Central Banks and Interest Rates: Controlling Monetary Policy through Reserve Markets, Study notes of Economic Analysis

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International Money and Banking:

8. How Central Banks Set Interest Rates

Karl Whelan

School of Economics, UCD

Spring 2020

Monetary Policy Strategies: The Fed and ECB

Most textbook discussions of macroeconomics assume that central banks set monetary policy by controlling the money supply (shifting the LM curve left and right). We have seen, however, that targeting the money supply is not an effective way to produce good macroeconomic outcomes. Most modern central banks do not practice monetary targeting. Instead, they focus on controlling short-term interest rates. Here, we will take a close look at how the Federal Reserve and the ECB implement policies to control interest rates.

Reserves and Interbank Markets

Banks are legally required to maintain a minimum amount of their assets in the form of reserve accounts at the Central Bank. Because reserve accounts are used by banks to make payments to each other, banks also need to keep a certain amount of reserves to process payments. So how much reserves should a bank keep? One strategy would be to behave in a “precautionary” manner, always keeping more reserves on hand than they probably need. But there is a downside to this. Central banks usually pay interest on reserves but traditionally this is a low interest rate. So holding large amounts of reserves is not very profitable. An alternative is to use what are known as inter-bank money markets in which banks borrow and loan reserves from each other. Banks can use these markets to make up any temporary shortfall in reserves. In the US, the interbank market for short-term funds is known as the Federal Funds market (despite its name, it is a private market) and the average rate in this market is known as the Federal Funds Rate.

Supply and Demand in the Reserves Market

Like all markets, the price set in the Federal Funds market—in this case the interest rate that banks charge to lend reserves—depends on both supply and demand. The Fed is uniquely positioned to control this price (i.e. the interest rate) because it can control both supply and demand in this market. I (^) Demand: The Fed sets reserve requirements so they can increase or reduce demand for reserves via adjusting this requirement. I (^) Supply: The Fed can determine the total supply of reserves to the system via open market operations. Traditionally, the Fed focused on controlling the supply of reserves. Adjustments in reserve requirements are generally not used by moden central banks as part of their monetary policy strategy. When the Fed creates lots of reserves, there is little demand for borrowing reserves and so the federal funds rate is low. When the Fed keeps the supply of reserves low, there is more demand for borrowing and the federal funds rate is high.

Historically, the Fed Kept the Funds Rate Close to Target

Reserve Balances of US Banks

Successful Implementation of New Policies

Unlike in the past when it had a specific target for the Federal Funds rate, with its new operational regime, the Fed decided to target a range for the federal funds rate that is 25 basis points wide. These new tools were effective in raising the fed funds rates and have been used more recently to implement three 25 basis point cuts. The FOMC currently has target range for the fed funds rate of between 1.5% and 1.75% The interest rate on reserves is currently set at 1.6%. The interest rate offered in its ON RPP programmes is currently set at 1.5%. The interest rate available from the discount window is 2.25%.

Current Target Funds Rate Is Between 1.5% and 1.75%

A Decision on Monetary Policy

By 2018, the Fed had realised the demand for reserves was going to prevent to require it to going back to its pre-crisis balance sheet size and officials discussed options for implementing monetary policy. Over the course of a number of meetings, the FOMC had a discussion about how to proceed, with lots of technical advice provided by its staff of economists and financial market experts. See the next slide. In January 2019, the FOMC announced: After extensive deliberations and thorough review of experience to date, the Committee judges that it is appropriate at this time to provide additional information regarding its plans to implement monetary policy over the longer run. Additionally, the Committee is revising its earlier guidance regarding the conditions under which it could adjust the details of its balance sheet normalization program. Accordingly, all participants agreed to the following. The Committee intends to continue to implement monetary policy in a regime in which an ample supply of reserves ensures that control over the level of the federal funds rate and other short-term interest rates is exercised primarily through the setting of the Federal Reserve’s administered rates, and in which active management of the supply of reserves is not required.

