Yellen's Defense of Interest on Reserves

Janet Yellen, IOER, interest on reserves, Federal Reserve, unconventional monetary policy, normalization
Photo courtesy of Caleb Martin:
Janet Yellen, IOER, interest on reserves, Federal Reserve, unconventional monetary policy, normalization
Photo courtesy of Caleb Martin

The Cat's Out of the Bag

In September, when current Fed chair Janet Yellen held a press conference announcing details of the Fed's normalization plan, yours truly insisted that that plan reflected the Fed's "determination to maintain its current, bureaucratically advantageous operating system," in which monetary policy is mainly implemented by altering the rate of interest the Fed pays on banks' reserve balances. Yellen never said so explicitly, however. On the contrary: she chose her words so craftily that she might be understood to be saying just the opposite. In particular, I noted then,

in reply to questions about the Fed's future plans for monetary control, Yellen says that the Fed intends to use changes in "the fed funds rate" rather than adjustments to its balance sheet as its chief means of monetary control. This reply could be taken to mean that it won't be engaging again in Quantitative Easing, and that it plans to return eventually to pre-2008 style fed funds rate targeting. The interpretation squares well, after all, with the Fed's claim that it is intent on "normalizing" monetary policy.

But that interpretation is wrong. What Yellen's words really mean is that the Fed plans to keep its current IOER-based operating system going. The changes in the "fed funds rate" to which Yellen refers are really changes to the Fed's IOER and ON-RRP rates, which define the upper and lower bounds, respectively, of the Fed's current fed funds rate "target range." It follows that when Yellen says that the Fed won't be implementing monetary policy by means of balance sheet changes, she doesn't just mean that it will no longer engage in post-2008 style Quantitative Easing. She also means that it won't be making use of conventional (that is, pre-2008 style) open-market operations to influence an otherwise market-determined federal funds rate. All this in turn requires that banks be kept flush with excess reserves, and that the Fed maintain a correspondingly enlarged balance sheet.

How do I know this? Do I have a specially-made Enigma-type machine designed to crack Fed code? I do not. But I have talked to Fed officials, and kept up with Fed publications, and all indications from those support my understanding, as does the theory of bureaucratic behavior to which I've referred.

In other words, I might be wrong. But who wants to bet on it?

Alas, no one did, which is too bad, because on November 21st — the day after she announced her plan to retire from the Fed — Yellen finally settled all doubts concerning the Fed's intentions, and did so in a way that would have allowed me to score some easy money.

The occasion was Yellen's appearance that day in the "In Conversation with Lord Mervyn King” series hosted by NYU's Stern School of Business. Although the first hour of the event was mainly devoted to affable reminiscing about her life as a Fed chair, the last half hour of Yellen's appearance was devoted to audience Q&A. It was then that some clever NYU undergrad (bless his heart!) asked Chair Yellen point-blank: "Do you see interest on reserves as the new normal, or something that will come to an end?"

To her credit, Chair Yellen did not equivocate this time. Interest on reserves, she said, "is our key policy tool. We absolutely need it."

There has been discussion in Congress about taking that power away, and I've argued very strenuously against it. We would not be able to control short-term interest rates, now, if we did not have that power. If it were to disappear we would really have to change our monetary policy strategy and probably start quickly selling off assets to gain control of short-term interest rates. That would be very disruptive. So I think the question said something about the new normal. I think the new normal needs to be that we will retain that power and keep it as our main monetary policy tool.

At which point Lord King interjected, "And that is in line with what most other central banks do," to which Chair Yellen replied, "That is."

Floors and Corridors

Well, yes and no. While it's true that many other, if not "most," central banks possess the power to pay interest on reserves (IOR), most use that power to support "corridor"-style operating systems, in which the IOR rate is usually a below-market rate that serves as the lower-bound of a policy-rate band (the rate "corridor"), the upper bound of which consists of a central bank lending rate corresponding to the Fed's discount rate. In corridor systems, bank reserves are scarce, overnight interbank lending markets remain active, and overnight rates are kept at their target values by means of open-market operations. In short, the corridor systems in wide use among central banks today most closely resemble, not the Fed's present operating system, but its pre-October 2008 — that is, pre-IOR — system. Indeed, the Fed's pre-2008 system was itself a corridor system, albeit one in which the IOR rate, and, hence, the lower-bound of the policy-rate corridor, was constrained to be zero.

