- Fed Vice Chairman Stanley Fischer spoke at the 2015 U.S. Monetary Policy Forum, sponsored by the University of Chicago Booth School of Business on February 27, 2015.
- The Fed is facing numerous challenges with its current balance sheet.
- As a result, the Fed is having to rely on other tools like ON REPOs and changes in the IOER to control the Fed Funds Rate.
Ever since the Great Recession the Fed has been pumping money into the economy which has created some new challenges for the Fed in terms of monetary policy. Fed Vice Chairman Stanley Fischer spoke at the 2015 U.S. Monetary Policy Forum, sponsored by the University of Chicago Booth School of Business on February 27, 2015. He used the time to discuss these challenges.
"To set the stage," begins the chairman, "consider the size of the Fed's balance sheet over the past several years. Assets have risen from about $900 billion in 2006 to about $4.5 trillion today."
"The net expansion over this period," he goes on to say, "reflects primarily our large-scale asset purchase programs." He's referring to programs like Quantitative Easing ("QE") that pumped $85 billion into the market every month by buying up bank assets, especially troubled mortgage-backed securities.
The U.S. isn't the only country to focus on liquidity, the Bank of Japan has increased assets from ~20 percent to more than 60 percent of nominal GDP over the same time period, and the Swiss National Bank increased assets from 20 percent to more than 80 percent of nominal GDP. At the ECB, assets increased from less than 10 percent to more than 20 percent of nominal GDP and Europe's Quantitative Easing program hasn't even started.
With all this liquidity in the market the Fed is naturally concerned about inflation, especially if energy prices rebound. They're also concerned about being able to "control" the Fed funds rate which is the rate at which banks lend money to each other. Historically, the rate is controlled by the Fed and used as a way to exact monetary policy. A higher rate meant banks had to pay more interest to borrow money and thus set the floor on rates across the market.
With excess reserves at an all time high due to QE, however, banks are more concerned with the interest rate paid on those reserves than the rate at which they can borrow funds from one another.
Sidebar: Banks only began receiving interest in 2008 due to a change in law. We'll be discussing this in more detail within an upcoming post, but to read more about that change in law now, click here.
As a result, the Fed is facing several challenges with its current balance sheet. "Among these," the vice chairman says, "are the possibility that elevated securities holdings and low interest rates could pose risks to financial stability, possible effects on the Fed's income and remittances to the U.S. Treasury, and possible difficulties in conducting policy normalization." He goes on to explain why this is the case:
Such potential difficulties arise because the level of reserve balances will be very high when the FOMC begins to raise the federal funds rate, and, consequently, the Federal Reserve will employ new tools, which have their own benefits and costs, to implement monetary policy.
What "tools" is Fischer talking about: The use of term and overnight repurchase agreements (ON Repos) and the interest rate paid on excess reserves (IOER). The Fed is currently running monthly auctions at varying amounts and rates to gauge whether or not ON Repos can help control the fed funds rate, but the Fed's primary tool to change interest rates is the IOER.
It's not like the Fed didn't know this was coming. "We have for some years been considering ways to operate monetary policy with an elevated balance sheet," admits the chairman in his speech. He also admits, though in a more veiled tone, that the Fed no longer has the same power over the fed funds rate that it used to. "Prior to the financial crisis," the chairman says,
...because reserve balances outstanding averaged only around $25 billion, relatively minor variations in the total amount of reserves supplied by the Desk could move the equilibrium federal funds rate up or down. With the nearly $3 trillion in excess reserves today, the traditional mechanism of adjustments in the quantity of reserve balances to achieve the desired level of the effective federal funds rate may well not be feasible or sufficiently predictable.
Did he say $3 trillion in excess reserves? As a result, Fischer continues:
we will use the rate of interest paid on excess reserves (IOER) as our primary tool to move the federal funds rate into the target range. This action should encourage banks not to lend to any private counterparty at a rate lower than the rate they can earn on balances maintained at the Fed, which should put upward pressure on a range of short-term interest rates.
So, in order to change the fed funds rate, the Fed has to pay banks a higher rate of interest on reserves, and reserves are already at all time highs.
To be clear, the chairman is not apologizing for the current state of the balance sheet and the challenges that may arise because of it, but he is acknowledging the Fed's weakness. Who cares about the cost to borrow funds when you have $3 trillion in excess reserves that you're getting paid interest on by the federal government? As a result, the mechanisms used to control one of the market's most fundamental rates is no longer effective and new tools must be created to control monetary policy.
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