A Monetary Policy Primer, Part 7: Monetary Control, Then

It's high time that I got 'round to the subject of "monetary control," meaning the various procedures and devices the Fed and other central banks employ in their attempts to regulate the overall availability of liquid assets, and through it the general course of spending, prices, and employment, in the economies they oversee.

In addressing this important subject, I'm especially anxious to disabuse my readers of the popular, but mistaken, belief — and it is popular, not only among non-experts, but also among economists — that monetary control is mainly, if not entirely, a matter of central banks' "setting" one or more interest rates.  As I hope to show, although there is a grain of truth to this perspective, a grain is all  the truth there is to it. The deeper truth is that "monetary control" is fundamentally about controlling the quantity of (hang on to your hats) … money! In particular, it is about altering the supply of (and, in recent years, the demand for) "base" money, meaning (once again) the sum of outstanding Federal Reserve notes and depository institutions' deposit balances at the Fed.

Although radical changes to the Fed's monetary control procedures since the recent crisis don't alter this fundamental truth about monetary control, they do make it impractical to address the Fed's control procedures both before and since the crisis within the space of a single blog entry.  Instead, I plan to limit myself here to describing monetary control as the Fed exercised it in the years leading to the crisis.  I'll then devote a separate post to describing how the Fed's methods of monetary control have changed since then, and why the changes matter.

The Mechanics of "Old-Fashioned" Monetary Control

In those good-old pre-crisis times, the Fed's chief monetary control challenge was one of adjusting the available quantity of base money, and of bank's deposit balances at the Fed especially, sufficiently to sustain or sponsor general levels of lending and spending consistent with its ultimate employment and inflation objectives. If, for example, the FOMC determined that the Fed had to encourage lending and spending beyond already projected levels if it was to avoid a decline in inflation,  a rise in unemployment, or a combination of both, it would proceed to increase depository institutions' reserve balances, with the intent of encouraging those institutions  to put their new reserves to work by lending (or otherwise investing) them.  Although the lending of unwanted reserves doesn't reduce the total amount of reserves available to the banking system, it does lead to a buildup of bank deposits as those unwanted reserves get passed around from bank to bank, hot-potato fashion.  As deposits expand, so do banks' reserve needs, owing partly (in the U.S.) to the presence of minimum legal reserve requirements. Excess reserves therefore decline. Once there are no longer any excess reserves, or rather once there is no excess beyond what banks choose to retain for their own prudential reasons, lending and deposit creation stop.

Such is the usual working-out of the much-disparaged, but nevertheless real, reserve-deposit multiplier. As I explained in the last post in this series, although the multiplier isn't constant — and although it can under certain circumstances decline dramatically, even assuming values less than one — these possibilities don't suffice to deprive the general notion of its usefulness, no matter how often some authorities claim otherwise.

Regardless of other possibilities, for present purposes we can take the existence of a multiplier, in the strict sense of the term, and of some official estimate of the value of this multiplier, for granted. The question then is, how, given such an estimate, does (or did) the Fed determine just how much base money it needed to create, or perhaps destroy, to keep overall credit conditions roughly consistent with its ultimate macroeconomic goals? It's here that the "setting" of interest rates, or rather, of one particular interest rate, comes into play.

The particular rate in question is the "federal funds rate," so called because it is the rate depository institutions charge one another for overnight loans of "federal funds," which is just another name for deposit balances kept at the Fed. Why overnight loans? In the course of a business day, a bank's customers make and receive all sorts of payments, mainly to and from customers of other banks. These days, most of these payments are handled electronically, and so consist of electronic debits from and credits to banks' reserve accounts at the Fed. Although the Fed allows banks to overdraw their accounts during the day, it requires them to have sufficient balances to end each day with non-zero balances sufficient to meet their reserve requirements, or else pay a penalty. So banks that end up short of reserves borrow "fed funds" overnight, at the "federal funds rate," from others that have more than they require.

Notice that the "federal funds rate" I just described is a private-market rate, the level of which is determined by the forces of reserve (or "federal funds") supply and demand. What the Fed "sets" is not the actual federal funds rate, but the "target" federal funds rate. That is, it determines and then announces a desired  federal funds rate, to which it aspires to make the actual fed funds rate conform using its various monetary control devices.

