As market interest rates continue their downward slide, the press is awash with predictions of how much the Fed will reduce interest rates at its September 17 and 18 meeting. The very fact that market interest rates are changing without Fed action begs the question of whether the Fed can even influence the direction of change in market interest rates, much less control these rates more precisely. This might be seen as unimportant, but such a view ignores the relationship between the primary policy rate set by the Fed – the interest rate on excess reserves (IOER) – and the nation’s money supply. It is this relationship that makes the Fed’s decision on IOER, and its closely related decision on the upper bound Federal Funds Rate target, extremely important.
A Post-QE History of Interest Rates and Fed Policy
It seems clear that the Fed is an interest rate follower, not a leader. The Fed has complete control of the IOER, of course, as this is an administered rate set by the Fed. But, does control of the IOER give the Fed control of market interest rates? The figure below shows the path of 1-year and 10-year treasuries, the Fed’s upper bound for the Fed Funds market, and the interest rate on reserves, the IOER. During the period of rising 1-year interest rates from the beginning of 2015 through October 2018, the Fed followed the 1-year rate up, increasing IOER as the 1-year rate rose. The graph shows that 1-year rates rose prior to Fed actions, and the Fed was not so much determining interest rates as following their upward trend.
From the beginning of 2015 through 2017, the IOER and the target Fed Funds rate upper limit were essentially identical, and they tracked the 1-year treasury rate with a lag. Every time the 1-year rate would rise it was followed by the Fed increasing the IOER and the Fed Funds upper bound. In mid-2017, the rate of increase in the 1-year rate accelerated, and the Fed followed by changing the IOER (and the Fed Funds upper target) at every FOMC meeting. Until October of 2018, the Fed’s increases in the IOER lagged the magnitude of increases in the 1-year rate. In addition, in June 2018, the Fed moved to separate the IOER from the Fed Funds upper target by 5 basis points, so IOER was ever so slightly below the Fed Funds upper bound target.
Market interest rates began falling on both 1-year and longer-term treasuries in November 2018. Despite these falling market interest rates, the Fed decided to raise the IOER again in December 2018, and it also moved to further separate the IOER and Federal Funds upper target, from 5 to 10 basis points. Did the Fed’s actions increase market interest rates? Clearly not, as market interest rates continued their decline, seemingly unabated. In fact, market interest rates have been declining ever since.
The Fed held firm on their Fed Funds upper target and the IOER against these declining market rates until May 1st when they reduced the IOER by a scant 5 basis points, with no change in the Fed Funds upper target. Finally, in July, after seven months of declining market interest rates the Fed cut the IOER by 25 basis points, to 2.1%, and also cut the Fed Funds upper target by the same 25 basis points. Notably this action still left the IOER 9 and 10 basis points, respectively, above the 1-year and 10-year treasuries. Since the end of July interest rates have continued to fall.
If the Fed cannot change market interest rates, do we care? Those interested in the Fed’s ability to pursue countercyclical monetary policy might find this troubling in the extreme. But in the current economic situation, why does it matter what the Fed is doing? In fact, if the Fed cannot influence market rates, then why worry about what the Fed does at the coming FOMC meeting?
The answer is that the Fed’s interest rate decision, and especially the setting for the IOER, matters for the money supply. It seems that an expansionary monetary policy is in order, which requires putting additional reserves in circulation. Ever since the Fed embarked on its grand experiment in quantitative easing, it is the IOER, relative to other market rates, that matters for reserves in circulation. Before the financial crisis, excess bank reserves were for all practical purposes zero. When the Fed increased reserves these additional reserves were not held as excess reserves but instead went into circulation in the economy. Any bank receiving an injection of reserves would move to lend these out or to purchase interest-earning securities. In today’s world, banks receiving an injection of reserves often hold them as interest-earning excess reserves instead of lending them out or investing them in interest-earning securities. Banks see the IOER as an opportunity cost of lending, and compare (risk-adjusted) rates on either interest-earning securities or loans to the IOER when deciding if reserves will be put into circulation or held as excess reserves in bank vaults and as deposits at the Fed. This fundamental change in the monetary policy environment makes the IOER the policy rate of focus. It also makes the spread between market rates and the IOER of high importance. The higher the IOER relative to market rates, the larger the incentive for banks to hold reserves instead of putting them in circulation.
Current Interest Rates
Is the Fed doing a good job in achieving monetary expansion? It seems not. Even after the 25 basis point reduction in the IOER in July, interest rates on all treasury securities less than 30 years are above the IOER. The figure shows the interest rates on all maturities of treasuries and the IOER as of September 12, 2019. Two things are apparent. First, all interest rates less than 30-year maturity are below the IOER. Bank reserves pay higher interest than treasury securities, basically providing an incentive for banks to keep reserves out of circulation, i.e., to hold substantial excess reserves. Second, the yield curve, the relation between term to maturity and rate of interest, is now U-shaped. Typically, the yield curve is upward sloping, reflecting the fact that bonds with longer maturities normally have higher rates than bonds with shorter maturities.
Where Does Monetary Policy Want to Go?
