For the Fed, simplicity is the best policy

Setting interest rates doesn’t require restricting the supply of money

John H. Cochrane

The Grumpy Economist

John H. Cochrane | May 23, 2019

Sections Economics Public Policy

Collections Monetary Policy

The Fed’s most well-known function is to set interest rates. But how does the Fed set interest rates? Our central bank is undergoing a big review of this question, the answer to which could have major implications for the banking industry and financial stability more generally. 

The two main instruments the Fed has for setting interest rates are the rate it pays on reserves and the supply of those reserves. (Reserves are the money that banks keep in their accounts at the Fed. The Fed sets the interest rates on such accounts.) 

How big should the balance sheet be?

The biggest question the Fed is asking right now is how big its supply of reserves should be. The graph below plots the demand for reserves as a function of the interest rate on other short-term assets, and the three main possibilities for supply. 

How big should the Fed’s supply of reserves be?

This diagram illustrates three approaches to how the Fed could consider banks’ demand for reserves in relation to interest rates on other similar assets.

A Corridor system
The Fed puts the supply of reserves in the downward-sloping part of the demand curve and tries to place the interest rate in the middle of a range it wants to target.

B Minimum floor system
The Fed maintains the supply of reserves at the smallest level consistent with satiation in reserves, where the demand curve just hits the floor.

C Abundant floor system
The Fed maintains a large supply of reserves, well beyond where the demand curve hits the lower bound.

The demand curve: if the interest rate on similar assets (overnight federal funds, Libor, repo rates) is above the interest rate on reserves, banks should want to get rid of reserves to invest in those better-paying alternatives. However, reserves are useful, as money is useful, so banks are willing to hold some reserves, even when they lose interest on reserves by doing so. The greater the interest costs—the difference between the rate banks can lend at and the rate they get on reserves—the harder they work to avoid holding reserves. In the end, there are legal and regulatory requirements to hold reserves.

Supply: the Fed currently fixes the supply of its reserves, a decision sometimes referred to as the “size of its balance sheet.” The balance sheet shows the Fed’s assets (e.g., Treasury debt) against liabilities (reserves and cash). Yes, the Fed is nothing more than an enormous money-market fund, offering fixed-value floating-rate accounts, which it backs by Treasuries and other securities. The Fed raises the supply of reserves by buying assets such as Treasuries and “printing money” (i.e., creating reserves) in return for the assets.

The graph’s vertical lines are three possibilities for where the Fed should set its supply—the leftmost representing supply in what’s called a corridor system, and the others representing the two options for what’s called a floor system. Let’s unpack these ideas a bit.

In a floor system, represented by the two supplies on the right, banks are satiated in reserves. Reserves don’t have any marginal liquidity value, but banks are happy to hold arbitrary quantities as an asset so long as the interest on reserves is above or equal to what they can get elsewhere.

The interest rate the Fed pays on reserves can control other interest rates in the economy. If banks could borrow at less than the interest on reserves, they would do so and demand infinite amounts of reserves. Therefore, competition among banks should drive other interest rates up to the interest on reserves. Similarly, if banks can lend at rates higher than the interest on reserves, banks should compete to lend, driving other rates down to the interest on reserves. Therefore, the Fed, by setting the interest on reserves, sets the overall level of overnight interest rates.

There are two floor-system variants: abundant reserves, with the supply of reserves well to the right, and minimalist reserves, with the supply set to the smallest possible level, where the reserve demand curve just hits the lower bound of satiation in reserves. The latter seems to be where the Fed is heading—a minimal-reserves floor system.

Why is whatever the Fed was doing in 2007 normal? Why is it good?

The alternative to a floor system is a corridor system, in which the Fed has an upper and lower band for the market interest rates it wants to target. Historically, the Fed targeted the federal funds rate, which is the rate at which banks lend reserves to each other overnight. The Fed tried to place that interest rate in the middle of the band by artfully putting the supply of reserves in the downward-sloping part of the demand curve. This is how the Fed operated before 2008.

