Are Fed Watchers Watching the Wrong People?

One effect of the financial crisis was to change how the Fed conducts monetary policy.  This could be long-lasting and important.

Prior to the crisis, the Federal Open Market Committee (FOMC) set a target for the so-called federal funds rate, the interest rate at which depository institutions lend balances to each other overnight.  The New York Fed would then conduct open market operations – buying and selling securities – in order to nudge that rate towards the target.  It did this by affecting the supply of banks’ reserve balances at the Fed, which go up when they sell securities to the Fed and down when they buy them.

The Fed kept the level of reserves in the system low enough that some banks needed to borrow from others in order to meet their requirements, thereby ensuring that the fed funds rate was always an important one.  The cost of borrowing through other means then tended to move up and down with the fed funds rate, thus giving the Fed effective power over the cost of short-term credit broadly.

During the crisis, the Fed’s Quantitative Easing programs – large-scale purchases of assets from the banks – drove up the volume of excess reserves, or reserves beyond those banks are required to hold, to unprecedented levels.  A consequence of this is that many institutions can fulfill their reserve requirements without needing to borrow, so competition for reserves is now low and small changes in their supply no longer induce the same changes in the cost of borrowing them that they once did.  This means that open market operations are no longer sufficient to drive the cost of borrowing in the fed funds market to the FOMC’s target. This can be seen clearly in the graphic above: the difference between the FOMC’s target for the fed funds rate and the actual fed funds rate increases and begins to gyrate wildly after 2007.

This is where recent legislation becomes important. Section 201 of the Financial Services Regulatory Relief Act of 2006 amended the 1913 Federal Reserve Act to give the Fed the authority to pay interest on reserves beginning October 1, 2011.  The 2008 Economic Stabilization Act brought this forward to October 1, 2008.  These changes gave the Fed a new tool to implement monetary policy.  Paying interest on reserves helps to set a floor under short-term rates because banks that can earn interest at the Fed are unwilling to lend to others below the rate the Fed is paying.  This allows the FOMC to achieve its target for the fed funds rate even with high levels of excess reserves -  as can be seen in the graphic from 2009 on.

The FOMC has said that the Fed intends to rely on adjustments in the rate of interest on excess reserves to achieve its fed funds target rate as it begins to tighten monetary policy – likely later this year or early next.  However, the 2006 Act gave authority for setting the rate of interest on excess reserves to the seven-member (currently five) Federal Reserve Board, and not to the twelve-member (currently ten) FOMC.  This could be consequential.

The Federal Reserve Act stipulates that the interest rate on reserves should not “exceed the general level of short-term interest rates,” but does not prevent the Board from setting it well below the general level of short-term interest rates.  This means that the FOMC could decide that short-term rates should rise to, say, 4 percent, while the Board, thinking this excessive, could decide only to raise the rate on reserves to, say, 3 percent.  Because the quantity of excess reserves is currently so massive, it would be virtually impossible for the trading desk at the New York Fed to conduct open market operations sufficient to achieve the 4 percent target set by the FOMC.  Overnight rates would therefore trade closer to the Board-determined 3 percent rate on reserves.

Section 505 of Senator Richard Shelby’s draft Financial Regulatory Improvement Act would transfer the authority to set the interest rate on reserves to the FOMC, which would restore its ability to control short-term rates generally.  But unless and until such an act is passed, or the volume of excess reserves declines significantly, the Board, and not the FOMC, will control how quickly rates rise.

This is potentially important because, as the graphic shows, the average Board member is considerably more dovish than the average non-Board FOMC member.  Fed watchers may therefore be overestimating the pace of rate increases because they’re focusing on the comments of the wrong committee.  For now, at least, it is the Board, and not the FOMC, that wields the real power over rate increases.

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