Disney, Oklahma
October 22, 2022
I picked this photo of Paul Volcker (RIP) because his expression is exactly how I feel trying to understand what the Fed is doing to bring inflation down. I found the following two articles at the St.l Louis Fed's website. All I have gathered so far is that the Fed is using a new playbook this time -- not a comforting feeling for me.
While the media is covering all of the politics garbage, they could (should?) be educating us on economics -- oh, but would that take effort on our part?
Do you remember the economics course you took in high school or college? You might recall memorizing the three tools of monetary policy that help the Federal Reserve achieve its congressional mandate of maximum employment and price stability.
The [old/passe] story went something like this: The Federal Open Market Committee (FOMC), which is the main policymaking body of the Fed, sets a desired target for the federal funds rate (FFR) to move the economy toward the dual mandate. The Fed uses its monetary policy tools to influence the supply of money and credit in the economy. It does this primarily by using daily open market operations. When the Fed buys or sells U.S. government securities, it increases or decreases the level (or supply) of reserves in the banking system. (Reserves are the cash banks hold in their vaults plus the deposits they maintain at Federal Reserve banks, and reserves influence the supply of money and credit in the economy.)
Your textbook might have had a graph like the one below. In this model of the money market, the Fed could use open market operations — the purchase or sale of U.S. government securities — to shift the supply curve right or left (along the x-axis) and adjust the FFR lower or higher (along the y-axis).
And, your textbook probably mentioned two other tools — the discount rate and reserve requirements — and said that the Fed could increase or decrease either or both of these to influence bank lending, and thereby the growth of the money supply.
In retrospect, we now refer to that model as the “limited reserves” framework. Those are the old days.
The Financial Crisis Changed the Fed’s Toolbox
The Great Financial Crisis of 2007-09 changed a lot of things — including the way the Fed implements monetary policy. You see, in response to the financial crisis, the FOMC lowered its target for the federal funds rate to near zero, and increased the level of reserves from around $15 billion (in 2007) to over $2.7 trillion (in late 2014). That increase shifted the supply curve far to the right — to the horizontal part of the demand curve.
At this point, reserves were much more than “limited.” At the peak, people described the quantity of reserves in the banking system as abundant or even super abundant!
With this large quantity of reserves, making minor adjustments to the supply of reserves (shifting slightly to the left or right) would no longer be an effective way to adjust the FFR up or down. And it became clear that as the economy recovered from the financial crisis, the Fed would need to rely on new tools to raise the federal funds rate.
The Fed’s New Monetary Policy Tools
Now, let’s fast-forward to today. The Fed still uses the federal funds rate as its policy rate, but it has decided to keep an “ample” level of reserves in the banking system — meaning having the supply curve always on the flat portion of the demand curve. So, the Fed’s methods for adjusting the FFR have forever changed. [My question is why did the Fed decide to keep an "ample" level of reserves in the banking system?]
The Fed’s new framework, dubbed the “ample reserves” framework, uses new monetary policy tools to guide the FFR. The key tools are two “administered” rates (i.e., they are interest rates set by the Fed rather than determined in a market) to guide the federal funds rate within the FOMC’s target range:
Interest on reserves (IOR)
Overnight reverse repurchase agreement (ON RRP) rate
But let’s not get ahead of ourselves.
Understanding the process starts with understanding what banks do with their cash that they want to have available for short-term needs.
One option for banks is to lend the cash to other banks in the overnight federal funds market and earn the FFR. The FFR is determined between the borrower and lender in the federal funds market, and it also serves as the Fed’s policy rate — the interest rate the Fed targets to communicate and set the stance (position) of monetary policy.
The Primary New Tool: Interest on Reserves
But banks have other options when seeking a return for their cash. They can deposit it into their reserve account at the Fed and earn interest on reserves (IOR). Because IOR offers banks a risk-free option, it serves as a reservation rate — the lowest rate a lender is willing to accept when lending funds.
As a result, the FFR should not fall below the IOR rate. If for some reason the FFR fell below IOR, banks could borrow at the FFR and deposit the reserves at the Fed (earning the IOR rate) to earn a profit. This arbitrage activity should ensure that the FFR won’t fall very far below the IOR rate and links the rates together. Because the IOR rate is an administered rate, the Fed can nudge the level of the market-determined federal funds rate by adjusting the setting of interest on reserves. In the ample reserves framework, IOR is now the primary tool the Fed uses to adjust the FFR.
