Fed Operating Targets
The latest round of will-the-Fed-or-won’t-the-Fed-finally-hike-rates has passed. The world waited breathlessly for the Federal Reserve to announce their latest FOMC decision. Once again, the Fed punted on announcing another measly .25% funds rate hike and averted the perceived threat of economic calamity for another few months. The capital markets can hopefully breathe a sigh of relief until the next performance of Fed Kabuki theater in December. How did an innocuous interest rate that governs inter-bank lending, historically set by the market, evolve into a potential global economy slayer?
The Fed’s power exists through its ability to create base money. Traditionally, the Fed targets a specific indicator to decide when to create or extinguish base money. Until 1971 the Fed targeted the price of gold. After 1971 and under Milton Friedman’s monetarism, the Fed targeted monetary aggregates, either through the funds rate or directly. This resulted in the 70s great inflation, and Volcker abandoned monetary aggregate targeting in 1982. The Fed returned to funds rate targeting. Greenspan targeted the funds rate specifically throughout his tenure. Bernanke began his term targeting the funds rate until the 2008 financial crisis. After 2008 Bernanke began quantitative easing. Under QE the Fed targets the size of its balance sheet to achieve specific interest rate goals. The Fed buys treasury securities, agency debt, and agency mortgage-backed securities to lower the rate of interest across the yield curve. The Fed accounts for these purchases as assets on its balance sheet. The Fed’s balance sheet exploded in growth from $.8 trillion in 2008 to $4.4 trillion today in tandem with a collapse of yields across the curve.
The purpose of the Fed’s operating target is to match the supply of base money with demand. Regulatory law mandates a certain level of required reserves to act as a safety net for the banking system. All reserves, whether required or excess, entail maintenance fees. Banks cannot lend against required reserves. Therefore, it is in a bank’s interest to hold as few reserves as possible. Prior to 2008, banks last held excess reserves during the banking crisis of the Great Depression.
The explosion in the growth of the Fed’s balance sheet became possible because of Title II of the 2006 Financial Services Regulatory Relief Act. This granted the Fed authority, commencing October 1, 2011, to begin paying interest on reserves, IOR (which includes required and excess reserves) — “at a rate or rates not to exceed the general level of short-term interest rates.” After the 2008 crash, the Emergency Economic Stabilization Act passed on October 3, 2008, accelerated the Fed’s authority to pay interest on bank reserves. That authority became effective as of the new law’s passage, instead of as of October 1, 2011.
Excess reserves held by banks increased along with each iteration of QE, from $2.0 billion to $2.3 trillion today. This allowed the Fed to create virtually unlimited base money to drive the price of interest toward zero. The Fed creates money out of thin air to buy bonds, then pays banks not to lend it. Targeted bond purchases lower the price of interest. With excess reserves, there is no balance between supply and demand for base money. Any real decrease in base money does not decrease the supply relative to demand, but only excess reserves. Rate hikes that prior to 2008 affected the balance between supply and demand for base money are a misnomer under the Fed’s current monetary targeting. Stated Fed policy is to maintain its balance sheet at the current $4.4 trillion. As long as there are excess reserves, a rate hike will not tighten. The Fed must remove excess reserves first.
The only way the Fed can “hike rates” now is to correspondingly increase IOR. The Fed remits seigniorage profits, less its operation costs, to the Treasury, which offsets the deficit. IOR decreases Fed remittances to Treasury which increases the deficit by a like amount. With its current balance sheet of $4.4 trillion and a funds rate of .25 percent, the Fed is paying roughly $6.25 billion in IOR yearly. Each quarter point increase in the funds rate results in an additional $6.25 billion in IOR. U.S. subsidiaries of foreign banks are receiving half this amount. This is another political problem for an already politicized Fed. Rate hikes increase IOR payments to foreign banks. This increases the deficit. U.S. taxpayers then receive the tax bill for the Fed subsidizing foreign banks. Increasing the deficit on the back of the Fed-decimated middle class to give free money to venti size foreign banks is not information that the Fed desires the public to understand.
IOR is only available for depository institutions. The Fed doesn’t control money market funds, hedge funds, and the shadow banking system which do not receive Fed IOR. If the Fed tries to force the funds rate up, these institutions could lend below the Fed’s desired rate. The Fed has an answer for that.
Our Expanded Toolkit
“To put a more effective floor under short-term interest rates, the Federal Reserve created supplementary tools to be used as needed. For instance, the overnight reverse repurchase agreement (ON RRP) facility is available to a variety of counterparties, including eligible money market funds, government-sponsored enterprises, broker-dealers, and depository institutions. Through it, eligible counterparties may invest funds overnight with the Federal Reserve at a rate determined by the FOMC. Similar to the payment of IOER, the ON RRP facility discourages participating institutions from lending at a rate substantially below that offered by the Fed.”
Attempts to hike rates require massive Fed manipulation of depository institutions, money market funds, hedge funds, and the shadow banking system. The efficacy of Fed attempts to normalize rates using its expanded monetary toolkit is unknown and unproven. It is no wonder that the Fed uses a moving goal post of economic data to justify their inability to normalize rates. The Fed Ph.D academics have no explanation for this round of Keynesian failure except to double down again on their errant economic model. They have already floated the desperate trial balloons of negative interest rates and helicopter money. If only there was an equation that could save them.