The Fed's current operating system, in contrast, is a type of "floor" system — what I have elsewhere referred to as a "leaky" floor system. In a floor system, the IOR rate (which is also, in the Fed's case, the interest rate on excess reserves) is an above-market rate, the purpose of which is to encourage banks to retain excess reserves. Once satiated with reserves, banks have no reason to borrow overnight for the sake of keeping liquid, so the overnight interbank market shuts down. The IOR rate itself, rather than open-market operations, thus becomes the central bank's chief means of implementing monetary policy, with a higher IOR rate serving to tighten, and a lower one serving to loosen, policy.

In the Fed's "leaky" system, GSEs that keep balances at the Fed, but are not entitled to interest on those balances, lend their balances overnight to banks for a share of the interest to which those banks are entitled. Consequently the fed funds market is still somewhat active, and the effective fed funds rate trades below, rather than at, the IOR rate. To limit the extent to which the funds rate can decline, the Fed makes overnight reverse repurchase (ON-RRP) agreements with the GSEs, as well as some other counterparties, thereby rewarding them the equivalent of interest on their Fed balances, albeit at a rate below the IOR rate. Between them the IOR and ON-RRP rates define the Fed's fed funds rate target "range." Although the range superficially resembles a corridor, notice that in this case the IOR rate defines the top rather than the bottom of the range.

Keeping IOR vs. Keeping a Floor System

It should be perfectly evident that, when Yellen says that the Fed intends to continue using interest on reserves as its "main monetary policy tool," she doesn't simply mean that it intends to use that tool to operate a corridor system of the sort used by many other central banks. Were that the Fed's intent, instead of planning to "normalize" its IOR rate by eventually raising it to about 300 basis points, it would be contemplating lowering that rate to get it below corresponding market rates. It might even be contemplating setting a negative IOR rate, as several other central banks have done, on the grounds that "natural" short-term rates have themselves gone negative. (No I am not endorsing that step.) By the same token, critics of the Fed's current IOR-based regime, myself included, are not opposed to IOR as such. What we oppose is the Fed's policy of paying IOR at above market rates, together with the floor-type operating system that this policy serves to establish.

Besides confusing arguments against the Fed's leaky-floor operating system with arguments against any sort of IOR-based regime, Yellen's defense of he Fed's leaky floor system proceeds as if the sole policy alternatives consisted of either retaining that system or abruptly ending it by suddenly depriving the Fed of its power to pay interest on reserves. If the Fed did not have the power to pay above-market IOR, Yellen observes, the Fed would be unable to control short-term interest rates "now."

Of course suddenly preventing the Fed from paying interest on reserves "now" would pose serious problems. In the short-run, and so long as reserves remained abundant, it would leave the Fed without any basis for monetary control.  Ultimately, though, it would inspire banks to shed their excess reserves, reviving the money multiplier, and re-establishing a corridor-type operating system in which monetary control could once again be achieved by means of conventional open-market operations. The problem is that, while the transition is taking place, it could indeed necessitate the "disruptive," large-scale asset sales Yellen worries about.

But there are other, less disruptive ways to get back to a corridor system. Most obviously the Fed's assets, and the outstanding quantity of excess reserves, can be allowed to decline gradually (though perhaps not so gradually as the Fed presently intends) in anticipation of an eventual reduction of the IOR rate, and subsequent revival of the base-money multiplier, so that the latter revival will itself require proportionately fewer offsetting asset sales. The Fed can also make use of its Term Deposit Facility to sterilize released reserves, as an alternative to asset sales. I'm not saying that the transition back to a corridor system, with or without IOR, will be easy. But it needn't be severely disruptive. And once the transition was complete, modest asset sales (and occasional purchases) — that is, old-fashioned open-market operations — would once again suffice to implement monetary policy.

Down with the Floor!

