FOMC June 18: A Post-Mortem

Media coverage of the Federal Reserve Open Market Committee’s action on June 18 reported that the Fed left interest rates unchanged, with the Federal Funds Rate range holding steady at 2.25% -2.5%.  Unremarked upon by the financial media, and unmentioned in the lead section of the Fed's statement, was the fact that the Fed’s Board of Governors also left the interest it pays on bank excess reserves unchanged. Unlike the targets for the Fed Funds Rate, the interest rate on excess reserves (IOER) has a direct effect on the money supply.

The FOMC’s inaction was surprising, since at the May meeting the Fed cut the rate it pays on reserves in a move “intended to foster trading in the federal funds market at rates well within the FOMC's target range.”  That cut of 5 basis points occurred because the market yield on 1 year Treasuries had fallen below the rate the Fed was paying on reserves, thus giving banks an incentive to build up excess reserves.  However, since that meeting interest rates on Treasury issues have continued to fall. Currently, the interest rate on all Treasury issues with maturities less than 30 years are yielding less than the 2.35% rate paid on bank excess reserves. Commercial paper rates on all maturities are also below the 2.35% interest rate on reserves.

Because excess reserves pay higher interest than similar alternative investments, bank holdings of excess reserves have been rising.  Meanwhile the Fed has continued to reduce its balance sheet, and without banks reducing their excess reserves this will, sooner or later, reduce total reserves supporting the money stock. The Fed’s assets reduction occurs as some portion of maturing securities are not replaced in the Fed’s asset holdings.  Letting assets mature and not replacing them is equivalent to asset sales of the same magnitude, since when maturing assets are not renewed the Fed basically takes in ‘cash’ – actually reserves – and essentially destroys them.

Since May 1, Fed holdings of securities have fallen by $57.9 billion, a move that should eventually reduce bank reserves by that same amount. During this same period, bank holdings of excess reserves rose by 8.4%, $112.4 billion.  For a given stock of assets, bank excess reserves rise when banks fail to replace maturing assets and instead hold those funds as additional income-earning reserves. This combination of Fed asset reductions and bank additions to excess reserves resulted in a $1 billion reduction in currency plus required reserves, a sum we might label the ‘adjusted monetary base,’ the quantity that supports the money supply.

In this ‘new’ interest-on-reserves world of monetary policy, the primary driver of monetary policy is the interest rate on reserves relative to the earnings available to banks on other potential assets.  Monetary policy actions that impact bank reserves, and bank lending, ultimately impact the nation’s money supply. The Fed’s continued efforts to reduce its asset position puts added pressure on managing the setting of IOR so that any negative effects of Fed asset reductions on reserves are offset by matching bank reductions in excess reserves. That is, the Fed wants its asset reductions to be a reduction in excess reserves, and not a reduction in required reserves signaling a reduction in the money stock.  Otherwise, the money supply will decline and put pressure on prices to decline as well.

The Fed – more specifically the Board of Governors – chose not to cut the IOR at the June meeting, despite the broad decline in interest rates on assets that banks regard as close substitutes for reserves.  Absent a reversal in these interest rate trends, the Fed will be forced to dramatically lower the interest it pays on reserves or to halt, at least temporarily, its asset reduction program in order to prevent an outright contraction of the money stock and the economic disruption it could cause.    

Posted: June 25, 2019 by Dennis W. Jansen, Thomas R. Saving