Monetary Policy: From Managing the Monetary Base to Setting an Interest Rate Floor

I have been following the exchange between Paul Krugman and Steve Randy Waldman with great interest.  For one thing, as a textbook author, I need to understand how the instruments of monetary policy are changing, if in fact the pattern of the last few years represents a fundamental shift.  Moreover, it seems to me that the changes in Fed operating procedure may be related to tectonic forces at work in the financial system.  See if you agree.

The old way of doing business is that the Fed, like any other central bank, would buy and sell bonds on the open market in order to inject or soak up liquidity.  Its open market operations would supply or withdraw reserves at member banks, and these reserves would constitute the raw material from which the money supply was generated.  (The money multiplier told us how much ultimate money would be created from these reserves, assuming the banks lent out everything they didn’t need to meet their required reserve ratio.)  The motive for lending excess reserves was that they didn’t pay interest, and almost any other use of money did.

Then 2008 happened, and the Fed wanted to unfreeze a number of financial markets—corporate paper, mortgage backed securities, you name it.  To bolster demand by putting these assets on its balance sheet, so-called quantitative easing, it was necessary to pump out vast amounts of reserves.  At this point the Fed began paying interest on excess reserves.  You could see this as a subsidy to the banking system (the Geithner doctrine: feed the beast) or a way of sterilizing its interventions in these markets or both.  In any case, banks now hold substantial excess reserves and, thanks to the return they get, they are in no hurry to shed them.  The irony has not been lost on some of us that, at a time when there is official consternation about the unwillingness of banks to finance small businesses and other ostensibly worthy borrowers, the Fed is paying them not to lend.

So what does the future portend?  At the very least, the Fed will use this new interest rate instrument to manage the unwinding of its portfolio.  If the economy picks up and banks begin to draw down their excess reserves, the Fed, if it worries about inflation, can slow down the process either by traditional open market operations or by raising the interest rate it pays on reserves.  The latter has the advantage of not risking unwanted impacts in the asset markets from which the Fed would otherwise be withdrawing.  And if it thinks that some of these markets are overheating, it can sell a portion of its portfolio while simultaneously lowering interest rates on reserves, a sort of reverse sterilization.  This much is clear.

But would it make sense for the Fed to undertake a permanent shift toward interest rate management as a substitute for open market operations?  Maybe yes.  Recall that the logic of OMO was based on a financial system in which the monetary base set a constraint on aggregate lending capacity.  We are now in a different world.  In shadow banking (a terrible misnomer—we need a new name) collateral serves this function across a wide range of nonbank institutions and nondepository functions within banks.  Securitization has its own multipliers, and aggregate activity can fluctuate with hardly a nod to whatever the level of the monetary base happens to be.  That said, the Fed can always diminish lending capacity via its interest rate floor, redirecting a portion of funds toward a class of assets (excess reserves) that do not multiply.  Of course, the floor can also be understood as a form of interest rate targeting that works on a different margin than OMO used to.  That will require a bit of institutional description in future textbooks, I suspect.

Paul Krugman is right to emphasize that there is a fiscal side to the interest rate floor: it reduces the income the treasury would otherwise receive from the Fed.  Stripped of all complexity, the government is paying wealth-holders to not invest.  This is unimpeachably logical in a world in which the government is also supplying an attractive put for all sorts of potentially dodgy institutions and activities.