But, given that the interest rate on reserves determines market interest rates, why bother with the corridor? It’s a bit like trying to slow down a car by starving it of oil rather than easing up on the gas pedal. 

I think the deepest economic argument for a corridor is the feeling that it is important for the central bank to limit the supply of money, and not purely to target interest rates, in order to guarantee price stability. Starting with Milton Friedman in the mid-1960s, it was thought that controlling the money supply was crucial to controlling inflation. Friedman argued against a pure interest-rate peg, saying inflation would spiral out of control. 

But money supply has disappeared from more recent economic thinking about inflation. My preferred model of the world (the fiscal theory of monetary policy) has an interest-rate target, which sets expected inflation, and fiscal theory, which sets unexpected inflation. Money is not needed. The standard Keynesian and New Keynesian models that have dominated the profession for three decades make no mention of monetary control other than what is implicit via an interest-rate target. To stabilize inflation, it is enough that the Fed controls interest rates, and raises or lowers rates appropriately. (At most, expanding the balance sheet helps when interest rates hit the zero bound, but the discussion now is about what to do in normal times away from the bound.) The past eight years of completely stable inflation with a flood of reserves, despite dire predictions of a deflation spiral or monetary hyperinflation, thoroughly confirm the point. 

Now, one should always distrust the latest fashions in economic models, and one should innovate slowly on historically successful policies. I understand how one can be nervous about casting off any pretense of monetary control and counting entirely on an interest-rate target to control inflation, no matter how much talk and modeling has gone that way since about 1982, when the Fed abandoned money targets in favor of explicit interest-rate targets.

On the other hand, I don’t know of any written model in which an interest-rate target and something like a vertical reserve supply interact to produce a determinate price level. So a desire to control reserves is a historical memory rather than an old and coherent theory.

Once the Fed resolves the broader question of corridor versus minimalist floor versus abundant floor, a few additional questions follow:

  1. If there is going to be a corridor, which rate should the Fed care about? The (justly) moribund federal funds rate? (Banks holding abundant reserves don’t actively borrow and lend money from each other anymore.) The overnight general collateral repo rate? Libor? One advantage of the abundant floor is that the Fed can stay quiet about all this and let the market sort out just what kind of overnight lending it prefers.
  2. If there is a band, how wide should the range be between the upper and lower bounds? 1 percent? 0.5? 0.25? 0.01 percent?
  3. How free should lending and borrowing from the Fed be? Who gets access to interest-paying reserves, and how much interest do they get? Who can borrow reserves, and on what terms—what collateral is acceptable, is it overnight or term borrowing, and does such borrowing incur formal regulatory attention or informal “stigma”?
  4. What assets should the Fed buy on the other side of the balance sheet, or accept as collateral if it lends reserves? Just short-term Treasuries? The current mix of long-term Treasuries and mortgage-backed securities? Or, perhaps, should it follow the European Central Bank and Bank of Japan and buy corporate bonds and stocks, many countries’ debts, or lend newly created reserves to banks and count the loans as assets?

There’s a tendency to refer to a reversion to prerecession policy as normalization, but that’s a pretty meaningless economic term to me. Why is whatever the Fed was doing in 2007 normal? Why is it good? 

Abundance and beyond

I like the floor system with abundant reserves. The great lesson of the past 10 years is that we can have money that pays full interest, so that holding money has no opportunity cost, and this will not cause inflation. This is genuinely new economic knowledge. Liquidity is free! There is no need for people to waste time and effort on cash management. Liquidity is good for financial stability too: banks holding huge reserves don’t fail.

I go beyond the abundant floor: the Fed should not target the supply of reserves at all. The supply curve of reserves should be horizontal. The Fed should just say, “Bring us your Treasuries, and we’ll give you reserves and pay the IOER (interest on excess reserves) rate.” Or, “Bring us your reserves, and you can have Treasuries.”

