interest on reserves, interest on excess reserves, Federal Reserve, operating framework, monetary policy, selgin
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interest on reserves, interest on excess reserves, Federal Reserve, monetary policy, Floored!If you've spent much time at all on these pages, you know that my favorite hobby-horse for several years now has been the Federal Reserve's policy of paying interest on (banks') excess reserves (IOER) at an above-market rate. By adopting that policy in October 2008, the Fed replaced the operating system that had seen it through the Great Moderation with a "floor"-type system in which banks are kept awash in excess reserves, and monetary policy is conducted by adjusting the Fed's IOER rate.

Although I've criticized various aspects of the floor system in numerous posts here, as well as in several op-eds and in testimony before the House  Financial Services Committee, I realized some time ago that the workings of the floor system, and especially the subtle ways in which it tends to undermine the Fed's ability to combat recession and control inflation, call for a more systematic exposé.

And so, my new Cato book, FLOORED!: How a Misguided Fed Experiment Deepened and Prolonged the Great Recession, and Why the Fed – or Congress – Ought to End It.  Among other things, FLOORED! explains how the Fed’s new operating system

  • intensified an already severe economic downturn by serving as the means by which the Fed maintained an excessively tight monetary policy;
  • led to a sustained collapse in the interbank market for federal funds, thereby destroying the Fed’s traditional means of monetary control;
  • dramatically reduced the effectiveness of open-market operations, so that even massive Fed asset purchases might not supply the stimulus to investment and spending that much smaller purchases would once have achieved;
  • undermined productivity by substantially increasing the Fed’s role in allocating scarce credit; and
  • made it more difficult for the Fed to reach its 2 percent inflation target.

Although FLOORED! is scheduled for publication as a proper book later this spring, we're releasing  it today as a Cato-CMFA Working Paper, so as to elicit comments and criticism from readers like yourself, and also from others with an interest in the subject. So please let me have your reactions, and pass the link on to anyone you know who may have thoughts to share with me on its subject.

So what are you waiting for? Get FLOORED! 


    1. Of course there were costly overdrafts during the crisis, and particularly following Lehman's failure. The passage, though, refers to the "decades" before then. In any event, banks rely less on overdrafts to the extent that they hold some excess reserves than they would otherwise, and that is one reason why some banks held excess reserves even before October 2008.

  1. Dr. Selgin,

    Thank you for your thorough, exhaustively-researched work. Your description/evaluation of floor vs. corridor systems and references to other central bank actions were particularly helpful in understanding the implications of IOER. The operations of the Fed have huge economic implications, yet, in my opinion, the (1) underlying principles and rationale and (2) results of some of the Fed’s actions receive relatively little scrutiny. I think the introduction of the IOER and the related evaporation of the Fed Funds market is an excellent example of this. You bring this situation to light in your call to action.

    During my read, I was struck by the number of times that the Fed’s original statements justifying policy changes evolved to their ultimate actions and/or contradictory statements at later times. You also highlight Fed actions that now appear to be at cross-purposes to each other. The frightening part is that I came away with the impression that the Fed’s approach is lacking in underlying fundamentals. I think your final determination of IOER as a “Misguided Fed Experiment” is appropriate.

    You requested comments on your working paper. I have some for your consideration, recognizing that I believe none of them change your final conclusions. They may warrant discussion in your paper.

    1. Moderate Long-term Interest Rates. The Federal Reserve Act states the monetary policy objectives as “…promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” The often-cited “dual mandate” of the Fed ignores the third objective. The Fed currently owns $1.8 trillion of MBSs, as well as Treasury holdings. Although I have not heard the Fed state this as a reason for its actions, wouldn’t the purchase of MBSs of this magnitude, substantially funded by excess reserves, suppress long-term rates? Is this part of the Fed’s intent as it relates to IOER?

    2. Money Market Changes. The SEC change that required Prime (Non-Government) mutual funds to be valued at market went into effect in October 2016 (i.e., after IOER began). This is one of the main reasons for an approximately $0.8 trillion decrease in Prime mutual fund balances in early 2016 (to $0.5 trillion in March 2018). Much of these balances appear to have shifted to Government mutual funds ($2.2 trillion in March 2018). These Government fund investments would be close alternatives to excess funds deposits at the Fed for financial institutions. Does this large shift to Government funds have implications for interest rates and the Fed’s execution of monetary policy going forward?

    3. Fed’s Reverse Repo Program. The Fed began its Reverse Repo program in December 2015. This provides a new avenue for non-financial institutions (such as money market funds) to deposit at the Fed. It has attracted up to $0.5 trillion at one of its quarter-end high points, but has received declining interest over about the last year. Will this have any implication in the Fed’s execution of monetary policy in the future?

    4. Increase in U.S. Currency. You mentioned the traditional relationship between U.S. currency and the size of the Fed’s balance sheet until 2008. U.S. currency outstanding has almost doubled in the 10 years preceding March 2018 to $1.6 trillion. With the rise in non-cash payments, this increase is counterintuitive (it may be explained by increased use by foreign sources). Considering the large amount of currency now outstanding and potential drawdowns, couldn’t this have a significant potential impact on the execution of monetary policy going forward?

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