Thursday, August 16, 2018

Is the Fed's Floor Falling Out?


David Beckworth has a piece up at Alt-M arguing that Trump's fiscal policy is causing problems for the "floor" system the Fed now uses to implement monetary policy.  Under the floor system, the Fed sets the rate of interest it pays on bank reserves, and it can then keep the banking system flush with cash without overstimulating the economy, since banks will prefer to hold excess cash as reserves.  It only works if the interest rate on reserves is above the rate banks can earn in the private market, otherwise they will drain their reserves to buy other assets.  A loose fiscal policy, David argues, is raising market rates through Treasury borrowing, thereby making it hard to maintain the floor system.

I take a different view: the Fed's current predicament, I would argue, says only a little about current fiscal policy but a lot about past monetary policy.  In particular, it says that, contrary to much conventional market wisdom at the time, monetary policy was too tight during the zero interest rate period.  But I'll get to that.

First, let's ask: is the floor system really in danger? I would say, no, or rather, it is only in danger if the Fed doesn't really like it.  In principle there is no particular problem with continuing the floor system if the Fed wishes to do so.

The floor system always depends on having an adequate supply of base money.  If there's not enough base money, the market rate rises, and the intended floor is no longer binding.  How much base money is enough?  That's something the Fed has to make an educated guess about.  If it's expecting a normal fiscal policy and instead gets a big tax cut paired with a lot of new spending, then it will find that its educated guess was wrong and the required amount of base money is more than it expected.  That's what's happening now.

But the situation is easily remedied. If the Fed wishes to continue the floor system, it simply has to create more base money through open market operations.  Or alternatively, it can raise the interest rate on reserves so that it is no longer in danger of being below the market interest rate.  But the Fed doesn't seem inclined to do the latter: there is no particular sign that interest rate pressure from fiscal policy is causing it to adopt a faster schedule for raising rates.

And the Fed has good reason not to raise rates more quickly.  We can debate about the particulars, but overall the Fed sees no strong sign that the economy is about to overheat, and even if it did, there's a case for allowing the inflation rate to rise temporarily to compensate for years of undershooting the target.  But surely fiscal policy is stimulating the US economy.  Presumably the Fed feels that this stimulus is appropriate for now, and in the absence of such fiscal stimulus, the Fed would be providing its own stimulus by slowing the increases in the interest rate it pays on reserves.

And in that case it would end up in the same predicament it is in now.  Interest rates overall would be lower, but market interest rates would still be rising more quickly than the Fed's floor rate.

So what is special about the Fed's current predicament?  Why do people suggest that the floor system is in trouble, rather than just saying the Fed needs to create more base money through open market operations, as one would normally do when the current floor is becoming problematic?

I think the answer is clear: the Fed created so much base money via open market operations during the zero interest rate period—via the Large Scale Asset Purchases (LSAP's), or Quantitative Easing (QE), as they were commonly known—that it figured it wouldn't have to create much more any time in the near future. It's kind of like when I spend $400 at the supermarket and then think, "I'll never have to go shopping again." It always turns out that I have to resume my market operations sooner than expected.

The upshot is this: the Fed thought it was doing a huge, huge thing with those LSAP's, but with the benefit of today's hindsight, it turns out they weren't so huge.  (Despite my $400 grocery purchase, I'm already running out of sandwich bread, and I don't have time to go shopping today.)  The Fed could have done a lot more.  And maybe if it had done more, the recovery would have been faster.

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