Why? Well, if you want to target a price, you offer to buy and sell freely at that price. If you want to target an interest rate, target an interest rate and transact freely at that rate. 

I see no economic or financial harm from arbitrary expansion of the Fed’s balance sheet, as long as the assets are all short-term Treasuries. Reserves are just overnight, electronically transferable government debt. If the banking system wants more overnight debt and less three-week to six-month debt, let it have what it wants. I see no reason to artificially starve the economy of overnight debt. The Fed offers free exchange between cash and reserves; the government as a whole should offer free exchange between short-term Treasuries and overnight Treasuries (i.e., reserves).

To accommodate the economy’s desire for ample reserves, and the Fed’s desire not to provide them, the Treasury Department should offer the same asset, and the Fed should encourage this and work with the department to make it happen. 

Specifically, the Treasury should issue overnight, fixed-value ($1), floating-rate, electronically transferable debt. Let’s call it Treasury electronic money. Legally, this would be Treasury debt that any individual or financial institution can hold, just as they can hold Treasury bills or Treasury coins. Functionally, these would be interest-paying reserves. Like reserves, but unlike T-bills, these could be bought or sold immediately: owners could transfer their ownership of Treasury money to someone else on the Treasury website, and could sell Treasury money and have the money wired (i.e., the Treasury Department would send an equivalent amount of reserves to the owner’s bank) instantly.

Given the Fed’s resistance to narrow banking, and the potential for Treasury electronic money to undercut banks’ (subsidized) deposit financing, I suspect the Fed’s first instinct would be to fight such an innovation. But the Fed should welcome a solution to the problem of providing lots of liquid assets without the downsides it sees in a large balance sheet.

As for the asset side of the Fed’s balance sheet, this is one area where the banner of normalization should be employed to its full effect: assets should return quickly to short-term Treasuries only. In my ideal world, the Fed would hold only Treasury electronic money. 

The Fed holds a much different portfolio now. In the various emergency support operations of 2008–09, the Fed first bought toxic assets and commercial paper. In quantitative-easing operations, it bought long-term Treasuries and mortgage-backed securities. Other central banks are buying corporate bonds, stocks, and sovereigns. All of these operations are designed to push the asset prices around, and have basically nothing to do with the supply of reserves.

But buying assets other than short-term Treasuries carries a great political risk, which central banks around the world are now confronting. If the Fed can “print money” to buy long-term government bonds, and to fund mortgages, without inflation; if the ECB can “print money” to buy dodgy government debt and corporate bonds without inflation; if the BOJ can “print money” to buy stocks without inflation, why not expand this piñata, and fund every congressperson’s pet project by printing ever more money? “Modern monetary theory” has already arisen to justify this vast expansion. (The answer is, since reserves pay interest, such purchases are exactly the same as regular issues of government debt, and will indeed cause inflation if they are not paid with future taxes.) 

For this reason, the Fed should quickly limit itself to buying short-term Treasuries. Other assets should be on the balance sheet in emergencies only, and then swiftly sold or transferred to the Treasury. The Fed needs to commit to that policy so that it can tell Congress, “Yes, you’d like us to fund Green New Deal investments, but we have a firm rule: we buy only short-term Treasuries.”

If the Fed feels the need to buy long-term Treasuries or take them as collateral, issuing reserves in return, because of a shortage of safe assets, it means that the Treasury has not issued enough short-term liquid Treasuries. That’s an easy problem for the Treasury to fix without opening this Pandora’s box. 

Keep it simple, Fed: a floor with abundant reserves, or better yet a very narrow band with a flat supply curve. An all-Treasuries balance sheet. And a commitment to resist the temptation to micromanage.

John H. Cochrane is a senior fellow at the Hoover Institution at Stanford University and distinguished senior fellow at Chicago Booth. This essay is adapted from a post on his blog, The Grumpy Economist.