The Fed Marches On

So it has come to pass. In his recent press conference, Chairman Jerome Powell has at last made official the Fed's plan to stick to its post-crisis "floor" system of monetary control, which uses changes in the interest rate paid on banks' excess reserve balances, rather than routine open-market operations, to keep the federal funds rate at its assigned target. Powell has also affirmed previous reports that the Fed may stop shrinking its balance sheet well before it reaches $3 trillion — the (itself still hefty) minimum it might reach if the Fed kept to its original unwind plan. The unwind might even end before the Fed's assets fall below $4 trillion, or not far from where they are today.

Although he's generally not one for making forecasts, yours truly has long anticipated both developments, in writings here on Alt-M and elsewhere. He has said as well that the Fed is likely to start Quantitatively Easing again at the first hint of another crisis. I'll add here the prediction that it will do so before, or instead of, setting its IOER rate back to zero, just as happened during the last crisis. In short, I repeat my belief that it's quite possible that Jerome Powell will have the dubious honor of becoming the Fed's first "Six Trillion Dollar Chairman." And because, under a floor system, the size of the Fed's balance sheet has no direct bearing on the level of short-term interest rates, there's practically no limit to how big it might get without interfering with the Fed's ability to hit its interest-rate targets.

Fed officials insist, of course, that the advantages of this brave new regime outweigh any dangers it poses, and that they've only decided to stick to it after carefully weighing its pros and cons. Perhaps. But I have my doubts.

There are, first of all, powerful bureaucratic motives favoring the change — motives that have nothing to do with the general public's well-being. For starters, the new regime makes life easy for the folks at the New York Fed, who are freed from having to study and anticipate changes in the demand for reserves, and "autonomous" changes in the stock of reserves, in order to plan and then undertake open-market operations aimed at offsetting those changes. Were that reduced labor load to translate into a reduced New York Fed staff, the bureaucratic gain it entails would be a gain to the general public as well. But until I hear of desk staff packing up their belongings, I'm inclined to regard that as a hypothetical possibility only.

If former Cato Chairman Bill Niskanen's budget-maximizing model of bureaucrats has any merit, Fed officials have a second important motive for favoring a floor system and the larger balance sheet that system helps them to rationalize; namely, a larger budget consisting of the additional revenue generated by a substantially increased asset portfolio. Finally, Willem Buiter has argued that Fed officials have reason to resist a more complete balance sheet unwind because such an unwind "is likely to reveal the true extent of the central bank's quasi-fiscal activities during the crisis and its aftermath."

The Fed's official reasons for keeping its floor system are, of course, unrelated to any of these bureaucratic motives. Instead they point out that the new system enhances banks' liquidity. They also claim that the greater volatility since the crisis of "autonomous" reserve-balance determinants — including the size of Treasury General Account balance — now make it very difficult, if not impossible, for the Fed to gauge and offset those autonomous factors. Yet it would have to do that to keep interest rates stable were it to return to a corridor system.

Are such arguments decisive? Hardly. For whatever their merits (and they have less merit than their proponents claim), they represent but one side of things. A floor system also has disadvantages compared to a corridor system — disadvantages that Fed officials consistently choose to overlook.

A floor system does away with unsecured interbank lending on the Fed funds market, eliminating that important venue for interbank monitoring. It involves a greater degree of Fed interference with private-market resource allocation, and particularly so when the Fed's portfolio consists of longer-term or risky assets, violating the long-standing Fed principle that it should "Structure its portfolio and undertake its activities so as to minimize their effect on relative asset values and credit allocation within the private sector." A floor system also exposes the Fed to all sorts of pressure to expand or otherwise alter its portfolio for reasons unconnected to monetary policy, as Charles Plosser has eloquently explained. Corridor systems, or "tiered" arrangements that blend features of both corridor and floor arrangements, are also widely favored over strict floor systems among central banks around the world. Finally, the ECB's Ulrich Bindseil, who has written more than anyone else about the relative merits of alternative central bank operating systems, concludes after a recent assessment of them that "best approach to steer [a central bank's policy rate] in normal times…still seems to be the symmetric corridor approach."

Despite these observations, is it still possible that a fair weighing of all the pros and cons might justify the Fed's decision to retain it's floor system? I doubt it, and I've written an entire book explaining why. But what I know for certain is that the merits of the Fed's floor system should be among the main topics of the Fed's ongoing, comprehensive review — informed by outsider input — of its "strategies, tools and communication practices." By suggesting in yesterday's press conference that the Fed has already made up its mind about its operating framework, Chairman Powell appears to have all but struck "tools" from the list of subjects up for discussion. If that's not his intention, I hope he'll say so. And if it is, I hope he'll tell us why.

[Cross-posted from Alt-M.org]