In our previous post, we highlighted Ben Bernanke’s testimony on the Hill today, and below is a full excerpt from the Fed’s most recent monetary policy report—this is the section discussing what they plan to do with rates as the economy recovers.
Monetary Policy as the Economy Recovers
At present, the focus of monetary policy is on stimulating economic activity in order to limit the degree to which the economy falls short of full employment and to prevent a sustained decline in inflation below levels consistent with the Federal Reserve’s legislated objectives. Economic conditions are likely to warrant accommodative monetary policy for an extended period. At some point, however, economic recovery will take hold, labor market conditions will improve, and the downward pressures on inflation will diminish. When this process has advanced sufficiently, the stance of policy will need to be tightened to prevent inflation from rising above levels consistent with price stability and to keep economic activity near its maximum sustainable level. The FOMC is confident that it has the necessary tools to withdraw policy accommodation, when such action becomes appropriate, in a smooth and timely manner.
Monetary policy actions taken over the past year have led to a considerable increase in the assets held by the Federal Reserve. This increase in assets reflects both the expansion of Federal Reserve liquidity facilities and the purchases of longer-term securities. On the margin, the extension of credit and acquisition of assets by the Federal Reserve has been funded by crediting the reserve accounts of depository institutions (henceforth referred to as banks). Thus, the increase in Federal Reserve assets has been associated with substantial growth in banks’ reserve balances, leaving the level of reserves far above that typically observed when short-term interest rates were significantly greater than zero.
To some extent, a contraction in the stock of reserve balances will occur automatically as financial conditions improve. In particular, most of the liquidity facilities deployed by the Federal Reserve in the current period of financial turmoil are priced at a premium over normal interest rate spreads or have a minimum bid rate that is high enough to make them unattractive under normal market conditions. Thus, the sizes of these programs, as well as the stock of reserve balances they create, will tend to diminish automatically as financial strains abate. Indeed, as noted elsewhere in this report, total credit extended to banks and other market participants (excluding support of critical institutions) declined from about $1.5 trillion as of December 31, 2008, to less than $600 billion as of July 15, 2009, as financial conditions improved. In addition, redemptions of the Federal Reserve’s holdings of agency debt, agency MBS, and longer-term Treasury securities are expected to occur at a rate of $100 billion to $200 billion per year over the next few years, leading to further reductions in reserve balances.
But even after lending facilities have wound down and holdings of long-term assets have begun to run off, the volume of assets on the Federal Reserve’s balance sheet may remain very large for some time. Without additional actions, the level of bank reserves would continue to remain elevated as well.
Despite continued large holdings of assets, the Federal Reserve will have at its disposal two broad means of tightening monetary policy at the appropriate time. In principle, either of these methods would suffice to raise short-term interest rates; however, to ensure effectiveness, the two methods will most likely be used in combination.
The first method for tightening monetary policy relies on the authority that the Congress granted to the Federal Reserve last fall to pay interest on the balances maintained by banks. By raising the rate it pays on banks’ reserve balances, the Federal Reserve will be able to tighten monetary policy by inducing increases in the federal funds rate and other short-term market interest rates. In general, banks will not supply funds to the money market at an interest rate lower than the rate they can earn risk free at the Federal Reserve. Moreover, they should compete to borrow any funds that are offered in the market at rates below the rate of interest paid by the Federal Reserve, as such borrowing allows them to earn a spread without any risk. Thus, raising the interest rate paid on balances that banks hold at the Federal Reserve should provide a powerful upward influence on short-term market interest rates, including the federal funds rate, without the need to drain reserve balances. A number of foreign central banks have been able to maintain overnight interbank interest rates at or above the level of interest paid on bank reserves even in the presence of unusually high levels of reserve balances (see the box titled “Foreign Experience with Interest on Reserves”).
Despite this logic, the federal funds rate has been somewhat lower than the rate of interest banks earn on reserve balances; the gap was especially noticeable in October and November 2008, when payment of interest on reserves first began. This gap appears to have reflected several factors: First, the Federal Reserve is not allowed to pay interest on balances held by nondepository institutions, including some large lenders in the federal funds market such as the government-sponsored enterprises (GSEs). Such institutions may have an incentive to lend at rates below the rate that banks receive on reserve balances. Second, the payment of interest on reserves was a new policy at the time that the gap was particularly noticeable, and banks may not have had time to adjust their operations to the new regime. Third, the unusually strained conditions in financial markets at that time may have reduced the willingness of banks to arbitrage by borrowing in the federal funds market at rates below the rate paid on reserve balances and earning a higher rate by increasing their deposits at the Federal Reserve. The latter two factors are not likely to persist, particularly as the economy and financial markets recover. Moreover, if, as the economy recovers, large-scale lending in the federal funds market by nondepository institutions threatens to hold the federal funds rate below its target, the Federal Reserve has various options to deal with the problem. For example, it could offer these institutions the option of investing in reverse repurchase agreements. Under these transactions, the Federal Reserve sells securities from its portfolio, thereby removing funds from the market, and agrees to buy back the securities at a later date.15 Eliminating the incentive of nondepository institutions to lend their excess funds into short-term money markets would help ensure that raising the rate of interest paid on reserves would raise the federal funds rate and tighten monetary conditions even if the level of reserve balances were to remain high.