Importantly, the target federal funds rate (or target ffr, for short) is only a means toward an end, and not a monetary policy end in itself. The Fed sets a target ffr, and then tries to hit that target, not because it regards some particular fed funds rate as "better" in itself than other rates, but because it believes that, by supplying banks with reserve balances consistent with that rate, it will also provide them with a quantity of reserves consistent with achieving its ultimate macroeconomic objectives. The fed funds rate is, in monetary economists' jargon, merely a policy "instrument," and not a policy "objective." Were a chosen rate target to prove incompatible with achieving the Fed's declared inflation or employment objectives, the target, rather than those objectives, would have to be abandoned in favor of a more suitable one. (I am, of course, describing the theory, and not necessarily Fed practice.)

But why target the federal funds rate? The basic idea here is that changes in depository institutions' demand for reserve balances are a rough indicator of changes in the overall demand for money balances and, perhaps, for liquid assets generally. So, other things equal, an increase in the ffr not itself inspired by any change in the Federal Reserve policy can be taken to reflect an increased demand for liquidity which, unless the Fed does something, will lead to some decline in spending, inflation, and (eventually) employment. Rather than wait to see whether these things transpire, an ffr-targeting Fed would respond by increasing the available quantity of federal funds just enough to offset the increased demand for them. If the fed funds rate is indeed a good instrument, and the Fed has chosen the appropriate target rate, then the Fed's actions will allow it to do a better job achieving its ultimate goals than it could if it merely kept an eye on those goal variables themselves.

Open Market Operations

To increase or reduce the available supply of federal funds, the Fed increases or reduces its open-market purchases of Treasury securities. (Bear in mind, again, that I'm here describing standard Fed operating procedures before the recent crisis.) Such "open-market operations" are conducted by the New York Fed, and directed by the manager of that bank's System Open Market Account (SOMA). The SOMA manager arranges frequent (usually daily) auctions by which it either adds to or reduces its purchases of Treasury securities, depending on the FOMC's chosen federal funds rate target and its understanding of how the demand for reserve balances is likely to evolve in the near future. The other auction participants consist of a score or so of designated large banks and non-bank broker-dealers known as "primary dealers." When the Fed purchases securities, it pays for them by crediting dealers' Fed deposit balances (if the dealers are themselves banks) or by crediting the balances of the dealers' banks, thereby increasing the aggregate supply of federal funds by the amount of the purchase. When it sells securities, it debits dealer and dealer-affiliated bank reserve balances by the amounts dealers have offered to pay for them, reducing total system reserves by that amount.

Because keeping the actual fed funds rate near its target often means adjusting the supply of federal funds to meet temporary rather than persistent changes in the demand for such, the Fed undertakes both "permanent" and "temporary" open-market operations, where the former involve "outright" security purchases or (more rarely) sales, and the latter involve purchases or sales accompanied by  "repurchase agreements" or "repos." (For convenience's sake, the term "repo" is in practice used to describe a complete sale and repurchase transaction.) For example, the Fed may purchase securities from dealers on the condition that they agree to repurchase those securities a day later, thereby increasing the supply of reserves for a single night only. (The opposite operation, where the Fed sells securities with the understanding that it will buy them back the next day, is called an "overnight reverse repo.") Practically speaking, repos are collateralized loans, except in name, where the securities being purchased are the loan collateral, and the difference between their purchase and their repurchase price constitutes the interest on the loan which, expressed in annual percentage terms, is known as the "repo rate."

The obvious advantage of repos, and of shorter-term repos especially, is that, because they are self-reversing, a central bank that relies extensively on them can for the most part avoid resorting to open-market sales when it wishes to reduce the supply of federal funds. Instead, it merely has to refrain from "rolling over" or otherwise replacing some of its maturing repos.

Sustainable and Unsustainable Interest Rate Targets

Having described the basic mechanics of open-market operations, and how such operations can allow the Fed to keep the federal funds rate on target, I don't wish to give the impression that achieving that goal is easy. On the contrary: it's often difficult, and sometimes downright impossible!

For one thing, just what scale, schedule, or types of open-market operations will serve best to help the Fed achieve its target is never certain. Instead, considerable guesswork is involved, including (as I've mentioned) guesswork concerning impending changes in depository institution's demand for liquidity. Ordinarily such changes are small and fairly predictable; but occasionally, and especially  when a crisis strikes, they are both unexpected and large.

But that's the least of it. The main challenge the Fed faces consists of picking the right funds rate target in the first place. For if it picks the wrong one, it's attempts to make the actual funds rate stay on target are bound to fail. To put the matter more precisely, given some ultimate inflation target, there is at any time a unique federal funds rate consistent with that target. Call that the "equilibrium" federal funds rate.** If the Fed sets its ffr target below the equilibrium rate, it will find itself engaging in endless open-market purchases so long as it insists on cleaving to that target.

