Money and Banking Part 5: Monetary Policy

In this post, we discuss monetary policy and the role that central banks play in a modern economy. Although our focus is primarily on the U.S. central bank, the Federal Reserve, the policy tools which we discuss our similar to those used by other central banks, such as the European Central Bank, the Bank of England, or the Bank of Japan. 

Monetary policy refers to the policy decisions which influence a nation’s interest rates and money supply. In the U.S., the Federal Reserve System implements monetary policy under mandates established by the U.S. Congress. The mandates for the Federal Reserve are to promote maximum employment, stable prices, and moderate long-term interest rates. Since the goal of moderate long-term interest rates is consistent with the other two policy goals, many people refer to the Fed as having a “dual mandate” of low inflation and full employment. 

Overview of the Federal Reserve System 

As we mentioned in a previous post, Congress established the Federal Reserve System in 1913. As part of new-deal era banking reforms, Congress passed the Banking Act of 1935, which established the current structure of the Federal Reserve. Under the current structure, the Federal Reserve System consists of three key entities: a seven-member Board of Governors, the twelve Federal Reserve Banks, and the Federal Open Market Committee. 

The Board of Governors consists of seven members who are appointed by the President and confirmed by the Senate. The members serve for fourteen years. One member must serve as the Chair and one member as the Vice Chair. These positions are chosen by the President for four-year terms.  

Each of the twelve Federal Reserve Banks has a board of directors responsible for overseeing bank operations and governance. The board elects a president to serve as the operating head of the reserve bank. The reserve bank presidents serve five-year terms. The election of the bank president must be approved by the Board of Governors. The reserve banks function as the system’s operating arm, holding reserves for the commercial banks within their jurisdiction and maintaining the payments system for those banks. The reserve banks are also important sources of information on economic conditions throughout the country. 

The Federal Open Market Committee (FOMC) is the body responsible for deciding monetary policy. The FOMC consists of twelve members – the seven-member Board of Governors, the President of the New York Federal Reserve, and four of the remaining reserve bank presidents who serve on a rotating one-year term. The non-voting bank presidents attend the meetings and participate in policy discussions. The Chair of the Board of Governors serves as the FOMC chair, and the president of the New York Fed serves as the vice chair. The FOMC has eight scheduled meetings throughout the year during which the attendees review and discuss economic data, and the voting members decide on policy. 

Monetary Policy in a Limited Reserves Regime 

Prior to the financial crisis, the Fed conducted policy in a “limited reserves” regime. In a limited reserves regime, the banking system does not hold significant excess reserves. 

During this period, the Fed relied on three primary monetary policy tools: open market operations, discount window lending, and reserve requirements. 

The most important tool during this period, by far, was open market operations. To understand open market operations, we must first understand the federal funds market.  

Commercial banks keep reserves at their respective Federal Reserve banks. During this time, the Fed required banks to maintain a minimum level of reserves relative to their total deposits. Because banks did not earn interest on reserves held at the Fed, banks had no incentive to hold reserves in excess of the required minimum. However, some banks would have temporary surplus reserves while others would have temporary deficits. Because banks could meet their reserve requirements by borrowing reserves from other banks, those banks with surpluses would lend reserves to those banks with deficits, generally on an overnight basis. This market in which banks lend and borrow reserves from one another is known as the federal funds market. The rate which banks charge for these loans is called the effective federal funds rate.  

At FOMC meetings, the committee decides on a target federal funds rate. In a limited reserves regime, the Fed attempts to bring the effective federal funds rate in line with its target by engaging in open market operations – the purchase or sale of securities from participating institutions. When the Fed wants to lower the federal funds rate, it directs the open-market trading desk at the New York Fed to buy securities from participating institutions, paying for the purchases by increasing the reserves of the selling institutions. When the Fed wants to increase the federal funds rate, it directs the open-market trading desk to sell securities to participating institutions, thus, reducing the reserves of the participating institutions. 

Here is the key point about open market operations: by engaging in open market operations, the Fed can increase or decrease reserves within the banking system. In a limited reserves regime, small changes in the level of reserves can lead to changes in the federal funds rate and other short-term interest rates. 

The Fed’s other policy tools in a limited reserves regime were reserve requirements and discount lending. If the Fed wanted to loosen credit conditions, it could lower reserve requirements. If the Fed wanted to tighten credit conditions, it could increase reserve requirements. However, the Fed seldom used reserve requirements as a monetary policy tool as it was far less effective than open-market operations. 

