A September FOMC Post-Mortem

Media coverage on the day following the Federal Reserve Open Market Committee’s (FOMC) action, as announced on September 18, widely applauded the Fed’s lowering of its target for the Fed Funds Rate.  The most important change in the September meeting was reducing the interest paid on bank reserves, the IOER, by 30 basis points. This 30 basis point reduction in the IOER represents the biggest reduction in the rate paid on reserves since the inauguration of the payment of interest on bank reserves.

In addition, 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 is now 20 basis points below the upper bound of the Fed Funds target. 

If anything about the FOMC’s action was surprising, it was that the reduction in the IOER was only 30 basis points.  This new interest rate paid on bank reserves, 1.80%, still leaves the return to banks for holding reserves just below the immediate close substitute - short-term treasury securities - and just above the 2-year through 10-year treasuries.  The Fed’s cut still leaves banks with an incentive to park their ‘safe’ investment funds in reserve accounts instead of Treasury securities.  Banks are still encouraged to retain excess reserves instead of putting them into circulation by purchasing Treasury securities or other closely related assets.

The Fed’s cut of 30 basis points on Wednesday in the IOER, along with the cut in the Federal Funds rate target band, was not matched by interest rate movements, although short-term Treasury rates generally declined on Wednesday but by Thursday has risen above their pre-FOMC meeting rates.  The largest move was in the very short-term maturities.  There was an immediate 16 basis point decline in 1-month Treasuries and a 13 basis point decline in 2-month Treasuries. But by Thursday, half of that decline had disappeared. All other maturities changed very little in either direction.  On Friday noon the 1-month Treasury rate was just at 13 basis points above the IOER.    

At its July meeting, the FOMC announced an immediate cessation to the Fed’s asset reduction program.  Since the first of this year the Fed has reduced is assets by $240 billion. During that same period, bank holdings of excess reserves fell by only $59 billion, so that the Fed’s support of the money supply was significantly reduced.  

Even since May 1, and despite the end of its asset reduction program, Fed holdings of securities have fallen by $132.9 billion.  Bank reserves have fallen by essentially that same amount.  Meanwhile, bank excess reserves have now dropped to their May 1 level after having been higher for almost all of the past 4 months.  Bank excess reserves typically rise when banks fail to replace maturing securities with new securities, and instead place those funds into interest-earning reserves.

There was a time when the Fed began its asset reduction program and excess reserves declined as the Fed shrunk its asset portfolio.  During that period banks had a stronger incentive to put excess reserves into circulation, i.e. to reduce excess reserves, because the mean spread between 10-year Treasuries and the IOER was 101 basis points.  Now it is -1 basis point!  The combination of Fed asset reductions with no reduction in bank excess reserves means that the full $132.9 billion asset reduction since May 1 was a reduction in Fed net assets.  Fed net assets might accurately be labeled the ‘adjusted monetary base,’ the quantity that supports the nation’s money supply, and it has been declining.

The Fed is in a difficult position.  It has expressed a desire to return to a monetary policy environment more like what existed before the financial crisis, when reserves were scarce and excess reserves were a tiny portion of total reserves.  The Fed wants a growing money supply to accompany a growing economy.  Yet as it sells assets, and attempts to raise the overnight interest rates, it must pay attention to the spread between the IOER and market rates on close substitute securities.  If the IOER is too high relative to market rates, banks have an incentive to hold large quantities of excess reserves instead of putting those reserves into circulation by purchasing securities or making loans.  This makes it difficult to have a rising money supply.  If the IOER is too low relative to market rates – and setting the IOER to zero would be more like the pre financial crisis monetary environment -- then banks will have an incentive to put all of their excess reserves into circulation, causing a large increase in the money supply.  The Fed wants a middle path, but it has created a monetary environment in which this middle path is difficult to achieve.  One thing seems clear; the Fed does not ‘control’ market interest rates.  Instead the Fed is forced to respond to movements in market interest rates by adjusting the IOER as it attempts to follow the middle path. 

Almost simultaneously with the FOMC announcement, the European Central Bank or ECB announced the reintroduction of a quantitative easing program and a negative bank rate. Importantly, the negative bank rate would only apply to new deposits at the ECB, virtually ensuring that the increase in ECB assets would increase bank lending rather than simply adding to bank deposits at the ECB.  Here at home, the Fed – more specifically the Board of Governors – chose to only cut the IOER at the September meeting by 30 basis points, despite the continued broad decline in interest rates on assets that banks regard as close substitutes for reserves.  There is a real danger that, absent a reversal in these interest rate trends, the Fed may be forced to dramatically lower the IOER in order to prevent an unacceptably slow growth in the money stock or even an outright contraction of the money stock.  Absent a halt to the downward trend in U.S. market interest rates, the Fed will continue to face pressure to significantly reduce the IOER in the future, or to follow the ECB and the Bank of Japan in establishing different categories of bank reserves with different rates of IOER for each category.

Posted: September 20, 2019 by Dennis W. Jansen, Thomas R. Saving