Modern Monetary Policy Tools in “ample” reserve framework

The definition of Monetary Policy can be summarised as “ the policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by‧‧‧

The definition of Monetary Policy can be summarised as “ the policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often as an attempt to reduce inflation or the interest rate to ensure price stability and general trust of the value and stability of the nation’s currency”. We all know (or we should know) that the US monetary authority, The Fed, can use four tools to achieve its monetary policy goals: the discount rate (the interest rate Reserve Banks charge commercial banks for short-term loans), reserve requirements (the portions of deposits that banks must hold in cash, either in their vaults or on deposit at a Reserve Bank), open market operations (the buying and selling of U.S. government securities), and interest on reserves (interest on reserves is paid on excess reserves held at Reserve Banks). All four affect the amount of funds in the banking system. The Federal Reserve has a Congres­sional mandate to promote maximum employment and price stability. Before the Financial Crisis of 2007-09, the Fed implemented monetary policy with limited reserves in the banking system and relied on open market operations as its key tool. Today, the Fed implements monetary policy with ample reserves and relies on one of its administered rates, interest on reserves (IOR), as its primary tool. In response to economic and financial conditions in 2008, the Federal Reserve lowered the FFR target to near zero and it also shifted from setting a single FFR target to setting a FFR target range. But even with that low range, the economy still needed more stimulus. As a result, between 2008 and 2014 the Fed conducted a series of large-scale asset-­purchase programs to lower longer-term interest rates, ease broader financial market conditions, and thus support economic activity and job creation. These purchases not only increased the Fed’s level of securities holdings but also increased the total level of reserves in the banking system from around $15 billion in 2007 to about $2.7 trillion in late 2014. The Financial Crisis therefore resulted in the implementation of IOR as the most significant new monetary policy tool. As the economy recovered from the Great Recession, the Fed took steps to reduce the supply of reserves from its peak in October 2014 of about $2.7 trillion. Over the next few years, the Fed reduced reserves to about $1.7 trillion. When there is a large quantity of reserves in the banking system, the Federal Reserve can no longer influence the FFR by making relatively small changes in the supply of reserves. That is, because the supply curve intersects the flat (horizontal) portion of the demand curve, small shifts in the supply curve to the right or left will not move the FFR higher or lower. Rather the Fed uses its administered rates, which include the IOR rate and the overnight reverse repurchase agreement (ON RRP) rate, to influence the FFR. Because IOR makes cash deposited at the Fed a risk-free investment option, banks are unlikely to lend reserves in the federal funds market for less than the IOR rate. Arbitrage ensures that the FFR does not fall much below IOR. However, not all institutions with reserve accounts can earn interest on their deposits at the Federal Reserve and not all important institutions in financial markets are allowed to have an account at the Fed. This leaves the possibility that important short-term rates (including the FFR) might drop below the IOR rate. So, in 2014, the FOMC announced that it intended to use the ON RRP facility to help control the FFR. As such, the ON RRP rate acts as a reservation rate and institutions can use it to arbitrage other short-term rates. Thus, the rate paid on ON RRP transactions, which is set below the IOR rate, acts like a floor for the FFR and serves as a supplementary policy tool. The Fed’s response to the COVID-19 pandemic has been similar to its response to the Financial Crisis of 2007-09. The Fed has lowered the FFR target range to 0 to 25 basis points; lowered the IOR and ON RRP rates to near zero; and taken other, often unconventional, actions to help markets function, support credit flows to households and businesses, and lower longer-term interest rates. The majority of the Fed’s special facilities enabled it to buy, lend, or swap less-liquid financial assets in return for reserves. Now, as during the Financial Crisis of 2007-09, these actions have shifted the supply curve and resulted in reserves becoming quite abundant. Though these actions were quite quick and substantial, implementation of monetary policy remained smooth as the Fed continued to operate in its existing (ample-­reserves) implementation framework. The use of large-scale asset purchases or emergency credit programs needed during these times results in very large increases in reserves in the banking system. Only one of the two frameworks would be able to implement such policies. A limited-reserves framework would no longer be functional. When reserves became super abundant the Fed must shift to operating in an ample-reserves framework, using IOR as the key tool.


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