Monday, January 14, 2013

Floor Systems

The quantity of reserves held by US financial institutions is now approaching $1.6 trillion, and the Fed has promised to increase that stock by $85 billion per month for the indefinite future. Thus, it seems safe to say that the Fed will be working within a monetary regime with a large quantity of excess reserves for a very long time.

In a financial system, like the one we have in the US currently, in which there is a positive stock of deposits with the central bank overnight, and the interest rate on those deposits essentially determines the overnight interest rate, the central bank works within a floor system. I have discussed that in several blog posts, including this one. To quote myself:
A floor system is different. Under such a system, the central bank sets an interest rate on reserves and a central bank lending rate, and plans to have a positive supply of reserves in the system overnight. As a result, the overnight rate must be equal to the IROR, by arbitrage. An open market operation in short-term government debt in a floor system will have no effect, at the margin, as the central bank is simply swapping one interest-bearing short-term asset for another. The instrument of monetary policy in a floor system is the IROR, which determines short-term nominal interest rates.

Currently, the Fed operates under a floor system. The supply of excess reserves is enormous, and the IROR determines short-term interest rates. There are some weird features of the system, such as the fact that the GSEs receive no interest on their reserve accounts, and there is some lack of arbitrage which results in a fed funds rate less than the IROR, but I think those weird features are irrelevant to how monetary policy works.

Under a floor system, we are effectively in a perpetual liquidity trap. Conventional open market operations in short-term government debt do not matter, whether the IROR is 5%, 0.25%, 10%, or zero. But, not to worry, the central bank can always change the IROR except, of course, when it hits the zero lower bound (neglecting the possibility of taxation of reserve balances, which is another issue altogether).

Steve Randy Waldman seems to agree with that. Paul Krugman does not. Here's what Krugman says:
Now, under current conditions that doesn’t matter; dead presidents don’t pay interest, but neither do T-bills, so short term debt and currency form an aggregate (a Hicksian composite commodity, for the serious nerds out there), whose composition doesn’t matter. But interest rates won’t always be zero, and at that point the size of the monetary base — dead presidents plus a sliver of bank reserves that can be converted into dead presidents at will — will matter again.
That's incorrect. The nature of the liquidity trap does not change if the interest rate on reserves (IROR) rises. With a positive stock of reserves in the system, there's a liquidity trap no matter what the IROR is. If the Fed swaps short maturity debt for reserves it's essentially irrelevant - the two assets are roughly identical. It's not a big deal though, as the Fed would conduct monetary policy in exactly the way it did in 2007. The policy rate is the IROR (not the fed funds rate), and moving the policy rate will have essentially the same effects as targeting a particular fed funds rate through open market operations.

Addendum: Where I don't agree with Waldman is on this:
Consistent with the “Great Moderation” trend, the so-called “natural rate” of interest may be negative for the indefinite future, unless we do something to alter the underlying causes of that condition.
I haven't seen a convincing explanation for why the "natural rate of interest" is currently low, or worse still, persistently low. See this post.


  1. Steve. You wrote:

    "If the Fed swaps short maturity debt for reserves it's essentially irrelevant - the two assets are roughly identical."

    "An open market operation in short-term government debt in a floor system will have no effect, at the margin, as the central bank is simply swapping one interest-bearing short-term asset for another."

    Makes a lot of sense. But, what if the Fed conducts open market operations in long-term government debt? Now there clearly are differences in yield, and wouldn't that be equivalent to the old system with zero IROR and a positive yield on short-term government debt?

    1. That's more complicated. I've made a case in other blog posts that, in a floor system, that's not going to matter either, in spite of the fact that the long bond yield is greater than the short rate. The idea is that the Fed is intermediating across maturities in a way that will be undone by private sector financial intermediaries (not the case in "normal" times as those private intermediaries can't issue currency). Obviously, that's not what the Fed thinks.

  2. I'm not sure I believe in the concept of a "natural rate of interest".

    However, in an economy where money later is likely to be worth more than money now (assuming we don't repudiate the money), the rate of interest becomes negative. And when does that happen? When it's excessively easy for anything you put your money in now to get stolen, perhaps?

    1. Or, in other words, the real rate of interest can be low when there is a scarcity of safe assets.

  3. "If the Fed swaps short maturity debt for reserves"

    But the Fed doesn't. Even in normal times, most Fed money is supplied by buying a range of bonds in "coupon passes". That suggests that there never is a liquidity trap; I am confused!

  4. [...] David Beckworth, Peter Dorman, Nick Rowe and Stephen Williamson (see here, here, and here) also share their thoughts. [...]

  5. However, in China, the money will be is worth more than money now (assuming we don't deny money), interest rate become negative. When did it happen? When it is too easy to anything you put your money in now to steal, perhaps?

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