Media coverage the day following the Federal Reserve Open Market Committee’s (FOMC) action on January 29, 2020 widely applauded the Fed’s decision to maintain its target for the Fed Funds rate. But the most important aspect of the December meeting was the decision to increase the interest paid on bank reserves, the IOER, from 1.55% to 1.60%. This increase in the IOER is the first such increase since December of 2018. With this change, the Committee’s stated intention is to keep trading in the Fed Funds market at rates well within the target range of 1.5% to 1.75%.
While the discussion in the implementation note emphasizes the Fed Funds market, the trading in this market is only $69 billion as of the FOMC’s decision. Raising the IOER a trivial 5 basis points in order to ensure that trading in the $69 billion Fed Funds market stays within the target range leaves bank holdings of excess reserves, a $1.5 trillion market, too valuable to ensure a robust economy without substantial Federal Reserve purchases of Treasuries. Indeed, that is exactly what the Committee is directing, as the Desk is instructed to continuing purchasing T-bills at least into the second quarter of 2020.
The market’s response to the announcement of a small increase in IOER was a further decline in treasury rates. As the figure shows, the new IOER is above the rate of interest on all treasury maturities less than 10-years, and equal to the 10-year rate. If the Fed is to achieve the rate of monetary expansion required to stay near its 2% inflation target, it must expand assets faster than banks add to excess reserves. Given the superior earning power of reserves relative to most treasuries, this presents a real challenge.
The press also continues to emphasize the role of the Fed in the determination of interest rates, but as the figure shows, interest rates were well below the Fed upper target and below the IOER from July 1 until November. Treasury rates seem to have no relation to either the Fed Funds upper bound target or the IOER. Starting from the late October change in the target and the IOER, rates on short term treasuries have hovered around the IOER while the 10-year rate has until recently been in the 1.8% to 2% range. Furthermore, given the huge potential supply of reserves available for trade in the Fed Funds market, the effective Fed Funds rate is usually equal to the IOER.
With Wednesday’s FOMC announcement that increased the IOER to 1.60%, the return to banks for holding reserves is now above almost all maturities of treasuries. The assets the Committee has instructed the Desk to buy, T-bills, have an interest rate below the IOER. Thus, the interest payments that the Fed will receive on the new T-bill purchases will be less than it must pay to banks to hold the new reserves the Fed is creating. The result will be a reduction in the transfer of Fed ‘profits’ that the Fed makes to the Treasury. Importantly, these transfers in 2015 financed 44% of the interest cost of the federal debt. In 2019, transfers covered less than 15% of the federal debt net interest cost.
The increase in the IOER was not matched by interest rate movements on Wednesday. The 1 month rate fell 1 basis point, the 2 month fell by 2 basis points, and the 3 month rate fell by 1 basis point. The 1 year rate fell 2 basis point to 1.51%, a full 9 basis points below the new IOER rate of 1.60%. In fact, you have to go all the way out of the maturity structure to 10-year treasuries to find a yield equal to the new IOER, as the 5-year rate is 19 basis points below and the 7-year rate is 9 basis points below the IOER.
The Fed voted to continue expanding its assets and to reinvest all principal payments from its holdings of Treasuries, mortgage backed securities and agency debt. The danger lies in that the increase in the IOER makes holding reserves better than their closest substitute, short term Treasuries, and will result in the Fed’s expansion simply adding to bank reserves rather than contributing to the economy.
In its press release, the FOMC reiterated its 2 percent inflation target, a target officially announced in an FOMC press release on January 25, 2012: “The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.” The Federal Reserve has emphasized that it prefers to focus on inflation as measured by the price index for personal consumption expenditures excluding food and energy, sometimes called core PCE inflation.
Today, we are not taking a stand on whether a 2 percent inflation target is a good thing. We are not taking a stand on the preferred measure of inflation. Instead, using the Fed’s stated policy target, and the Fed’s stated preferred measure of inflation, how has the Fed done in achieving its newly-reiterated inflation target? The answer, unfortunately, is not well at all. One of the most basic roles of the Fed, of any central bank, is to provide a stable and predictable price level, a stable and predictable inflation rate. The Fed has just reiterated its interest in achieving a 2 percent inflation target, and yet as the figure shows, it has done rather poorly in achieving its goal. Over this almost eight-year period, the Fed on average has been 37 basis points below its 200 basis point inflation target. Perhaps the Fed could explain its problems with generating its target level of inflation at its next press conference.