The year 2019 was a year of declining market interest rates. In fact, 10-year Treasuries fell from 2.8% in January to a low of 1.47 in early September, during the period of the interest rate inversion. At that point, 3-month Treasuries were yielding almost 2%. The inversion ended in early October but the 3-month, 1-year and 10-year rates were all near or below the Fed’s interest on excess reserves, or IOER, until the late October FOMC meeting. At this meeting, the IOER was reduced to 1.55, which was essentially equal to the level of the 3-month and 1-year rates.
This pattern is shown in the accompanying graph. While the Fed raised rates and held them constant for more than half a year, the general level of market interest rates continued to fall, and not just at the long end of the term structure. The 3-month rate was at 2.4% during the first five months of 2019, but then began falling in early June and was down to 2% by the time of the July FOMC meeting. The 3- month rate continued its decline until the October FOMC meeting, reaching a low of 1.49% just after the October FOMC meeting.
While the popular press, and many economists, talk about the Fed as ‘setting’ interest rates, the reality is quite a bit different. The Fed has not ‘controlled’ market interest rates. On the contrary, market interest rate movements have influenced Fed behavior, albeit with a lag. The Fed has been not so much the leader of falling market rates as it was the reluctant follower, reducing the Federal Funds Rate target (finally!) at its July meeting and then following up with two additional reductions. The Fed, eventually and reluctantly, followed market interest rates down during 2019.
The following figure shows that as of January 24, the IOER was 1 basis point above the 1-month and 3-month rates, equal to the 1-year rate, 6 basis points above the 2-year rate, 7 basis points above the 3-year rate and 4 basis points above the 5-year rate. Given what has happened in the last six months, it is no surprise that bank holdings of reserves are rising.
What Should the Fed do in January?
Because of the continued lack of market yields above the IOER, banks have increased reserve holdings. To counter these rising reserves, or perhaps because of them, the Fed began in September making open-market purchases of Treasuries while reducing its holdings of mortgage backed securities. In total, the Fed’s total holdings of securities rose by over $190 billion, almost one-third of the total of the asset reductions during the almost two-year period that began in October of 2017. These purchases have more than offset the banking system’s increase in excess reserves holdings, so the monetary base, adjusted for excess reserves, has risen.
The Fed’s announced goal is 2% inflation. Meeting this goal requires an increasing money supply at a rate 2% points faster than the rate of growth of real GDP. The latest GDP growth estimates for the 3rd quarter of 2019 show a 2.1% growth. Meeting the Fed’s inflation goal will require that the money supply grow at 4.1%. The M1 measure of the money supply actually grew in the 4rd quarter at an annual rate greater than required to meet the Fed’s inflation goal.
To continue to achieve the money supply growth to keep the economy moving and to achieve the Fed’s target inflation rate will require that the Fed continue its asset expansion or that bank holdings of excess reserves fall. If the Fed suspends its current asset expansion, then it must reduce the IOER by at least 20 basis points. Or if it continues its asset expansion, it will dramatically reduce the transfer it makes to the Treasury as the revenue from the new assets will be at or below what it pays banks to hold reserves. These transfers in 2015 financed 44% of the interest cost of the federal debt. In 2019, the transfers covered less than 15% of the federal debt net interest cost.
The solution to the falling Fed contribution to the Treasury is a return to the asset reduction program suspended in September of 2019 and a greater than 20 basis point reduction in the IOER.