The Fed Staff’s Discussion of Two Options

November 2018 FOMC minutes.“The staff highlighted how changes in the determinants of reserve demand since the crisis could affect the tradeoffs between two types of operating regimes: (1) one in which aggregate excess reserves are sufficiently limited that money market interest rates are sensitive to small changes in the supply of reserves and (2) one in which aggregate excess reserves are sufficiently abundant that money market interest rates are not sensitive to small changes in reserve supply. In the former type of regime, the Federal Reserve actively adjusts reserve supply in order to keep its policy rate close to target. This technique worked well before the financial crisis, when reserve demand was fairly stable in the aggregate and largely influenced by payment needs and reserve requirements. However, with the increased use of reserves for precautionary liquidity purposes following the crisis, there was some uncertainty about whether banks’ demand for reserves would now be sufficiently predictable for the Federal Reserve to be able to precisely target an interest rate in this way. In the latter type of regime, money market interest rates are not sensitive to small fluctuations in the demand for and supply of reserves, and the stance of monetary policy is instead transmitted from the Federal Reserve’s administered rates to market rates–an approach that has been effective in controlling short-term interest rates in the United States since the financial crisis, as well as in other countries where central banks have used this approach.”

Why is Demand for Reserves So High?

Prior to the global financial crisis, banks generally had very low levels of reserve balances and yet now we are seeing a “shortage” at a time when the Fed has supplied $1.5 trillion to the system. What has changed? The answer is new liquidity regulation introduced after the global financial crisis, particularly the liquidity coverage ratio (LCR). The LCR requires banks to hold sufficient high-quality liquid assets (HQLA) to meet net cash outflows over a thirty-day stress period. In the US, HQLA include reserve balances held in a Federal Reserve account and Treasury securities, as well as some other assets. But if banks can hold Treasury bonds, why keep the money on reserve, which generally earns a lower interest rate? See the quote on the next page from a blog post by Cechetti and Schonholz:

Cechetti and Schonholz on Demand for Reserves

“Today, banks must hold significant liquid assets to back various sorts of short-term liabilities. The details of the Liquidity Coverage Ratio (LCR) are complex, but the basics are simple: banks need to hold some combination of reserves and U.S. Treasury securities to guard against deposit outflows in times of stress. That is, prior to going to the Fed to borrow, these new regulations envision that banks will use the liquid assets they have on hand to meet withdrawals. In practice, it turns out that banks prefer to hold reserves than securities to insure against the possibility of outflows. There are several reasons for this. First, if securities—even U.S. Treasuries—are sold quickly, it can drive prices down (something that banks’ own liquidity stress tests may assume). Second, everyone finds out when someone is selling securities under stress. If a bank uses reserves to meet withdrawals, only the Fed knows. The mix of liquidity considerations and the stigma from large Treasury sales makes reserves very attractive.

Paul Volcker and Monetarism: 1979-

Daily and weekly demand for reserves tends to be very volatile, as the large amounts of transactions moving around systems like on Fedwire or TARGET can create unpredictable shortages and excesses of reserves at individual banks. If central banks follow a monetarist policy and thus supply a fixed level of reserves, this can cause interest rates in money markets to move around a lot from day to day as some days lots of banks are seeking loans, forcing the interest rate up, while other days few banks are seeking loans and interest rates are low. During the period when monetarist policies were pursued in the US, the Federal Funds rate was highly volatile, moving around on a daily and monthly basis in a way that was not seen before or since. Similar volatility was seen in the UK during this period, as their government also adopted monetary policies.

October 1982: Abandoning Monetarism

In one sense, Volcker’s monetarist strategy was a success: US inflation fell rapidly after the implementation of monetary targeting. However, if one looks at the pattern for interest rates, this wasn’t too surprising. The Federal Funds rate reached about 20% on three different occasions between 1980 and 1982 and the US economy suffered a severe double-dip recession. By late 1982, with inflation conquered and interest rates high and volatile, Volcker became dissatisfied with the restrictions placed on him by monetary targeting, particularly because the link between the monetary base and M was proving to be so imprecise. Today, many believe that Volcker’s apparent embrace of monetarism was a tactical decision to avoid having to take direct responsibility for the high interest rates required to bring down inflation.