Plosser proposes a new Accord between the Fed and the Treasury, which would limit the normal range of monetary policy interventions to standard discount window lending and purchases of Treasury securities. This Accord would put unusual interventions, such as the ones undertaken by the Fed during the financial crisis, under the Treasury's authority. This seems like a useful idea, as it would clearly delimit what is fiscal, and what is monetary policy, in the United States. Over the last two years, those distinctions have become blurred, to the point where it is not clear whether the Fed is taking a particular action because that action is sound monetary policy, or because it is a vehicle for taking some activity off the Treasury's balance sheet. As a case in point, consider the Supplementary Financing Program, which has been in place since September 2008. Currently, the Treasury still holds about $200 billion under this program. The idea is that the Treasury issues T-bills, and deposits the proceeds in its reserve account with the Fed. The Fed's statement makes it seem that this is just a reserve-draining operation - the Treasury is simply moving reserves from the accounts of private financial institutions to its own account. In terms of the consolidated government balance sheet vs. the private sector's consolidated balance sheet, an increase in the Treasury's supplementary reserves reduces outside money outstanding and increases T-bills outstanding. Under current circumstances, the effect is essentially nil, but in any event the Fed could accomplish the same thing by selling T-bills. However, note that the Fed only has about $18 billion in T-bills on its balance sheet currently. It could sell long-maturity Treasuries or MBS though, but apparently it does not want to do that. The clearest explanation for what is going on is that the supplementary financing is not reserve-draining, but an agreement between the Fed and the Treasury to shorten the average maturity of Treasury debt held by the private sector. This has more to do with traditional fiscal policy than with traditional monetary policy.
Now, where Plosser's speech takes an odd turn is in his discussion of interest on reserves. The key section of interest is:
Yet, many overlook that paying IOR ties together the central bank’s balance sheet and the government’s budget constraint, since the interest is financed by government revenues. This may come at the cost of central bank independence.I think this is goofy. First, we know that paying interest on reserves in general increases economic efficiency. The ECB and the central banks of Canada, Australia, and New Zealand, have been paying interest on reserves for some time. Second, the fact that paying interest on reserves has implications for the revenue that the Fed returns to the Treasury makes this element of policy no different from another other dimension of monetary policy. Actions by the Fed consist of changing administered interest rates (the discount rate and the interest rate on reserves) and buying or selling assets. All of these actions will make a difference to the Fed's income statement, and will matter in some way for fiscal policy. Monetary policy and fiscal policy are intertwined, and paying interest on reserves does not make the monetary and fiscal arms of policy any less or more interdependent. Third, the "floor system" that Plosser describes does not have the property that "...an unlimited amount of reserves are available at the IOR-policy rate." Indeed, the floor system is what we currently have in the U.S. All it takes for the IOR to determine the overnight interbank rate is for the central bank to target a positive quantity of excess overnight reserves. Canada adhered to a floor system through much of the financial crisis period, and is now back on a corridor system. Fourth, being on a floor system or a corridor system has nothing to do with the "footprint" of the central bank. Indeed, we could imagine economies where the central bank accounts for a large fraction of total financial intermediation and there is a corridor system, and other economies where the central bank does not do much financial intermediation but runs a floor system. Indeed, the Bank of Canada operated a floor system with a target of $3 billion in overnight reserves, during the financial crisis. That's hardly a big footprint.
There are two proposed mechanisms for implementing IOR, both of which can impinge on central bank independence. One IOR operating mechanism is the floor system, in which the central bank sets its policy rate equal to the IOR. Under this framework, the central bank supplies enough reserves so that the banking system faces a perfectly elastic supply schedule of reserves.16 Under such a floor system, the Fed’s balance sheet is divorced from interest rate policy because an unlimited amount of reserves are available at the IOR-policy rate. Some have described the floor system as the “big footprint” central bank because its balance sheet can be large without directly affecting the monetary policy instrument, the IOR. Some think that this approach has advantages because it would enable the central bank to provide liquidity in a financial crisis without necessarily altering the stance of monetary policy.
The other IOR operating mechanism is the corridor system, in which the central bank’s policy rate is a market rate that is always between the rate charged at the discount window and the IOR. The corridor system does impose constraints on the size of the balance sheet because the supply of reserves would be set at a level that achieves the targeted interest rate. Thus, this might be called the “small footprint” central bank.
If we take the good parts of Plosser's speech, we could construct the following two elements that could be a basis for a new Accord between the Treasury and the Fed. These would be:
1. Restrict the Fed's monetary policy actions to discount window lending to member financial institutions and the purchase of Treasury securities, except under special authorization from the Treasury.
2. Establish explicit inflation targets. Much as in the countries where inflation targets are already a reality (Australia, Brazil, Canada, Chile, Israel, Mexico, and New Zealand), the Fed and the Treasury would periodically negotiate a new inflation target, and there could even be explicit penalties for the Chairman for deviating from the target. Adopting inflation targeting would mean abandoning the old Humphrey-Hawkins Act.
Now is a good time to get this proposal on the table, as it is important to lay the groundwork for how monetary policy will proceed.