ceiling on the price of reserves and establishes the top of the channel. The deposit facility, in contrast, pays banks a fixed interest rate on their reserves that is below the target rate. If the Federal Reserve provides too many reserves through open market operations, individual banks compete to lend reserves until the excess supply ceases to exist, or until the effective federal funds rate reaches the deposit facility rate. The interest rate on reserves sets a floor on the price of reserves and establishes the bottom of the channel. The desk, through open market operations, aims to set the supply of reserves equal to the demand for reserves, at the policy rate target.

    Three important aspects of the channel system, as practiced in the United States, are worth highlighting. First, the Federal Reserve lacked legal authority to pay interest on reserves until October 2008. Therefore, the interest rate on reserves was zero, which meant zero was also the "price floor." Second, the size of the Federal Reserve's balance sheet was a function of the policy rate target and banks' demand for reserves. Third, open market operations were limited to transactions involving short-term Treasury securities and reserves. The composition of the Federal Reserve's assets was therefore effectively Treasuries only. Given these features of a channel system, the Federal Reserve controlled overnight interest rates through adjustments to its balance sheet size and the composition of its liabilities. A channel system thereby inhibits the Federal Reserve's ability to conduct balance sheet policy, independently of interest rate policy, a tool it would come to seek during the financial crisis.

    During the summer of 2007, global credit markets started to tighten as investors questioned the solvency of several large European banks (see, e.g., Lavoie 2010). Responding to rising global demand for dollar funding, the Federal Reserve began extending loans to foreign central banks and other financial institutions. With the supply of reserves rapidly increasing, the Federal Reserve found itself in a precarious position. To keep the effective federal funds rate from falling below its target, this expansion of reserves required sterilization. As Bech and Klee (2011, p. 418) note, "The intensifying financial turmoil over the course of 2008 required larger and larger injections of liquidity into the financial system and it became increasingly more difficult for the Federal Reserve to sterilize the resulting increases in [reserves] by redeeming or outright selling Treasury securities from the System Open Market Account (SOMA) portfolio." In other words, the appropriate interest rate policy for maximizing employment and stabilizing prices was inconsistent with the appropriate balance sheet policy for maintaining financial stability. Consequently, the effective federal funds rate fell and remained below the target rate (figure 1). This growing divergence between the desirable interest rate and balance sheet policies created a desire to separate these policy tools. However, doing so would require the legal authority to pay interest on reserves, an authority the Federal Reserve lacked historically.

    [FIGURE 1 OMITTED]

    The idea of interest on reserves dates back at least to the National Bank Act of 1863 (Weiner 1985). Although the creators of the Federal Reserve System considered permitting the payment of interest on reserves, the final draft of the Federal Reserve Act ultimately failed to grant that authority to the Federal Reserve. Although the reason for that decision remains a bit of a mystery, it was clear to the founders that "the power to purchase and rediscount securities in exchange for its own non-interest-[bearing] liabilities gave the [Federal Reserve] a means of earning substantial income" (Goodfriend and Hargraves 1983, p. 11). These means were readily apparent during the Federal Reserve's first several years of existence, as its balance sheet and profits grew rapidly (Willis 1920). (4) The Federal Reserve retained these initial profits until its retained earnings equaled twice its subscribed capital. After that, the Federal Reserve turned its earnings over to the Treasury. The...

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