CHOICE Cuts: The House Serves Up Some Monetary Reform

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fed reform, form act, monetary reform, ioer, federal reserve, congress, choice actMembers of the House Financial Services Committee made some progress on monetary reform this past week by introducing three new bills on November 7th and 8th, which are to be marked-up in Committee on Tuesday — along with a host of other financial services related bills. The monetary measures serve as free-standing counterparts to similar provisions and goals of the comprehensive Financial CHOICE Act passed by the House earlier this year.

The Independence from Credit Policy Act (H.R. 4278), introduced by Rep. French Hill (R-AR), is intended to restrict the Fed's asset holdings, apart from gold, foreign exchange, and IMF-issued SDRs, particularly by requiring it to swap its current MBS holdings for Treasury obligations. In future emergencies the Fed could temporarily acquire certain non-Treasury assets in connection with its 13(3) lending operations (concerning which see below); but it would be allowed to hold such assets for no more than a year, after which it would also have to trade them in for Treasury securities.

The Monetary Policy Transparency Act (H.R. 4270), introduced by Rep. Andy Barr (R-KY), is a variation on a core aspect of the Fed Oversight Reform and Modernization (FORM) Act, which was originally introduced in 2015. The FORM Act required the FOMC to adopt a specific, formal monetary policy rule, of the FOMC's own choosing, and report to Congress when monetary policy deviates from the rule — although this requirement is not to be "construed  to prevent" the FOMC from allowing such deviations. The new measure calls as well for the FOMC to announce a particular monetary policy "strategy" each year, specifying, not mathematically but "in plain English," its policy targets and the instrument or instruments it plans to employ to achieve them. The the Fed would also have to make a report to the appropriate House and Senate Committees concerning any deviations from its proposed strategy.

Finally, Rep. Scott Tipton (R-CO) introduced the Congressional Accountability for Emergency Lending Programs of 2017 Act (H.R. 4302). That Act would further restrict the Fed's 13(3) lending operations by requiring that they be approved by at least two-thirds of the FOMC (as opposed to the present 5-member requirement); by disallowing the use of equity as collateral for 13(3) loans; by requiring that loans be approved not only by the Federal Reserve Board but by all Federal banking regulators having jurisdiction over the prospective borrowers; and by allowing emergency lending to be extended beyond a term of 30 days only by means of a joint resolution approved by Congress.

There's no question that these measures, if adopted, would help to impose some much-needed discipline on the Fed — especially by preventing it from propping-up markets for particular securities, save those issued by the U.S. Treasury — and by making it harder for it to bail-out insolvent firms. But  they leave untouched the Fed's current system of monetary control, with its reliance upon interest payments on banks' excess reserve holdings as an alternative to conventional open-market operations. And a reform of that system is no less desperately needed to limit the Fed's capacity for doing mischief to the U.S. economy.

As I've stressed on numerous occasions, both on these pages and in testifying before Congress, the current system involves a far less reliable "monetary transmission mechanism" than the old one — because it divorces changes in the Fed's policy rate settings from any corresponding changes in the quantity of bank reserves, and also because it encourages banks to hoard reserves that come their way, instead of using them to support corresponding growth in the nominal quantities of money and credit. By encouraging banks and other financial institutions to direct funds to the Fed rather than to private-market borrowers, thereby increasing the Fed's size relative to that of the commercial banking system, the new system also limits growth by employing savings less productively. Finally, by allowing the size of the Fed's balance sheet — formerly a crucial determinant of the Fed's monetary policy stance — into a "free parameter," the new set-up makes the Fed vulnerable to the Treasury's importuning, if not to that of other borrowers.

So, while I wish the sponsors of the present legislation good luck with their efforts so far, I hope they'll follow them up with some reforms specifically aimed at replacing the present, unreliable, and inefficient monetary control system with a more old-fashioned, but nonetheless better, alternative.

The good news is that, legislatively-speaking, the fix is relatively easy. To compel the Fed to switch from its current "leaky floor" monetary control system, based on paying banks an above-market return on their excess reserves, to a more orthodox system in which the interest rate on excess reserves defines the lower bound of a fed funds rate "corridor," all that's needed is a slight clarification of existing law.

According to the statute that grants the Fed authority to pay interest on reserves, the rate it pays is "not to exceed the general level of short-term interest rates."  Unfortunately, Congress left it to the Fed to interpret "the general level of short-term interest rates" however it liked. By choosing to interpret it so loosely as to refer to the Fed's own discount rate (or "primary rate"), among other proxies, the Fed has managed to pretend to conform to the statute, while actually thumbing its nose at it.

To put a stop to that, Congress just has to amend the law to make the "general level of short-term rates" mean what it was originally supposed to mean, to wit: the level of any of several reasonably comparable short-term market rates. Here is one way Congress could do just that — call it the Undo the Fed's Abuse of Interest on Reserves Act:

Section 19(b)(12) of the Federal Reserve Act (12 U.S.C. 461(b)(12)) is hereby amended by inserting after Subparagraph (C)

‘(D) General level of short-term interest rates defined.—

For purposes of this paragraph, the term “general level of short-term interest rates” shall be defined as the average value over the preceding six-week interval of the Federal Reserve Bank of New York’s benchmark Broad Treasury financing rate on overnight repurchase agreements’

So, what do you say, FSC? As long as you're tidying-up the Federal Reserve Act, a little clarification here could go a long way.