And make no mistake: the transition will be worth it, because no matter what Yellen and other apologists for it claim — and setting aside its doubtful legality — the Fed's current operating system stinks. It stinks in part because it places the Fed in command of an excessively large share of the public's savings, which it steers towards the government and housing market and whatever other markets its administrators choose to favor, depriving other borrowers of that much potentially productive credit.

The present system also stinks because, by separating monetary control from balance-sheet policy it turns the Fed's balance sheet into a fiscal Trojan Horse — one that Treasury officials and other special interests alike will try to have the Fed employ in their favor, further aggravating the squandering of scarce savings that has already taken place.

Even more disconcertingly, precisely because it can only be maintained by keeping IOR rates above their "natural" counterparts, the Fed's present operating system harbors a built-in deflationary bias which, if you ask me, is the main reason why the Fed keeps undershooting its inflation target.

Finally, the last-mentioned bug of the present arrangement also means that, unless it wants to risk a "disruptive" revival of the money multiplier, the Fed can only lower its IOR-based policy target so much to combat a liquidity crisis. That's true, by the way, regardless of the absolute height of the IOR rate when the crisis occurs. Maintaining a floor system therefore means, in practice, having to resort again to Large-Scale Asset Purchases ("Quantitative Easing") to combat any serious liquidity crunch.

I hope, for this last reason, that Chair-Elect Powell would rather not like to be remembered as the "The Six-Trillion Dollar Chairman." Assuming he wouldn't, he can avoid that fate by taking steps to get the Fed from its leaky floor system to a true corridor system.

Avoiding disruptive change is all very well, when maintaining the status-quo is itself unlikely to prove dangerous. But there are times when a little disruptive change today is a price well-worth paying for the sake of avoiding future turmoil; and this happens to be one of them.

  • "…the Fed's present operating system harbors a built-in deflationary bias which, if you ask me, is the main reason why the Fed keeps undershooting its inflation target."

    George, what do you make of Janet Yellen's reported comments concerning the need for fiscal stimulus?

    • George Selgin

      I make it that Yellen hopes the government will do the Fed's job for it, because the Fed isn't capable of hitting its inflation target using the current operating regime.

  • The fact that Yellen and the FOMC will not manage IOER at or below the markets is quite telling, since this addresses many of the key criticisms of the policy. It suggests two things to me, first that there really is no "free" trading in fed funds anyway and the Fed is the market. Second that the Committee somehow thinks that it must push higher the bottom of the band — this despite the huge net short duration position of the street.

    The more urgent question is Yellen's view of QE/open market operations vs IOER that you illustrate very nicely. The FOMC seems to think that merely not growing the portfolio or slowly selling is an option vs setting the benchmark rates. In fact, reducing the portfolio was the first task, before changing benchmark rates. Especially if one is cognizant of current market conditions.

    The Fed could sell the entire system portfolio and the street would probably still be short duration due to low rates and continued QE purchases by ECB, BOJ, etc. The agency mortgage securities market is down 30% on issuance YOY. The FOMC does not seem to appreciate that the yield curve must invert, probably by Q1 '18, unless the desk at the FRBNY is actively selling all of the MBS and even longer dated Treasury paper. What fun.


    • George Selgin

      All agreed. But I would stress the crucial distinctions between the small-scale and largely "temporary" OMOs that were employed to keep the ffr on target before 2008 and QE-type asset purchases. Yellen routinely fails to make this distinction, as when she says that she wants the Fed to implement policy via "fed funds rate changes" RATHER THAN balance sheet changes. In a corridor system, that would not be a valid dichotomy.

  • Mattyoung,

    Janet! Say it n't so! As the Fed has been twisting the curve to lower the one year treasury rate. The sheet is loaded with 360 billion of short notes, up from zero two years ago. The mathematics of her job forces the corridor, maybe not the optimum one. She is stuck sharing currency risk with a single issuer of short term treasuries.

  • J T

    (usd) Tether is the significant topic imo. The provider of liquidity to the crypto exchange realm that allows exchanges a type of protection from trading/price attacks. There is an army of trolls/shills attacking is viability suggesting tether is propping up the price of bitcoin…rather, I suspect its providing much needed liquidity and therefore the issuers might have incentive to NOT inflate it.

