The Fed Sticks to Its Plan, the Market Moves

The minutes of the Federal Reserve’s June FOMC meeting were released yesterday and there were few, if any, surprises. The minutes show a policy discussion hewing close to the Fed’s normalization plan. Members view the current economic expansion as “progressing roughly as anticipated” and see the risks to the economic outlook “as roughly balanced.” Though the Fed continues to undershoot its preferred measure of inflation, the Committee continues to expect 2% inflation “on a sustained basis over the medium term.” 

Two rather new developments received attention at the meeting. The first relates to increasing tensions over trade and tariffs. FOMC members are concerned that global disruptions and trade policies will exert downward pressure on financial markets. Furthermore, several regional Federal Reserve districts report that proposed plans for capital spending across the country have already been reduced, with several contacts within districts expressing concerns over tariff policies.

The second issue is the flattening yield curve that has the potential to invert. Recently the spread between short-term and long-term Treasuries has narrowed. In the past, this compression has presaged a recession. However, the FOMC is currently split as to whether or not the current flattening is similarly a cause for concern; namely, that increasing yields on the front end of the curve are indicative of investor concern about the short-term economic outlook. Due to this split, the Fed seems inclined to take a wait-and-see approach before adjusting the path of monetary policy in response to financial market data.

Lastly, and most concerning, there was precious little revealed about the Fed’s thinking on the operational aspects of monetary policy that remain in uncharted waters.

One decision during the June meeting was to raise the interest rate paid on excess reserves (IOER) less than the top of the Fed’s range for the federal funds rate. IOER is the interest the Fed pays banks on their excess cash on deposit at the Fed. The federal funds rate is the interest rate that banks charge one another for overnight loans. Since the crisis the Fed has adopted a target “range” for the federal funds rate, rather than a single interest rate target as it did before the crisis. Now, in order to influence short-term rates in the economy, including the effective federal funds rate, the Fed adjusts the IOER. Until the recent FOMC meeting the top of this range was the IOER rate. Recently, however, the effective federal funds rate had been approaching the IOER rate, getting too close to the top of the target range for the Fed’s comfort. By raising the IOER rate less than the target range in June, the Fed intended to move the effective federal funds rate towards the middle of their range. 

But that hasn’t happened. While the effective federal funds rate has backed off the top, it remains elevated above the midpoint of the target range, hovering just four basis points below the IOER rate. While this is more of a window dressing problem than a cause for immediate concern, it is an important reminder that the current operating system, a creation of the Fed’s reaction to the financial crisis, is still very much an experiment—one with which the Fed has little experience.

Prominent economists are already considering what will become of the Fed’s new operating system. My colleague George Selgin recently discussed why the Fed’s “leaky floor” system is ultimately responsible for the recent compression between IOER and the effective federal funds rate. And Stephen Williamson, formerly of the St Louis Fed, blogged about why the adverse effects of quantitative easing and ill-targeted regulations are culpable for the trouble the Fed is facing. Unfortunately, the recent FOMC minutes give us no indication that the Fed has been wrestling with these issues in a similar fashion.