CHOICE Cuts: The House Serves Up Some Monetary Reform

Members of the House Financial Services Committee made some progress on monetary reform this past week by introducing three new bills in the House on November 7th and 8th, 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 and if monetary policy deviated from the rule — although such a requirement was not to be "construed  to prevent" the FOMC from such deviations. The new measure adds a step, calling 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. And again, report to the appropriate House and Senate Committees concerning any deviations.

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 the Fed 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 crucial steps toward reforming 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, still need to be taken.

As I've stressed on numerous occasions, 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.

[Cross-posted from Alt-M.org]