Discount lending involves banks borrowing directly from the Federal Reserve’s “discount window.” These loans are generally short-term, and the borrowing banks must post collateral which is acceptable to the lending reserve bank. Discount lending is generally only used during times of financial distress. 

Monetary Policy in an Ample Reserves Regime 

The Federal Reserve reacted to the 2008 financial crisis and subsequent economic downturn with unprecedented policy interventions. Among these was the Fed’s large-scale asset purchase program, which market commentators and investors dubbed “quantitative easing (QE)”. 

The traditional policy response to an economic downturn – lowering the federal funds rate through open market purchases – has a natural limit. After all, the Fed can only set a target federal funds rate of zero (although several foreign central banks would later experiment with negative interest rates). The Fed refers to this floor as the “effective lower bound.” The scope of the crisis called for additional stimulus, and the fed began to come up with various nontraditional policies in order to support financial markets and stimulate the economy. 

The Fed began its first round of “QE” in late 2008. Stagnation in the economy, however, led the Fed to engage in two other rounds of quantitative easing in 2010 and 2012. The press referred to the three rounds of assets purchases as “QE1”, “QE2”, and “QE3.” The Fed’s goals for quantitative easing were to enhance liquidity in asset markets and to lower long-term interest rates. 

One consequence of the Fed’s asset purchases was to flood the banking system with excess reserves since the Fed paid for the asset purchases by increasing  the reserve accounts of the counterparties. This surplus of reserves meant that traditional open market operations would no longer be effective in moving the federal funds rate. 

In 2006, Congress passed the Financial Services Regulatory Relief Act of 2006. This legislation gave the Fed the ability to pay interest on reserves held at the Fed. This authority was scheduled to go into effect in 2011 but was later moved up to 2008. 

In an “ample reserves regime” – i.e., a banking system flushed with reserves – interest on reserves balances (IORB) became the FOMC’s key policy tool. Since banks will not lend at rates lower than what they can earn at the Fed, the IORB acts as a floor on short-term interest rates. 

The Fed continues to use the federal funds rate as its policy rate. However, as noted above, the Fed now influences the federal funds rate using IORB and a supplementary instrument called an overnight reverse repurchase agreement (ON RRP). The ON RRP is needed because certain non-bank institutions, which are ineligible to earn interest on reserves, are active in the federal funds market. With an ON RRP, the Fed sells a security to the counterparty and repurchases the security the next day at a slightly higher price (the difference being the ON RRP rate). Thus, the counterparty effectively deposits funds overnight at the Fed and receives interest in return. 

With the IORB and the ON RRP, policy works as follows. If the FOMC decides to lower its target range for the federal funds rate, it will lower the IORB and ON RRP rates, bringing down the federal funds rate and other money market rates. If the FOMC decides to increase its target range for the federal funds rate, it will increase the IORB and ON RRP rates. Because institutions are unwilling to lend at rates lower than what they can earn with the Fed, an increase in the IORB and ON RRP rates leads to an increase in the federal funds rate and other money market rates. 

In January 2019, the Fed announced that it will maintain an “ample reserves” policy going forward, formally acknowledging what had been policy since 2008. Under an ample reserves regime, the Fed relies on IORB and ON RRP rates as their key policy instruments and uses open market operations as needed to support ample reserves. The Fed continues to offer discount loans to member banks that need temporary liquidity. The Fed formally abolished reserve requirements in 2020. 

Conclusion 

Throughout much of the post-war period, the Federal Reserve used open-market operations to expand or contract the quantity of reserves within the financial system. Beginning in 2008, however, the Fed created a new policy regime. Several rounds of long-term asset purchases, “quantitative easing”, led to an abundance of reserves in the banking system. When reserves are abundant, open market operations no longer influence short-term interest rates. 

In 2008, Congress gave the Fed a new authority, allowing it to pay interest on reserves banks held at the Fed. In an “ample reserves” regime, this authority became the Fed’s key policy instrument in raising or lowering short-term rates. 

In the next post, we will discuss price inflation and deflation. 

Sources: 

Cecchetti, Stephen and Kermit Schoenholtz. Money, Banking, and Financial Markets, 5^th Ed. New York: McGraw-Hill, 2016. 

Federal Reserve Board of Governors. The Fed Explained: What the Central Bank Does, 11^th Ed.