  1. I am more than a little annoyed that an overhaul of Section 13(3) is being contemplated and that no congressional staffer has contacted me about this. If you ask around in Washington or within the Federal Reserve System, I think you’ll find that no one has given more blood than I on reform (or better yet, repeal) of Section 13(3). I’ve been writing and speaking about it for only 30 years in public forums. I have co-written an article with Anna Schwartz covering, among other things, Section 13(3). I presented a paper at the June 2017 annual meeting of the Western Economic Association International on this very subject. Neither I nor my views are hard to find. Bottom line: Outright repeal is the only way to go. If, for political reasons, repeal is not allowed (tsk, tsk), then the bills described are improvements. But 13(3) ultimately is all about fiscal policy (constitutionally a matter for Congress, not for politically unaccountable entities like the Fed), so Repeal still should be the goal. If Congress wants someone bailed out, then let Congress man up and woman up and vote on the record for that bailout (no voice votes). Voters then can respond appropriately. After all, for or against whom do I vote if I disapprove of what Janet Yellen or Ben Bernanke or Jerome Powell is doing or has done? But if Congress were forced to vote for or against a bailout, then I would know for or against whom to vote. And if congressional staff members say that they cannot find me, I teach in the Department of Economics and Finance at Middle Tennessee State University, Murfreesboro, TN, my hometown. My telephone number is 216-970-9013, and my e-mail is [email protected]. I hope that I shall hear from you. Walker F. Todd

    1. Well put — Congress should be forced to appropriate bailout funds (and increase the nat'l debt limit if necessary). The Fed can monetize the new bonds or not as appropriate for its price stability goal.

  2. How before should the Fed balance sheet be?
    If we look at the implicit price deflator, and assume that is the most accurate pricing we have, then the graph tells us that the economy gets pricing to within a point, after interest charges and full data recovery.

    So buyers and sellers have a round off error of 1/2 a point, or 1 trillion, fairly big. But the balance sheet will be spread between negative and positive as the no arb condition is established, the error will be zero mean. The Fed must be willing to incur a temporary loss of nearly 500 billion, unless someone knows different.

    1. Finish this up a bit, and hope I have the numbers right.
      The actual error carried by the 'market making' , its current real losses and gains, will be 150 billion if pricing is maintained to a percentage. The extra error is need handle the requantization. Buyers and sellers actually undersample a bit because they need to hedge for large players that enter the market and change structure. This is the difference between determinism and random processes. When agents keep a slight hedge on then samplinh requirements are unmet, the system is non stationary. Models like DSGE will only be valid for two quarters.

      1. I am sort of incomplete until I talk about how auto pricing works.
        It rests on a basic assumption, the economy is packing a sphere. By that I mean congestive flow, big containers in and smaller containers out. If we are sphere packing, then we know high prices happen less frequently and are more significant. We do not need to organize by price, we organize by the layers of containers we need to pack the sphere, and the price becomes the typical price, the price appropriate to the container.

        We first find the containers, then we can look at price and see how well it fits the container. What do we know about containers?

        -i*log(i) tells us the number of spots in the sphere needed for a container that arrives with i frequency. Log(i) is the quant word size, and that will appear with frequency i over the complete sequence.

        Great, we have an algorithm that can create a sphere packer to match the sequence, a Huffman encoder. Given a set of typical pricess, this algorithm will make a generator which, when fed a uniform random number, generates sets of typical sequences within the specified error. We know how to compare these generators because the pit boss function can create two generators, one for buy and one for sale. The pit boss can make these generators equal, in shape, it will make matching graphs by filling in with pseudo buys and sells until the two graphs match. Then it can set prices to find the optimal graph that exactly matches buy and sell, the pit boss insertions picking up the matching error.

  3. While they're at it, they should repeal the Humphrey-Hawkins dual mandate of price stability + employment..

    1. I agree with your Humphrey-Hawkins repeal of dual mandate proposal, but believe me, this is a different legislative proposition from the narrow question of Section 13(3). Congress has enough difficulty walking and chewing gum simultaneously currently. One reform at a time, please.–Walker Todd

  4. Better yet, just set the rate on excess reserves to 0.

    A more concrete (at least in my mind) bound on IORR would be to replace "not to exceed the general level of short-term interest rates" with "not to exceed the average secondary market yield on 3-month Treasury Bills, averaged over the preceding six (or two?) week period."

    1. The Fed's own statistics (H.15 series) quote a one-month Treasury bill rate in the secondary market. You want the interest on reserves, whether required or excess, to mirror the shortest Treasury maturity you can find in the secondary market. Go for one month (or less), not three. And the ideal rate on excess reserves is zero. I was at a conference full of Swiss bankers a few years ago, and they kept asking me, "Why is the Fed paying any interest at all on excess reserves?"
      Indeed, why? Right now, they do it to maintain their rate collar (a ceiling set by the Fed funds target rate and a floor set by the reverse repurchase agreement rate) on excess reserves. But why? – Walker Todd

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