    I think this phenomenon deserves your attention and CAREFUL scrutiny. Cheers. Tether or any similar counterpart seems crucial for price discovery and honest and therefore critical for the process of asymptotically ideal money.

    • J T

      Multiple exchanges just went down and the tether price lost its dollar parity for a moment. And the exchanges return and the tether parity returns as an indicator.

    • George Selgin

      There are plenty of "significant topics" to go around: we can't all just be talking about Tether! (Besides, Larry White wrote about it a few posts back.) Nor can Tether itself be any good if the dollar to which it's tethered goes awry.

      • J T

        It's true, however from a crypto-exchange-land perspective the USD is quite/relatively stable. I suspect we might see more tethered fiats to provide counter-opponents, and if this caught on there might exist the possibility to make a digital basket of tethered fiats.

        I am also considering that bitcoin cash (BCH) might serve as a chinese protection in a similar way against an American lead (price?) attack on bitcoin and bitcoin exchanges (after all the Chinese are heavily invested in and benefits from mining).

        Cheers, and thx for the comment. I can't comment on your article here it is the specific content about banking I don't understand. But I will use it as a reference to learn about the FED.

        • George Selgin

          If you want to bone-up on the Fed, JT, have a look at my (Monetary Policy) Primer: click on the "Primer" button below the masthead for links.

          • J T

            thank you, no idea why i didn't ask!!!

          • J T

            I read the fed primers and they were great. Exactly what I was looking for and happy they were written by you because I respond to your style well. I can’t say I perfectly understand but I now feel I have a strong understanding of the scope of what I am not yet clear on. I will return to them over time.

            I also realized something I have to think will be very interesting to you and any related careers.

            I said to you once that Nash called for a stable monetary unit and you quickly rebuted with titles of your essays and specifically an older one that gives the crux of your argument (production norm?)in short, inflationary stable money is NOT ideal.

            But I understand very well now that you are thinking from a national/domestic perspective (I used to call it micro but I believe it's actually called macro) whereas Nash is observing international relationship.

            So the resolution is that Nash saying, effectively, if Selgin’s optimal money supply was achieved by each nation then we would expect an asymptotic approach to stability from an international comparison viewpoint.

            Well managed domestic supply is “good money” and good money is internationally comparable.

            There would be international stability but also (from an objectively stable basis) secular deflation on a long term horizon.

            I think there is still a hidden consideration, or missing presumption, in regard to having a nation serve as the (de facto) reserve currency provider and so loosely I have to imply this role wouldn’t be played by any nation in a situation where there is international stability created by well managed domestic supplies.

            I have another parallel thought I want separate from this one.

          • J T

            This comment is in regard to your observations on Ruritania and how they are comparable to the software space that is evolving between crypto-currency exchanges. I call this space Cryptoexchangelandea.

            From a total perspective that includes our legacy financial system Cryptoexchangelandea is not as interesting, is quite complex, and is incredibly regulated (or expected to be so). However, if we think of Cryptoexchangelandea as its own REALM, all of a sudden it can be observed as a free banking environment nearly perfectly comparable to Ruritania.

            It might not be obvious, and the benefits of this observation might also not be immediately obvious, but truly this should be exciting to you.

            This is why I brought the USD tether program to your attention (tried to) as it is a perfect example.

            There is a troll/shill army campaign crying fraud in regard to USD tethers and the general crypto community is buying the FUD. But I don’t necessarily subscribe to the fear that tethers are not properly backed.

            You should already be thinking about how IF Cryptoexchangelandea WAS a free banking environment then an issuer (especially as a sister company to an exchange which fudsters are claiming) could not provide a thriving dishonest currency in such a market.

            But here is what is more significant.

            Central banks have reason to print either inflationary or instable (and internationally frowned upon) money/fiat. But tether’s in Cryptoexchangelandea don’t serve the same purpose.

            Someone figured out, likely an exchange, that the market needs a crypto-indifferent hedge for liquidity and protection especially for the exchanges that don’t have access to fiat or the traditional banking system.

