Discount rate adjustments, in turn, became unimportant in influencing the stance of monetary policy when the Fed switched from reserve targeting to targeting the federal funds rate during the 1980s. Since 2003, moreover, the discount rate has been set above the fed funds target (or, since November 2008, above the upper bound of the fed funds target range). When the discount rate is above the effective fed funds rate, banks ordinarily have no reason to borrow at the discount window.
Consequently, for all intents and purposes, for several decades prior to October 2008, when the Fed began paying interest on banks’ reserve balances, the FOMC – and the regional bank presidents taking part in it – exercised exclusive control over monetary policy. Moreover, as we shall see, Fed officials themselves now take for granted the FOMC’s ultimate responsibility for the conduct of monetary policy.
Interest on Reserves transfers Formal Control over Monetary Policy to the Board of Governors
The 1935 compromise by which regional Fed bank presidents, through their participation in the FOMC, shared the legal authority to determine the stance of monetary policy with the Board of Governors, came to an abrupt—if generally unnoticed—end in 2008 as a result of the passage of the Financial Services Regulatory Relief Act of 2006 and the Emergency Economic Stabilization Act of 2008.
Section 203 of the 2006 Act allowed the Fed to begin paying interest on banks’ reserve balances beginning on October 1, 2011. The 2008 Act advanced that date by three years, allowing the Fed to begin making interest payments as early as October 1, 2008. The Fed was authorized by these Acts to pay interest on both banks’ required and their excess reserve balances. Importantly, the 2006 law assigned responsibility for setting both rates, not to the FOMC, but to the Board of Governors, and this provision remained unaltered by the 2008 law.
The Fed’s immediate goal in securing the authority to start paying interest on banks’ Fed balances in October 2008 was to prevent the crisis‐related emergency lending it was engaging in at that time from driving the fed funds rate below the FOMC’s then‐chosen target of 2 percent. By paying interest not just on required but on excess reserves, the Fed could encourage banks to retain newly‐created reserves that came their way, instead of lending them. Interest on excess reserves (henceforth IOER) was thus deployed early so that it might bolster the Fed’s ordinary means of monetary control.
As the crisis continued, however, the IOER rate came to perform, not merely a supplementary role, but the lead role in the Fed’s setting of monetary policy. Instead of relying on open‐market operations to achieve a target federal funds rate, the Fed switched to a new “floor” operating system in which the IOER rate itself took the place of open‐market operations as its chief instrument of monetary control. The basic idea was that, instead of loosening or tightening its policy stance by buying or selling securities in the open market (and thereby adding to or subtracting from the total supply of bank reserves) the Fed could loosen or tighten by influencing banks’ demand for reserves. A higher IOER rate would, other things equal, increase banks’ demand for reserves, tightening credit by discouraging bank lending, while a lower one, by reducing banks’ appetite for reserves, would loosen credit, encouraging them to lend more.
By keeping its IOER rate above corresponding market interest rates, as it has done since November 2008, the Fed has prevented additions to the supply of bank reserves from resulting in any general increases in the supply of credit. Instead, increases in total bank reserves were matched by roughly equal changes in banks’ excess reserve holdings. Although the Fed could still purchase or sell assets on the open market, and although it did, in fact, ultimately undertake three rounds of Large Scale Asset Purchases, its open‐market operations ceased to play their traditional role as the Fed’s main instrument of monetary policy.
Thus the Fed’s switch to an IOER‐based operating system had the effect of transferring control over the Fed’s monetary policy stance from the FOMC, where it had resided for decades, to the Board of Governors, which had previously exercised that control solely through its participation, together with several Fed bank presidents, in the FOMC.
A Change Not Anticipated by Congress
The just‐described transfer of authority for conducting monetary policy, from the FOMC to the Board of Governors, had not been anticipated, and was certainly not intended, by Congress when it passed the 2006 Financial Services Regulatory Relief Act.
Instead, when Congress originally granted the Fed authority to pay interest on banks’ Fed balances, it did so in order, as the Federal Reserve Board itself stated in its 2006 Annual Report, to “reduce unnecessary burden [sic] on banking organizations and improve operation of the financial system.“4 Interest payments on required reserves, the report said, would “remove a substantial portion of the incentive for depositories to engage in reserve‐avoidance measures,” allowing “the resulting improvements in efficiency [to] eventually be passed through to bank borrowers and depositors.”
As for interest on banks’ excess reserves, although the 2006 Act also granted the Fed the authority to pay such interest, the Fed at that time anticipated employing the IOER rate, not as its chief device for regulating the federal funds rate, and for thereby adjusting the Fed’s monetary policy stance, but merely to serve as an above‐zero minimum possible value for the effective fed funds rate, so as to limit that rate’s potential volatility.Because the Fed’s target fed funds rate would generally fall between that minimum value and the Fed’s discount rate, open‐market operations were to continue to serve as the Fed’s primary monetary control instrument.
These originally‐intended functions of interest payments on banks’ reserve balances were reflected in the 2006 law’s stipulation that interest on Fed balances be paid “at a rate or rates not to exceed the general level of short‐term interest rates” – which stipulation was not altered by the Emergency Economic Stabilization Act. Had Congress intended to have the Fed employ the interest rate on banks’ reserve balances as an instrument of monetary control, and certainly had it intended to have that rate serve as the Fed’s chief instrument of control, rather than as a mere means for offsetting the reserve requirement tax, it would certainly not have placed such a limit on the rates the Fed was authorized to pay.5
The decision to make the Board of Governors, rather than the FOMC, responsible for setting interest rates on banks’ Fed balances, which was also carried over from the 2006 to the 2008 Act, likewise reflected the originally‐intended purpose of interest on reserves. Because such interest payments weren’t intended to serve as a primary means of monetary control, vesting control over them with the Board rather than the FOMC was not seen as contradicting the spirit of either the 1935 Banking Act or subsequent developments that had left the FOMC exclusively in charge of determining the stance of monetary policy.
An Untenable Situation
When, at the Fed’s urging, Congress passed the 2008 Emergency Economic Stabilization Act, allowing the Fed to immediately begin making interest payments on banks’ reserve balances, it cannot possibly have anticipated that the Fed would end up treating those interest payments, not only as an additional instrument of monetary control, but as its chief instrument of monetary control.6 Consequently, it was only inadvertently that Congress ended up transferring responsibility for monetary policy from the FOMC to the Federal Reserve Board, thereby denying to the regional Fed banks the influence they had long exercised, at least to some extent, in shaping the course of monetary policy.
It’s true that the difference between control of monetary policy by the FOMC and control of that policy by the Board of Governors is not as great as it may seem. As Ben Bernanke has pointed out,