The Changing Operational Face of Monetary Policy

This is big.

The Federal Reserve is now coming out with studies reporting on the impact that the Fed's change in interest policy is having on reserves. If you didn't pay attention to this when I wrote about it, maybe you will now that the Fed is writing on the topic.

Back in early October, I wrote:

Paying interest on required and excess reserve balances changes the entire role of the Fed Funds rate with regard to Fed monetary policy, as long as real rates are below the rate paid by the Fed on excess reserves.

The Fed generally adds monetary reserves to the system through its open market operations, i.e., the buying of Treasury securities. This, in the past, had a downward impact on the Fed Funds rate, as the new money the Fed adds shows up as reserves at various banks. Thus, in the past, the more new reserves, the more the Fed Funds rate dropped, since the Fed Funds rate is a rate set by the loaning and borrowing of the reserves. With the Fed targeting the Fed Funds rate, most recently at 2%, the Fed was in effect frozen, by its own target, from adding more reserves to the system if the Fed Funds rate was already at 2% , since any additional purchases of Treasury securities would push the Fed Funds rate below the targeted 2% rate...

Now, however, with the Fed paying interest on its reserves at a rate near the target Fed Funds rate, the Fed can add any amount of reserves it wants and the Fed Funds rate won't go down, because the Fed is, in effect, simultaneously providing a floor to the Fed Funds rate at the near target rate...

In summary, in the past, a cut in the Fed Funds rate was required to increase Fed open market operations to add reserves. This is no longer the case, now that the Fed will support the Fed Funds rate by paying interest on required and excess reserves AND it is has always been the actual adding of reserves, rather than the cut in rates that has fueled the economic boom times with the new money flowing into the economy.

Now, David Altig, senior vice president and director of research at the Federal Reserve Bank of Atlanta has a blog post linking to an FRBNY Economic Policy Review article written by New York Fed economists Todd Keister, Antoine Martin, and James McAndrews that discusses this topic. Their conclusion coincides with mine:

The key feature of this system is immediately apparent in the exhibit: the equilibrium interest rate no longer depends on the exact quantity of reserve balances supplied. Any quantity that is large enough to fall on the flat portion of the demand curve will implement the target rate…

Altig pulls out the meaty part of their analysis here, and writes:

I haven’t thus far offered explanations for why these changes might be desirable and how they relate to the broader context of monetary policy generally. More on that tomorrow.