The FOMC’s press release from its May 1 meeting emphasized that the economy was on an even keel, and that no change in the Fed Funds Rate target was in store. This steady-as-you-go decision was highlighted in the popular press. Hardly noticed was the small 5 basis point reduction in the interest rate on excess reserves, IOER, despite the fact that the IOER is the
important policy rate set by the Fed, much more important than the widely publicized Federal Funds Rate.
The FOMC release failed to report on the general fall in market interest rates that began at the onset of 2019. Falling market rates, coupled with the Fed’s ongoing policy of reducing its bloated asset holdings, are putting the economy – and the Fed -- in a precarious position.
The problem is simply stated. The Fed has a 2% inflation goal, and to achieve that goal its assets less excess reserves, or net assets, must rise 2% faster than real GDP. For example, the latest real GDP growth measure for the first quarter of 2019 was 3.2%, indicating that the money supply, and hence required reserves, would have to increase by 5.2%. This, and the ongoing Fed asset reduction program, would require the Fed to engineer a process by which it is reducing assets but also raising required reserves, meaning that excess reserves would have to decline by more than Fed assets were declining. Alternatively stated, Fed net assets must increase
by 5.2% as Fed gross assets decline.
In the first year of the asset reduction program, this is exactly what happened. The Fed’s assets decreased by $255 billion while excess reserves of the banking system decreased by $431 billion, allowing required reserves to increase even as total reserves fell. This happened because market interest rates exceeded the IOER, enticing banks to switch their holdings from excess reserves to market securities. For example, the interest rate on 1-year treasuries exceeded the IOER by an average of 43 basis points. Thus, market alternatives provided a high enough additional return to entice banks to reduce reserve holdings even as the Fed increased the IOER by 95 basis points, from 1.25% to 2.20%. During this period, this resulted in the money supply increasing by 2.8%.
Unfortunately, the year 2019 has not been so kind to the Fed. Beginning in December of 2018, market interest rates fell. For example, 1-year treasuries in December of 2018 averaged 2.66% and at the end of April had fallen to 2.39%. The IOER remained at 2.40% before May, so the spread between 1-year treasuries and excess reserves fell from 42 basis points at the beginning of 2019 to a negative
1 basis point at the end of April. The Fed’s response on May 2 was to reduce the IOER by a mere 5 basis points. To make matters worse, even with the May 2nd reduction in the IOER from 2.4% to 2.35%, the spread as of June 4 was -24 basis points for 1-year treasuries and even more negative for the 2, 3, and 7 year treasuries and -23 basis points for 10-year treasuries!
Given the increasingly favorable rate of return on reserves relative to treasury securities, it is not surprising that bank holdings of excess reserves is rising. This rise in excess reserves, coupled with the continuing reduction in the Fed’s asset holdings, places the Fed in a precarious position. It is not able to reduce assets while also maintaining sufficient growth in net assets so as to achieve its inflation target.
On May 22, 2019 the spread between the interest rate on 1-year treasuries and the IOER was a meager 2 basis points, and the IOER was above the 2, 3, 5 and 7 year treasuries! Excess reserves are a safe asset, essentially a call deposit by banks at the Fed, and unlike treasuries are not subject to interest rate risk. With the IOER exceeding the interest rate on treasuries over a broad stretch of the maturity spectrum, banks have little financial incentive to reduce excess reserves.
The Fed’s asset reduction plan of the last 18 months, if continued into the future, would result in asset reductions of $6.8 billion per month over the next 6 months, or a decline in assets of $175 billion. To achieve the desired 5% growth in net assets, excess reserves would have to fall by $234 billion. This is not going to happen when the IOER exceeds market rates on treasuries. In fact, for the two week period ending May 22, excess reserves increased
by $4.2 billion as Fed holdings of securities fell $15.6 billion.
The advent of falling market interest rates has changed everything. As long as banks hold massive excess reserves that earn interest, the Fed will have to react to changes in the market interest rate or else risk changes in the money supply. The degree to which the Fed was ever able to set interest rates independent of credit market rates has been dramatically curtailed by changes brought about by the Fed itself, and the mechanism by which the Fed can control the money supply has become far more complex.
Basically, if the IOER is set above the market alternatives banks will attempt to expand their holding of excess reserves, and all else held constant, the money supply will fall. If the IOER is set appropriately relative to the market rates, the money supply will remain unchanged. But when market interest rates fall and the IOER stays the same or rises, banks will move assets toward excess reserves, reducing loans and eventually reducing the money supply. Prior to paying the IOER, the money supply changed with Fed actions. Now changes in market interest rates change the money supply even absent Fed actions. Never in the Fed’s 105-year history has it had less control over market interest rates. The Fed has put itself in a position of being even more of an interest rate follower than in the past.
So, what should the Fed do now? At current market interest rates, it behooves the Fed to restore the incentive for banks to reduce excess reserves. An immediate first step would be for the Fed to reduce the IOER in order to restore the spread to last year’s average of 40 basis points. To be concrete, at current market interest rates the Fed should reduce the IOER from its current level of 2.35% to no more than 2.00%!