FOMC Statement And The New Normal

by: John Cochrane

The September 17 FOMC statement made the usual waves in the when-will-they-raise-rates commentary. But the separate "policy normalization principles and plans" document is, I think, more interesting. And since the Wall Street Journal called "a new technical plan for how it will raise short-term interest rates" and then moved on, it is I think worth a bit of examination.

It confirms the previous plan:

During normalization, the Federal Reserve intends to move the federal funds rate into the target range set by the FOMC primarily by adjusting the interest rate it pays on excess reserve balances.

What does this mean? The Fed has about $3 trillion of reserves outstanding, and required reserves are about $80 billion. The old way of raising rates would require that they sell off $2.9 trillion of assets, soaking up $2.9 trillion of reserves, so that rates will go up without paying interest on reserves. I illustrated this in the graph above.

Instead, the Fed will simply keep the $3 trillion of reserves outstanding, and just pay interest on them. I illustrated this in the second graph.

The idea is, if the Fed pays 5% interest on reserves, banks will compete with each other to get depositors, and thus start paying 4.99% on deposits. Banks will also charge at least 5% on loans. Depositors will dump their treasuries until those rates go up to 5%. And then Treasury rates will also go up to 5%.

Whether it will work, whether banks are really that large and competitive, will be interesting to see. They sure haven't competed credit card rates down to zero. And if you decide to raise the minimum wage by paying your gardener $15 per hour, that won't raise the whole minimum wage in the country. But the Fed is bigger, and my guess is that it will work, or at least will appear to work so long as the Fed doesn't try to raise rates 5% overnight. Which it won't.

Anyway, I approved of interest on reserves and a big balance sheet in a recent WSJ OpEd and associated blog post so I still cheer.

However, the critics of the "repurchase facility" seem to be winning

During normalization, the Federal Reserve intends to use an overnight reverse repurchase agreement facility and other supplementary tools as needed to help control the federal funds rate. The Committee will use an overnight reverse repurchase agreement facility only to the extent necessary and will phase it out when it is no longer needed to help control the federal funds rate

OK, what is this? Basically, the Fed will allow financial institutions that aren't banks to have interest-paying reserves. Again, I approve loudly. If banks turn out not to be that competitive, and just take money, pay no interest, and earn interest on reserves, now other institutions can get in the game. That should help raise rates. If you make the offer to the gardener next door, he too will get $15 an hour.

I like it, and also loudly like opening reserves up to everyone. Who can object to lots of interest paying electronic money that cannot default and cannot have a run?

Alas, the naysayers seem to be winning on this one. Fortunately, "necessary" and "needed" are pretty vague, so I suspect this will in fact go on a long time.

The Committee intends to reduce the Federal Reserve's securities holdings in a gradual and predictable manner primarily by ceasing to reinvest repayments of principal on securities held in the SOMA.

The Committee intends that the Federal Reserve will, in the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively, and that it will hold primarily Treasury securities, thereby minimizing the effect of Federal Reserve holdings on the allocation of credit across sectors of the economy.

So, at least they won't sell any securities -- and thus deal with the ramifications of taking losses. But they won't keep the large balance sheet. Since my OpEd encouraged them precisely to keep the large balance sheet, I'm disappointed.

A small balance sheet means small reserves, potentially paying less than market interest on reserves, re-stoking the whole shadow banking business that just exploded in our faces, reducing a large completely safe fraction of bank assets, and leaving the looming uncertainty about just what the reserve regime will be.

So, one thumbs up, one neutral, and one thumbs down, at least relative to my admittedly unorthodox ideas.


The Committee is prepared to adjust the details of its approach to policy normalization in light of economic and financial developments.

Translation, we'll do what we feel like doing at the time, and continue to argue about it. In this case, I'm grateful for the discretion.

I think we have reached a new era. We have discovered that massive reserves which pay the same interest as treasuries are not at all inflationary, and a great bedrock for a new financial system. We should not forget those lessons and go back to a monetary policy regime that was part of a financial system that blew up.

So, a last piece of unasked for advice. Dear Fed, don't use the word "normalization!" You may discover that a huge balance sheet, reverse repos for everyone, and even near-zero rates and zero inflation are a permanent and healthy policy configuration. If you've called tiny reserves that don't pay interest "normal," it's going to be awfully hard to accept that the "new normal" is just fine. Maybe now is "normal!"

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