Author:McCulloch, J. Huston

Since 2008, the monetary base has more than quadrupled through the Federal Reserve's quantitative easing (QE) programs, and yet inflation has shown no signs of accelerating. In fact, inflation has not even met the Fed's announced 2 percent target, despite an essentially zero fed funds rate from 2009 to 2015. This is quite puzzling, both in terms of the traditional quantity theory of money and in terms of the Taylor ride approach to monetary policy.

Before 2008, the Fed could accelerate or decelerate inflation by expanding or contracting the monetary base and therefore bank reserves with open market operations and repo loans to dealers. Since 2008, however, the Fed has paid interest on excess reserves (IOER) equal to or even higher than the effective federal funds rate. As a result, the banks are awash with excess reserves that have zero opportunity cost, and the Fed has lost its primary mode of control over the price level and inflation.

In order to restore the Fed's control over inflation, it is necessary that IOER be abolished. In doing so, however, it is also necessary to undo the post-2008 explosion of the base in order to prevent massive inflation.

Fed economists have recently invoked Milton Friedman's 1969 essay, "The Optimum Quantity of Money" as providing justification for tire Fed's IOER policy. However, I shall show that strict application of this rule would leave the price level indeterminate in a that money world, and hence that it cannot be taken seriously as a monetary policy.

The zero lower bound (ZLB) issue has been used to justify many of die extraordinary measures the Fed has taken since 2008 as well as its interpretation of price stability as 2 percent inflation. This article shows that problem can be solved by temporarily targeting interest rates on loans with maturities longer than the six weeks implicit in the Fed's current operating procedures, even with a 0 percent inflation target.

The Pre-2008 Regime

Prior to October of 2008, bank reserve deposits paid zero interest. (1) Banks normally held only a tiny inventory of excess reserves to meet withdrawals and adverse clearings, typically well under 0.5 percent of checkable deposits. The federal funds market efficiently allowed banks with surplus reserves and no immediate borrowing partner to lend them to banks that were short on reserves or were able to expand loans. The fed funds rate that banks charge one another for one-day use of reserves was typically well below the average rate banks got on somewhat risky customer loans that required close supervision, but represented the risk-adjusted opportunity cost to banks of marginal excess reserves.

Under this regime, if the Fed expanded the base and therefore excess reserves, banks would scramble to lend out any excess reserves beyond this small inventory to business or consumers who wanted the loans to make purchases they could not otherwise make, thereby driving up prices and at the same time temporarily driving down die fed funds rate.

Similarly, it could decelerate inflation by contracting the base, leaving banks with either precariously small excess reserves or an outright reserve shortfall. As banks contracted loans and thereby deposits to restore their reserves, businesses and consumers would spend less. At the same time, banks would temporarily bid the fed funds rate up.

Interest on Excess Reserves since 2008

Since October of 2008, die Fed has paid IOER at or slightly above the fed funds rate. During the same period, the Fed has more than quadrupled the monetary base though its QE I--III acquisitions of mortgage-backed securities (MBS) and Treasury securities. These acquisitions were financed mostly through the creation of new excess reserve balances. Thanks to IOER, however, banks have been in no rush to lend these funds out, and instead are content to just sit on them. The Fed in effect is now acting as a huge financial intermediary, borrowing reserve deposits from the banks at interest and lending them back to homeowners as mortgages or by transforming the maturity of the national debt.

This intermediation activity on the part of the Fed is not without adverse consequences, but has not in itself been inflationary, since IOER ensures that it is being financed with deposits that are savings instruments at the margin, rather than money per se. Thanks to IOER, the Fed is therefore essentially "rudderless" and unable to exert either inflationary or deflationary pressure on the economy.

When banks are awash with interest-bearing excess reserves, as they have been since 2008, there is little if any need for a federal funds market, since banks can earn interest simply by depositing surplus reserves with the Fed, and can obtain funds simply by withdrawing these deposits. To the extent there is a federal funds market, the fed funds rate should be essentially equal to the IOER rate. Indeed, the federal funds market has shrunk from over $300 billion in 2007 to barely $50 or $60 billion in recent years.

From late 2008 through November 2015, the IOER rate was only 0.25 percent and the fed funds rate itself was a little under 0.2 percent, neither of which is much different from zero--recall that the Federal Open Market Committee (FOMC) typically moves its fed funds target in multiples of 0.25 percent, which is therefore its estimate of the smallest perceptible increment to the rate. However, the Fed's IOER policy in fact made a difference for banks' willingness to hold reserves, since they could be confident that when market rates rose, IOER would rise with them, so that there never would be an opportunity cost to holding excess reserves. Since late 2015, the IOER and fed funds rate have indeed risen together, to 1.25 percent and 1.16 percent, respectively, by October of 2017.

The Fed's Reckless Maturity Gambles

The Fed's large-scale asset purchases represent financial intermediation rather than central banking--since they are being financed mostly by interest-bearing liabilities of the Fed that provide few if any monetary services at the margin.

Since the national debt is unlikely to be paid off any time soon, the Treasury prudently finances a large portion of it with long-term bonds, so as to lock in current long-term rates and protect taxpayers from even higher future interest rates. Moreover, because the Fed turns the bulk of its profits (or losses) over to the Treasury, its non-monetary liabilities are essentially liabilities of the Treasury. The Fed's purchases of long-term Treasury bonds with interest-bearing zero-maturity excess reserves therefore have essentially second guessed die Treasury's prudent decision to borrow long with its own gamble to finance this substantial portion of the national debt with short-term borrowing instead. This is a decision that properly is the Treasury's, not the Fed's, and in any event the Fed is making the wrong decision.

Furthermore, by financing long-term mortgages with interest-bearing excess reserves, the Fed has taken the same reckless gamble that savings and loan associations (S&Ls) did in the 1960s and 1970s, and that led to the demise of most of the industry, not to mention the Federal Savings and Loan Insurance Corporation, during the 1980s. Long-term mortgages are a sound way to finance durable housing but should be financed by private intermediaries that issue long-term debt of comparable maturity. For all their faults, Fannie Mae and Freddie Mac have at least generally financed their mortgage portfolios with bonds of comparable maturity rather than with zero maturity savings accounts as did the now largely defunct S&Ls, and as now is...

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