So, the first new tool, and also the primary tool of monetary policy, is interest on reserves, or IOR.
A New Supplementary Tool: ON RRP Rate
Now, there is a small complication. Not every financial institution that operates in the federal funds market has access to interest on reserves. So, the FFR could fall below the setting of the IOR rate.
To aid in the control of the level of the FFR, the Fed introduced the overnight reverse repurchase agreement (ON RRP) facility to a broad set of financial institutions. When an institution uses the ON RRP facility, it essentially deposits reserves at the Fed overnight, receiving a government security as collateral. The next day the transaction is “unwound” — the Fed buys back the security, and the institution earns the ON RRP rate on the cash it deposited at the Fed.
Because this is a risk-free investment option, the institutions will likely never be willing to lend funds in any market for lower than the ON RRP rate. And, if similar short-term rates fell too far below the ON RRP rate, institutions would borrow at those lower rates and deposit this cash at the ON RRP facility to earn the ON RRP rate.
These forces link the ON RRP rate to other short-term rates, including the FFR. Because many large nonbank financial institutions have access to the Fed’s ON RRP facility and the ON RRP rate is set below the IOR rate, the ON RRP rate serves as a supplementary policy tool and acts like a floor for the FFR.
So, the second new tool, which supplements IOR, is the overnight reverse repurchase agreement (ON RRP) rate.
How Do the Fed’s New Policy Tools Work Together?
The graph below shows how the new tools work. In the ample reserves framework, the Fed moves the federal funds rate up and down by adjusting its administered rates — IOR and ON RRP rates, along with the discount rate (see the table below) — higher and lower.
By this time, you’ve got it figured out, but let’s be clear: The Fed no longer uses daily open market operations to adjust the federal funds rate.
While open market operations are used to ensure that the level of reserves remains ample, interest on reserves is the primary tool for adjusting the FFR higher and lower. And the ON RRP rate acts as a floor; it is a supplementary tool.
But where does that leave the other tools? The table below identifies the role of the old tools, as well as new tools.
Conclusion
To sum up, the Fed has a congressional mandate of maximum employment and price stability. It has, for decades, used the setting of the FFR to steer market interest rates in a way that households’ and businesses’ spending and investment decisions move the economy toward the Fed’s dual mandate.
But there has been a big change in the tools that the Fed uses to ensure interest rate control. Today, the Fed uses its administered rate of IOR as its primary tool to move market rates up and down. If the economy loses momentum, for example, the FOMC will lower the target for the FFR and the Fed will lower all its administered rates, which include IOR. This lower setting of the administered rates encourages market interest rates to also decline.
Of course, in severe economic downturns, like the one during the COVID-19 pandemic, the Fed can take other actions to support the economy in addition to lowering interest rates. Some of these tools are only used in “unusual and exigent circumstances” and need the approval of the Secretary of Treasury. These tools are the topic of our next blog post.
More to Explore
Federal Reserve Board of Governors’ Finance and Economics Discussion Series: The Fed’s “Ample Reserves” Approach to Implementing Monetary Policy
Page One Economics: The Fed’s New Monetary Policy Tools
FRED Blog: Fixing the “Textbook Lag” with FRED (Part I): Monetary Policy in a World of Ample Reserves
FRED Blog: Fixing the “Textbook Lag” with FRED (Part II): Monetary Policy in a World of Ample Reserves
Getting Ahead of U.S. Inflation: A Lesson from 1974 and 1983 June 28, 2022 By James Bullard
The Federal Reserve has a mandate to promote stable prices for the U.S. economy as well as maximum employment. Consistent with the price stability part of that mandate, the Federal Open Market Committee (FOMC) has set an inflation target of 2%, as measured by the year-over-year percentage change in the price index for personal consumption expenditures (PCE).
Inflation in the U.S. is currently running far above the Fed’s 2% target and is at levels last seen in the 1970s and early 1980s. The FOMC faced inflation levels in 1974 and 1983 that were similar to today’s inflation rate, but its policy responses were very different in the two episodes. Consequently, the results were also quite different. The contrast between the 1974 and 1983 experiences has convinced many that it is important to “get ahead” of inflation—a lesson that is valuable today.