That's the case because pushing the ffr below its equilibrium value means, not just accommodating changes in banks' reserve needs, thereby preserving desirable levels of lending and spending, but supplying them with reserves beyond those needs. Consequently the banks, in ridding themselves of the unwanted reserves, will cause purchasing of all sorts, or "aggregate demand," to increase beyond levels consistent with the Fed's objectives. Since the demand for loans of all kinds, including that for overnight loans of federal funds, itself tends to increase along with the demand for other things, the funds rate will once again tend to rise above target, instigating another round of open-market purchases, and so on. Eventually one of two things must happen: either the Fed, realizing that sticking to its chosen rate target will cause it to overshoot its long-run inflation goal, will revise that target upwards, or the Fed, in insisting on trying to do the impossible, will end up causing run-away inflation.  Persistent attempts to push the fed funds rate below its equilibrium value will, in other words, backfire: eventually interest rates, instead of falling, will end up increasing in response to an increasing inflation rate.  A Fed attempting to target an above-equilibrium ffr will find itself facing the opposite predicament: unless it adjusts its target downwards, a deflationary crisis, involving falling rather than rising interest rates, will unfold.

The public would be wise to keep these possibilities in mind whenever it's tempted to complain that the Fed is "setting" interest rates "too high" or "too low."  The public may be right, in the sense that the FOMC needs to adjust the fed funds target if it's to keep inflation under control.  On the other hand, if what the public is really asking is that the Fed try to force rates above or below their equilibrium values, it should consider itself lucky if the FOMC refuses to listen.

A Steamship Analogy

I hope I've already said enough to drive home the fact that there was, prior to the crisis at least, only a grain of truth to the common belief that the Fed "sets" interest rates. It is, of course, true that the Fed can influence the prevailing level of interest rates through its ability to alter both the actual and the expected rate of inflation. But apart from that, and allowing that the Fed has long-run inflation goals that it's determined to achieve, it's more correct to say that the Fed's monetary policy actions are themselves "set" or dictated to it by market-determined equilibrium rates of interest, than that the Fed "sets" interest rates.

But in case the point still isn't clear, an analogy may perhaps help. Suppose that the captain of a steamship wishes to maintain a sea speed of 19 knots. To do so, he (I said it was a steamship, didn't I?) sends instructions, using the ship's engine-order telegraph, to the engineer, signaling "full ahead," "half ahead," "slow ahead," "dead slow ahead," "stand by," "dead slow astern," "slow astern," and so on, depending on how fast, and in what direction, he wants the propellers to turn. The engine room in turn acknowledges the order, and then conveys it to the boiler room, where the firemen are responsible for getting steam up, or letting it down, by stoking more or less coal into the boilers. But engine speed is only part of the equation: there's also the current to consider, variations in which require compensating changes in engine speed if the desired sea speed is to be maintained.

Now for the analogy: the captain of our steamship is like the FOMC; its engineer is like the manager of the New York Fed's System Open Market Account, and the ship's telegraph is like…a telephone.  The instructions "full ahead," "half ahead," "stand by," "half astern," and so forth, are the counterparts of such FOMC rate-target adjustments as "lower by 50 basis points," "lower by 25 basis points," "stand pat," "raise by 25 basis points," etc. Coal being stoked into the ship's boilers is like fed funds being auctioned off. Changes in the current are the counterpart of changes in the demand for federal funds that occur independently of changes in Fed policy.  Finally, the engine speed consistent at any moment with the desired ship's speed of 19 knots is analogous to the "equilibrium" federal funds rate.  Just as a responsible ship's captain must ultimately let the sea itself determine the commands he sends below, so too must a responsible FOMC allow market forces dictate how it "sets" its fed funds target.

***

Such was monetary control before the crisis. Since then, much has changed, at least superficially; so we must revisit the subject with those changes in mind. But first, I must explain how these changes came about, which means saying something about how the S.S. Fed managed to steam its way straight into a disaster.

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**I resist calling it the "natural" rate, because that term is mostly associated with the work of the great Swedish economist Knut Wicksell, who meant by it the rate of interest consistent with a constant price level or zero inflation, rather than with any constant but positive inflation rate. The difference between my "equilibrium" rate and Wicksell's "natural" rate is simply policymakers' preferred long-run inflation rate target. Note also that I say nothing here about the Fed's employment goals.  That's because, to the extent that such goals are defined precisely rather than vaguely, they may also be incompatible, not only with the Fed's long-run inflation objectives, but with the avoidance of accelerating inflation or deflation.

[Cross-posted from Alt-M.org]