The Fed Is Entering Uncharted Territory

While this is welcome added clarity on the Fed’s intentions, they have once again missed an opportunity to offer a comprehensive strategy for conducting monetary policy. There are still too many potential risks in the Fed’s plan. 

Chair Janet Yellen, in her prepared remarks, said that the Fed does “…not plan on making adjustments to the balance sheet normalization program.” But as they venture into uncharted territory, conducting a monetary operation that they have no experience with, a measure of caution — rather than certainty — should be coming out of the central bank.  

As the Fed unwinds its balance sheet, new questions arise: How will this reduction interact with the Fed’s other monetary policy instrument, the policy rate, and how might those effects be interpreted by the public? 

Since the crisis, the Federal Reserve’s balance sheet has grown from $900 billion to $4.5 trillion through several rounds of quantitative easing. The Fed bought Treasuries and mortgage-backed securities and paid for them with newly created money, called reserves.

Much of that money is sitting in banks’ accounts at the Federal Reserve in the form of excess reserves. That is, more than what banks are required to hold for regulatory reasons or need in order to settle daily financial transactions.  

Due to this increase in reserves, the Fed cannot raise its policy rate by adjusting the overall quantity of reserves in the system, like it once did. Therefore, since 2008, it has been paying interest on excess reserves (IOER) in an effort to maintain some degree of monetary control.

IOER is the interest rate the Fed pays to domestic commercial and foreign banks on cash that sits idle at the Federal Reserve. For each rate hike since the crisis, the Fed has needed to raise the IOER rate as well in order to have a commensurate rise in the policy rate. 

Markets are currently expecting another policy rate hike in December and three more in 2018. This is where friction in the Fed’s plan could develop.

Reducing the size of the Fed’s balance sheet will mean reducing the quantity of reserves in the financial system. But as fewer reserves are available, the Fed’s path of interest rates hikes will make it even more profitable for banks to hold excessreserves, as IOER payments get higher and higher. 

In short, the Fed is going to reduce the amount of money in the system while simultaneously making it even more attractive for banks to hold money at the Fed.

This may result in monetary overtightening. The combination of rising interest rates and increasing banks’ appetite for reserves, if the face of weakening economic data, may be more than the economy can handle right now.

At a minimum, increasing bank demand for a shrinking supply of reserves will make banks less likely to deploy those funds in productive uses, such as funding loans to households and business. This risks putting unnecessary downward pressure on future economic growth.

Raising the policy rate using IOER will also increase payments made to banks. As IOER increases, banks “earn” more from idle cash kept at the Fed. Last year, with IOER at half a percent, the Fed paid banks $12 billion. How long will Congress and the public tolerate the Fed paying large domestic and foreign banks 2 percent on their cash holdings, while most savers are earning barely a fraction of that?

No one expects the balance sheet to return to its pre-crisis level, and the Fed worryingly did not include a target size in yesterday’s announcements. But given the gradual run-off — only $50 billion per month from October 2018 on — it will be well past 2020 before the balance sheet approaches any of the potential target sizes previously mentioned by Fed officials. 

What the Fed should have done yesterday, and ought to have done long before then, is outline a comprehensive strategy for conducting monetary policy over the medium term. The Fed needs a strategy that considers both how to set the policy rate and how to reduce the balance sheet in ways that will not confuse one another, or be too contractionary.