The second method for tightening monetary policy, despite a high level of assets on the Federal Reserve’s balance sheet, is to take steps to reduce the overall level of reserve balances. Policymakers have several options for reducing the level of reserve balances should such action be desired. First, the Federal Reserve could engage in large-scale reverse repurchase agreements with financial market participants, including GSEs as well as other institutions. Reverse repurchase agreements are a traditional tool of Federal Reserve monetary policy implementation. Second, the Treasury could sell more bills and deposit the proceeds with the Federal Reserve. The Treasury has been conducting such operations since last fall; the resulting deposits are reported on the Federal Reserve balance sheet as the Supplementary Financing Account. One limitation on this option is that the associated Treasury debt is subject to the statutory debt ceiling. Also, to preserve monetary policy independence, the Federal Reserve must ensure that it can achieve its policy objectives without reliance on the Treasury if necessary. A third option is for the Federal Reserve to offer banks the opportunity to hold some of their balances as term deposits. Such deposits would pay interest but would not have the liquidity and transactions features of reserve balances. Term deposits could not be counted toward reserve requirements, nor could they be used to avoid overnight overdraft penalties in reserve accounts.16 Each of these three policy options would allow a tightening of monetary policy by draining reserve balances and raising short-term interest rates. As noted earlier, measures to drain reserves will likely be used in conjunction with increases in the interest rate paid on reserves to tighten conditions in short-term money markets.
Raising the rate of interest on reserve balances and draining reserves through the options just described would allow policy to be tightened even if the level of assets on the Federal Reserve’s balance sheet remained very high. In addition, the Federal Reserve retains the option to reduce its stock of assets by selling off a portion of its holdings of longer-term securities before they mature. Asset sales by the Federal Reserve would serve to raise short-term interest rates and tighten monetary policy by reducing the level of reserve balances; in addition, such sales could put upward pressure on longer-term interest rates by expanding the supply of longer-term assets available to investors. In an environment of strengthening economic activity and rising inflation pressures, broad-based increases in interest rates could facilitate the achievement of the Federal Reserve’s dual mandate.
In short, the Federal Reserve has a wide range of tools that can be used to tighten the stance of monetary policy at the point that the economic outlook calls for such action. However, economic conditions are not likely to warrant a tightening of monetary policy for an extended period. The timing and pace of any future tightening, together with the mix of tools employed, will be calibrated to best foster the Federal Reserve’s dual objectives of maximum employment and price stability.
Foreign Experience with Interest on Reserves
Paying interest on excess reserve balances, either directly or by allowing banks to place excess balances into an interest-bearing account, is a standard tool used by major foreign central banks. Many have used interest on reserves, in combination with other tools, to maintain a floor under overnight interbank interest rates both in normal circumstances and during the period of financial turmoil. The European Central Bank (ECB), for example, has long allowed banks to place excess reserves into a deposit facility that pays interest at a rate below the ECB’s main refinancing rate (its bellwether policy rate). The quantity of funds that banks hold in that facility increased sharply as the ECB expanded its liquidity-providing operations last fall and has remained well above pre-crisis levels; as a result, the euro-area overnight interbank rate fell from a level close to the main refinancing rate toward the rate the ECB pays on deposits–but, importantly, not below that rate. Since November 2008, the Bank of Japan (BOJ) on a temporary basis has paid interest on excess reserve balances, at a rate of 10 basis points per year, which is also its current target for the overnight uncollateralized call rate; the BOJ noted that its action was intended to keep the call rate close to the targeted level as it supplied additional liquidity to the banking system. Indeed, the overnight rate has traded near 10 basis points in recent months, even as reserve balances at the BOJ have risen substantially, returning to their level during much of 2002, when the BOJ was implementing its Quantitative Easing Policy and the call rate was trading at 1 basis point or below. The Bank of Canada and the Bank of England also have used their standing deposit facilities to help manage interbank interest rates.