A December FOMC Post-Mortem

Media coverage the day following the Federal Reserve Open Market Committee’s (FOMC) action on December 11, 2019 widely applauded the Fed’s decision to maintainin its target for the Fed Funds rate.  But the most important aspect of the December meeting was to maintain the interest paid on bank reserves, the IOER, at its current level of 1.55%.  This decision follows four straight FOMC meetings where the IOER was reduced. Leaving the IOER unchanged leaves bank holdings of excess reserves too valuable to ensure a robust economy.  This failure to reduce the IOER leaves all short-term Treasuries earning the same as bank reserves; as of December 11, 2019 the 1 year Treasury rate is exactly equal to the IOER and 8 basis points below the spread achieved back at the September meeting.

Media coverage continues to emphasize Fed statements about the Federal Funds Rate, despite the reality that the interest rate that matters most in the current monetary policy environment is the IOER.  That rate remains 20 basis points below the upper bound of the Fed Funds target. 

The press also continues to emphasize the role of the Fed in the determination of interest rates, but as the figure shows, the period of falling interest rates preceded the onset of any Fed reductions in the IOER. In fact, despite the reality of falling market interest rates that began in mid-November of 2018, the Fed raised both its upper Fed Funds target and the IOER in December 2018. Then with market interest rates continuing to fall, it made a minimal reduction in the IOER of 5 basis points in May 2019 with no change in the Fed Funds target after holding firm for six months.  By that time, the 10 year Treasury rate had fallen 27 basis points and the 1 year Treasury rate had fallen 8 basis points from their December 2018 levels. Most importantly, both of these rates were below the IOER.

At its July FOMC meeting, the Fed finally took action that recognized the ongoing 8 month general fall in market interest rates, and lowered both the IOER and Fed Fund target by 25 basis points.  This change basically restored the Fed policy rates to their levels of early December of 2018.  In September, it lowered the IOER by another 30 basis points to 1.80% while lowering the Fed Funds target by 25 basis points to 2.0%. In October, the FOMC lowered both the IOER and the Fed target by another 25 basis points to 1.55% and 1.75%. That change still left the return to banks for holding reserves just below their immediate close substitutes, short-term treasury securities, where they remain even after the December meeting.

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Wednesday’s FOMC announcement that the interest rate paid on bank reserves will remain at 1.55% still leaves the return to banks for holding reserves at just below the immediate close substitute, short-term treasury securities.  This latest stand-pat decision has the interest rate on all short-term Treasuries virtually at the IOER. The Fed has given banks little marginal incentive to move reserves to other higher-paying securities, a move that would expand the money supply.

The period of interest inversion, where the 3 month and 1 year rates exceeded the 10 year rate, ended in early October.  While many pundits breathed a sigh of relief, as such inversions preceded the onset of the last three recessions, it is important to note that those last three recessions began an average of 4 months after the end of the interest rate inversions.  The sustained monetary expansion required to keep the economy on track requires that banks move excess reserves into the economy.

The Fed’s failure to cut the IOER or its Fed Funds target rates was not matched by interest rate movements that stayed about the same on Wednesday.  The 1 month rate rose 1 basis point, the 2 month rate rose by 2 basis points, and the 3 month rate by 1 basis point.  The 1 year rate fell 1 basis point to match the IOER at 1.55%, the 2 year rate declined by 4 basis points, the 10 year rate by 6 basis points, and the 30 year rate by 3 basis points.

The Fed voted to continue expanding its assets by as much as $20 billion monthly. Since this expansion began in September, the Fed has expanded asset holdings of $89 billion, or just over 2%. The danger is that the continuation of an IOER that makes holding reserves as good as their closest substitute, short term Treasuries, will result in the Fed’s expansion simply adding to bank reserves rather than contributing to the economy.

Posted: December 12, 2019 by Dennis W. Jansen, Thomas R. Saving