There are multiple demand and supply factors contributing to today’s high inflation, but this article focuses on reviewing the Fed’s actions during previous high inflationary periods as a guide to informing the Fed’s actions in the current situation.
Above-Target Inflation
Headline PCE inflation was 6.3% in April 2022 after hitting 6.6% in March. Because of large movements in food and energy prices, we can look at the core PCE inflation rate, which excludes those two components and is a widely watched measure of underlying inflation. Core PCE inflation exceeded 5% earlier this year—coming in at 5.1% in January, 5.3% in February and 5.2% in March—though it declined to 4.9% in April.
Thus, even after excluding food and energy prices, inflation in recent months has been comparable to levels the FOMC confronted in 1974 and 1983. This can be seen in the figure below, which shows core PCE inflation from 1960 to the present.
Monetary Policy in 1974
In 1974, the FOMC focused on nonmonetary factors affecting inflation—such as government budget deficits, oil price shocks, and “excessive” price and wage increases by firms and labor unions—as opposed to monetary policy. It kept the policy rate relatively low, even in the face of rising inflation. As a result, the ex-post real interest rate (e.g., the one-year Treasury bill rate minus the inflation rate) was exceptionally low, similar to today’s ex-post real interest rate.
What followed was high and variable inflation over the next decade. Core PCE inflation remained above 5% for about 10 years, and it was nearly 10% twice during that period (in late 1974 to early 1975 and again in late 1980 to early 1981). In addition, the real economy was volatile, in part because high inflation distorts price signals, which can hamper real economic activity. Consequently, the U.S. experienced three recessions from the mid-1970s to the early 1980s.
Monetary Policy in 1983
In 1983, the FOMC took a different approach to monetary policy. The 1983 FOMC focused more on monetary factors affecting inflation and consequently kept the policy rate relatively high, even as inflation declined. In this case, the associated ex-post real interest rate was very high.
The FOMC’s policy in 1983 proved to be successful. Core PCE inflation remained below 5% for the next decade, and the real economy stabilized. One might have expected the high real interest rates to cause a recession, but that didn’t happen. The U.S. experienced a robust expansion during the remainder of the 1980s and didn’t have a recession until 1990-91.
The Lesson from 1974 and 1983
The lesson from these two different approaches to monetary policy is the importance of staying ahead of—rather than getting behind—inflation. In particular, the takeaway is that getting ahead of inflation will keep inflation low and stable and promote a strong real economy.
In the 1990s, the FOMC stayed ahead of inflation as it tightened monetary policy following the 1990-91 recession. From early 1994 to early 1995, the FOMC raised the policy rate by 300 basis points (going from 3% to 6%) in an environment where inflation was generally moderate. Similar to the 1983 experience, the associated ex-post real interest rate at that time was high. Again, the result was not a recession but instead an expansion, which lasted until 2001. In fact, one of the best periods for economic growth and labor market performance in the entire post-World War II era occurred in the second half of the 1990s.
Monetary Policy Today
These three experiences provide useful guidance for today’s monetary policymakers, namely that the approaches of 1983 and 1994 are better examples to follow. In those cases, the FOMC kept the policy rate relatively high above the inflation rate, and therefore real interest rates were relatively high. The subsequent macroeconomic performance—with respect both to inflation and to output and labor markets—was very good, which shows the merits of staying ahead of inflation as opposed to falling behind.
Today’s FOMC has taken important first steps to return inflation to target. Specifically, the FOMC has raised the policy rate by 150 basis points so far in 2022 and begun to reduce the size of the Fed’s balance sheet through the roll-off of maturing securities.1 Furthermore, its forward guidance that additional policy rate increases are likely in coming months is a deliberate step to help the FOMC more quickly move policy as necessary to bring inflation back in line with the Fed’s 2% target.
Note
While the impact of the balance sheet reduction is uncertain, Fed Governor Chris Waller provided one estimate in his speech on May 30, 2022. He asserted that the current pace of balance sheet runoff is roughly equivalent to a couple of 25-basis-point increases in the policy rate.
Comments