Monetary Policy: When The Policy Rate Is Not The Policy Rate

by: Kurt Dew


Monetary policy, we have been informed, has new implementation tools since the crisis.

Excess reserves and the rate the Fed pays banks that carry them have been added to the kit.

One tool is enough. Mop up the excess reserves at a prudent pace and do away with interest paid on excess reserves.

"It is a tale

Told by an idiot, full of sound and fury

Signifying nothing."

-- Shakespeare

Amid incredible fanfare, the Fed raised its target range for the fed funds rate, the purported rate by which the Fed sets policy in an effort to manage inflation and unemployment. While money market yields roiled in a manner suggesting that something important had happened - and, indeed, something important had happened - it wasn't the change in the fed funds target rate.

Perhaps now that the entire world is focused upon the fed funds rate as if in a trance, it is time to make this rate matter again. The reality is that since the Fed began to enhance the benefits of holding excess reserves, banks are not particularly interested in the fed funds market.

The most important incentive the Fed now provides for holding excess reserves is the payment of interest on reserve balances. The current rate the Fed pays on excess reserves is 50 basis points. The excess reserve rate, as long as it exceeds the Treasury rate (3-month Treasury rate at the close today, 26 basis points), renders the fed funds target irrelevant, except as a symbol of things to come. The graph below, from the Federal Reserve of St Louis' FRED tool, shows what's going on with three-month Treasuries.

I can picture in my mind's eye how the excess reserve rate replaced the fed funds rate as the de facto policy tool of the Federal Reserve. Fed officials are familiar, in some cases experts, on the role of excess reserves in the Depression. It is part of the economic canon explaining the reasons for the Great Depression that the primary source of this disaster was the Fed's incredibly wrong-headed management of bank excess reserves.

Following a run on The Bank of the United States (a relatively small New York city bank with an unfortunate name that gave the impression that it was a government bank) and the decision of other New York banks not to prevent its failure, other American Banks decided to hold excess reserves in anticipation of a possible run of their own.

In one of the major blunders of banking history, the Fed interpreted these excess reserves as a sign of imminent inflation and withdrew them from the system, ultimately leading to the general collapse of the entire banking system and FDR's "banking holidays."

So it comes as no surprise that during the crisis, the Fed considered substantial excess reserves within the banking system to be desirable. Hence, separate policy tools to achieve this objective.

However, there is no longer anything to be gained from using two separate policy rates.

My greatest concern about the conduct of current Fed policy is that I believe too much thought is put into the mechanics of monetary policy and the mechanics of bank regulation, while too little thought is put into communication with the public and financial markets.

One of the examples of this weakness is the apparent intent to use two interest rates to implement policy, not one. The rate paid to banks to hold excess reserves was increased to 50 basis points as part of the December decision, leaving the Fed with multiple moving policy parts, two interest rates and one quantity, the amount of excess reserves.

Back in the stone age, the Fed viewed another quantity, the amount of required reserves, as a second tool of policy. That tool fell into disuse because, among other things, it bred uncertainty about the purpose of its use. Was it being used to control banks' riskiness, as a tax upon banks, or to implement monetary policy? Excess reserves can be misinterpreted as having something to do with increased banking safety or as a transfer payment from taxpayers to banks.

How will a decision by the Fed to mop up excess reserves affect the banks? There will be marginal effects, if any. To prevent a capital charge, the banks will most likely replace the excess reserves with short-term Treasuries. The Treasuries will provide a market yield rather than the administered yield on excess reserves. Depending upon where the fed funds rate falls within the target range, the banks could lose between 0 and 25 basis points in income.

Indeed, something like this mop-up might already be in the cards, as the Fed has been buying substantial amounts of excess reserves in the recent past.

What is the effect on the taxpayer? It will eliminate the Fed's payments on excess reserves, replacing them with the Treasury's payments on Treasury bills. I prefer this change since it simplifies the web of transfer payments between the government and the banking system.

I share with many others the belief that simple policies are good policies because they improve the communication of government intent to the public. In this case, there is no need to multiply the Fed's policy levers. The fed funds rate is sufficient to achieve monetary policy goals in the coming year.

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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.