A lot of ink was spilled last month over President Trump’s criticism of the Fed raising interest rates. Observers worried that those criticisms meant the President was prepared to directly meddle with U.S. monetary policy. But so far, at least, there’s no evidence that any such meddling has occurred.
The Trump administration’s fiscal policies have, however, indirectly influenced the Fed, by straining it’s post-crisis operating system. In particular, the large federal budget deficit has been putting upward pressure on short-term market interest rates; and those rising rates have, in turn, put pressure on the Fed’s “floor” system of monetary control. If the deficit continues to grow, as is expected, it might even bring an end to that system.
To see why, a quick review of the floor system’s workings is in order.
The Fed’s Floor System
In one of its more important but underappreciated crisis-era monetary policy innovations, the Fed switched from a corridor-like operating system to a floor operating system. It did so by paying interest on excess reserves (IOER) at a rate higher than going short-term market interest rates, thereby pushing banks onto the perfectly elastic region of their reserve demand curve. The change allowed the Fed to add reserves to the banking system, as it had been doing through various emergency lending programs, without loosening its monetary policy stance by causing the effective fed funds rate to fall below its target. Changes to the supply of money were thus “divorced” from the setting of monetary policy (Keister et al. 2008). This divorce was seen by some as a virtue of the floor system, for it allowed the Fed to manage bank liquidity and monetary policy independently, changing the size of its balance sheet to control liquidity, and the IOER rate to alter its monetary policy stance.
George Selgin, however, has noted a number of challenges facing the floor operating system, one of which is its inherent fragility. Maintaining a floor system means keeping the IOER rate at or above comparable market interest rates, so that banks will be willing to hold on to any reserves that come their way. Stated differently, the return on reserves needs to exceed the risk-adjusted marginal return banks might earn, net of their operating and other variable costs, on other assets.*
The figure below compares the Fed’s IOER rate to both the overnight dollar LIBOR rate and the 1-month Treasury-bill yield for the period from 2009 until 2017, showing how the spreads between the IOER rate and these other representative market rates has almost always been positive. The IOER-LIBOR spread averaged almost 10 basis points, while the IOER-Treasury spread averaged about 20 basis points. Such spreads are what has kept the floor system running.
On a few occasions, however, the spreads in question, and other similar measures, have been very small, and in some brief instances negative. What’s more, the spreads have been declining. Since January 2018 the IOER-LIBOR spread has declined to about 5 basis points, while the IOER-Treasury spread average has fallen to 7 basis points. Were the decline to continue to the point where other short-term interest rates rise above the IOER rate for a sustained period, the Fed’s floor system would unravel: instead of having a practically unlimited demand for excess reserves, banks would start rebalancing their portfolios away from excess reserves and toward other, more profitable investments. Monetary policy would then cease to be “divorced” from money, for changes in the quantity of money and changes in the Fed’s monetary policy stance would once again tend to go hand-in-hand.
Though the floor system is still intact for now, we can already see in the figures below that the narrowing of the spreads is straining the floor system. The first figure plots the IOER-LIBOR spread against the banking system’s cash assets as a percent of all assets. This cash asset category comes from the Fed’s H8 database and has consisted mostly of excess reserves over the past decade. The shrinking of the IOER-LIBOR spread has coincided with a decline in the share of cash assets held by banks.
The next figure plots the same spread against the loan share of bank assets. It has been rising sharply as the spread has declined this year. Banks, in other words, suddenly began investing a larger share of their portfolios in loans starting in early 2018.
These two figures suggest that the Fed may be already pushing the limits of its floor system. The banks appear to be shying away from holding so many excess reserves. That change suggests reserve demand is becoming less elastic at this narrowed IOER spread. The floor system may be more fragile than many Fed officials believe it to be.
The only way to ease this pressure on the floor system would be for the Fed to raise the IOER above these other interest rates. That, though, could lead to an undesirable tightening of monetary policy, putting the Fed in a bind: should the Fed raise rates to keep its floor system intact, at the risk of overtightening? Or should it avoid overtightening at the risk of seeing its operating system come unglued?
Trump’s Policies and Short-Term Interest Rates
But why have IOER-market rate spreads been narrowing? One answer is President Trump’s large budget deficits. His administration’s heavy spending is causing it to borrow a great deal. In addition, the shrinking of the Fed’s balance sheet and the restocking of Treasury’s General Account, which had been wiped out during the recent debt ceiling episode, have also contributed to the rising budget deficit.
To fund this growing deficit, the Treasury has been increasing its issuance of Treasury bills. The next figure shows this surge is evident in terms of both gross and net Treasury bill issuance. The black line shows the trend gross issuance and the blue line shows the net cumulative issuance.
The recent burst of Treasury bill issues has a bearing on the IOER spread over other interest rates. In particular, the greater issuance of Treasury bills should drive up (down) their yields (prices), moving other short-term interest rates in the same direction through arbitrage. This should narrow the IOER spread over other interest rates.
The Federal Reserve agrees. From the June FOMC minutes, we learn the following:
The deputy manager [of the System Open Market Account at the NY Fed] followed with a discussion of money markets… Rates on Treasury repurchase agreements (repo) had remained elevated in recent weeks, apparently responding, in part, to increased Treasury issuance over recent months… Elevated repo rates may also have contributed to some upward pressure on the effective federal funds rate in recent weeks as lenders in that market shifted some of their investments to earn higher rates available in repo markets.
So some Fed officials themselves believe that the increased issuance of Treasury bills is pushing up short-term interest rates via arbitrage.
But is there any evidence for this claim? The figures below suggest the answer is yes, especially as it relates to interbank rates. The first set of figures plot the trend gross and cumulative net issuance of Treasury bills during the Fed’s floor system against the IOER-LIBOR spread. Both measures suggests a fairly strong, negative relationship. That is, a higher supply of Treasury bills shrinks the IOER-LIBOR spread.
One should be careful, though, in looking at the absolute dollar amount of Treasury bill issuance as it may grow secularly due to a rising economy. To account for this possibility, the next set of figures normalizes the two Treasury bill issuance measures by dividing them by total marketable Treasury securities outstanding. Now the relationship is even tighter and stronger. Relationships like these are not found for the issuance of Treasury notes and bonds against the IOER spreads.
President Trump, then, appears to be already influencing Fed policy by putting upward pressure on short-term interest rates and thereby causing pressure on the Fed’s floor system. The Wall Street Journal recently reported this budget pressure is only expected to increase:
Rising federal budget deficits are boosting the U.S. Treasury’s borrowing… [T]he Treasury plans to borrow $329 billion from July through September—up $56 billion from the agency’s April estimate—in addition to $440 billion in October through December. The figures are 63% higher than what the Treasury borrowed during the same six-month period last year.
To be clear, there are other explanations for the narrowing of the IOER spread. George Selgin, for example, points to the unequal distribution of bank reserves causing problems as the Fed winds down its balance sheet. That seems right and complements the above explanation. Both explanations point to increasing strains on the Fed’s floor system moving forward.
In short, its at least conceivable that the Trump administration’s fiscal policies could compel the Fed to rethink its floor system. Given this possibility, the Fed has yet another reason to start thinking now about its floor system and whether sticking to it will be worth the trouble. Far better for the Fed to leave the floor system on its own terms, than to be forced out by fiscal policy.
*Banks cannot control the total quantity of reserves, but they can control the form of reserves held. That is, banks can choose to hold excess reserves or invest in other assets like treasuries and loans that, in the aggregate, would lead to a rise in required reserves.