            I suspect whoever figured that out has no incentive to inflate the tethers but rather is benefiting simply from a reliably pegged supply of market liquidity and protection. In this sense it is not very relevant that the USD might not be perfectly stable or stable long term-the utility would still be there in regard to establishing Cryptoexchangelandea.

            If any of this is reasonable and novel to you then I think there are other very interesting inferences to be made that should ultimately be considered by someone in the Fed Chair’s position.

  • Hu McCulloch

    How could Yellen have forgotten that the Fed was quite able to fine-tune the FF Rate for two decades or more prior to 2008 without IOER?

    My understanding, though, is that day-to-day this was not done by OMOs, but rather through Loans to dealers via ON repos secured by Treasuries. As long as the Fed kept these Loans positive and substantial, (typically $10B – $50B), it was the marginal lender in the market, and the rate it set once a day was the FF Rate at that time, and therefore approximately the FF Rate throughout the day, on average, since banks knew what was going on.

    Post-2003 the Discount Rate set an upper bound (3/4% above the FF rate target), but it was only rarely relevant. The zero IOER then set a lower bound, but again this was only rarely binding. So there was a corridor that set bounds on the FF Rate, but the horizontal supply of Loans was ordinarily what mattered.

    In order to keep Loans in the desired range, it was necessary occasionally to hold "coupon passes" (OMO purchases or sales of Treasuries, which may have been the very Treasuries that served as repo collateral the day before or after). Long-run growth in the base was therefore through OMOs, even though day-to-day growth was usually through Loans.

    • George Selgin

      The pre-2008 ON-repos are generally regarded as OMOs, albeit "temporary" ones (see Outright purchases were mainly used in accommodating secular demand for currency.

      • Hu McCulloch

        The Fed could equally set the FF rate until the next meeting by setting the yield on T-bills maturing before the next meeting at its target rate. These would be explicit OMOs, but the ones that matter would be these very short-term ones.

        However, if the Fed became the sole holder of these short T-bills, it might still have to resort to Loans to dealers secured by longer stuff in order to hold the FF rate on target.

        (Maturing T-bills typically yield only about 90% of the FF rate, but I would attribute this to their exemption from state and local taxes. Any T-bill target should therefore in fact be roughly 90% of the FF target.)

  • EdwardCDIngram

    The Fed's system is way too complex and is in any case the wrong system altogether.

    At Macro-economic Design (visit my website by that name and check the BOOK SUMMARY page, there is a whole new era awaiting us.

    The banks will have high reserve ratios but will get Fed interest on those reserves equal to the cost of them of holding them there.

    For example, they will bid for money at auctions by the Fed and the part of the interest payable to the Fed on those reserves will be given to them by the Fed to neutralise the cost of holding those reserves.

    The same goes for the deposits and savings accounts which they may hold. The reserves will earn interest equivalent to what they paid to obtain those deposits and savings.

    The money auctions will be as in auctions of treasuries – as needed to supply the amount of debt-based money (lending money) and can be offered on terms of various duration.

    They can also be repaid without penalty at any time.

    Or in some cases rolled over indefinitely as in an overdraft.

    Offering debt-based money can be like pushing on a string so there is a need to print and distribute debt-free money to reduce that dependence.

    I explain that side of things in my published essays for where I am advising ZIMBABWE and South AFrican Treasury since a few days ago. Both are VERY interested..

    Start with this one:

    The next essay on 'Why Zimbabwe will overtake the rest' has a video link at the end – 8 minute lecture to the university. Same message.

  • Philon

    You write that "the Fed's current operating system stinks . . . in part because it places the Fed in command of an excessively large share of the public's savings, which it steers towards the government and housing market and whatever other markets its administrators choose to favor . . . ." So far as I know its administrators have not been favoring any markets besides government and housing, and I doubt that they have the legal authority to do so (though I admit that they seem quite successful at flouting whatever laws are supposed to govern their activities; and, of course, the law could easily be changed). But my question concerns the magnitude of their effect in favoring government and housing. Because of the Fed's choice of bonds to buy for its own portfolio, the Federal Government and home-buyers can borrow at lower rates than they would have to pay without the Fed's behavior. My question is: how much lower? My guess is that the Fed's effect is very small, perhaps even very, very small–i.e., negligible.