The Fed’s inflation goal is 2%, a typical inflation goal among developed economies. It may be no coincidence that the Fed and other central banks are having great difficulty in meeting this goal. So far this year the U.S. inflation rate is running at 1.6%, as measured using the Fed's preferred measure, the core PCE inflation rate. Meanwhile real GDP grew at a 2.55% annual rate for the first half of the year. The simple quantity equation, MV=PQ, would indicate that money growth would need to be 4.55% in order to support the 2% inflation target (assuming constant velocity). Is this happening?
Money growth requires an increase in reserves in circulation, reserves not held as bank excess reserves. Now that the Fed has discontinued it asset reduction program, the Fed’s balance sheet is being held rather constant. In this case, reserves in circulation will grow only if some of the current excess reserves held by banks are put in circulation, basically being converted from excess reserves to required reserves. For this to happen, banks must have an incentive to put reserves in circulation. Before the Great Recession this was easy, as banks earned zero interest on excess reserves and hence held almost no excess reserves. Additional reserves were put in circulation. Currently, however, this is more of a delicate balancing act.
The Fed will not reduce the IOER to zero, as this would generate a huge move of excess reserves into circulation, and the result would be a huge increase in the money supply. The Fed seeks a middle way – it wants the IOER to be low enough to move a relatively small portion of excess reserves into circulation, but not so low as to cause a money growth rate and an inflation rate that greatly exceeds the 2% target. This problem is one of the Fed’s own making. It chose to start paying interest on reserves in order to sterilize (or keep out of circulation) the massive increase in reserves caused by the Fed’s three successive quantitative easing programs that only ended at the close of 2014. The decision to engage in such large scale quantitative easing, and the decision to pay interest on reserves, may have helped rescue banks by providing a source of additional interest income, and certainly succeeded in keeping the massive increase in reserves mostly parked at the Fed in interest-earning excess reserve accounts, but it also led to the present situation and has tied the hands of the Fed in conducting monetary policy today.
Today market interest rates are at almost historic lows, and almost all maturities of treasuries are well below the IOER. If Fed policy is to induce the banking system to release some of its holdings of excess reserves into the economy, it is imperative that the Fed reduce the IOER. For example, during the period of rising interest rates and falling excess reserves, the average spread between the rate of interest on 10-year treasuries and the IOER was 138 basis points, and between 1-year treasuries and the IOER was 17 basis points. Compare that to September 12, when the 10-year spread was negative (– 31 basis points) and so was the 1-year spread (-28 basis points). Moreover, since May 1 Fed securities holdings have declined by almost $132 billion while bank excess reserves had risen but have now returned to their May 1 level, as have reserve deposits at the Fed. As a result, the net assets of the Fed on which the money is based are falling. In contrast, during the first year of Fed asset reductions, bank excess reserves were falling faster than Fed asset reductions, resulting in rising Fed net assets. What is the reason for this difference? The explanation is the interest rate spreads mentioned above. When market interest rates exceed the IOER banks release reserves and increase Fed net assets. Now, with market rates below the IOER, banks have little incentive to release reserves into the economy by buying other securities or making loans.
One complication causing confusion in discussing these issues is the Fed’s continued emphasis on the Federal Funds rate and the Fed’s upper bound target for the effective Fed Funds rate. The Federal Funds rate is of reduced importance in the current monetary environment, mainly serving as a signal of what is happening with the IOER. It is the IOER that indicates the stance of monetary policy. The Fed has obfuscated this point by taking actions at various times to force the Federal Funds rate to closely track the IOER. But make no mistake, it is the IOER that is most important for monetary policy. It is the IOER that, for all intents and purposes, determines the effective Fed Funds rate. For instance, all the Fed Funds supplied in the upper end of transactions in the Fed Funds market come from member banks and occur at rates above the IOER. Since early June, over 75% of all transactions in the Fed Funds market have occurred at rates above the IOER. At these rates, member banks participate in the Fed Funds market and earn additional income by lending Federal Funds at rates above the IOER. Further, given the availability of Fed member bank excess reserves, over $1.3 trillion, and the scale of the Fed Funds market, $70 billion as of September 3, the IOER is now the dominant factor in determining the effective Fed Funds rate.
The IOER, and the related effective Fed Funds rate, indicates the potential return to the banking system for holding excess reserves, and it is this return to holding excess reserves that is critically important for the economy. Given current market interest rates, a substantial reduction in the IOER is necessary to ensure that banks will move some of their excess reserves into circulation.
What Should the Fed Do In September?
The press, and the futures market, expects a reduction in the Federal Funds upper target of 25 basis points at the September FOMC meeting. This would almost certainly be accompanied by a reduction in the IOER of 25 basis points. If this happens, the IOER would be set at 1.85%. Compared to market interest rates on September 10, this new level of the IOER would still be higher than both the 1-year and 10-year treasury rates. Banks would still get a higher interest rate from keeping reserves out of circulation than they could earn on equally safe treasuries. If the Fed wants banks to reduce excess reserves and get these reductions into circulation it must reduce the IOER to a level below these treasury rates. We would strongly recommend a decline in the IOER on the order of 50 basis points in order to return the spread between 10-year treasuries and the IOER to significant positive values.