Sunday, September 26, 2010

Plosser: Central Bank Commitment and Interest on Reserves

Charlie Plosser made a speech last week to at the Swiss National Bank Monetary Policy Conference that looks at some recent monetary policy issues. Much of the speech deals with commitment, and for the most part I agree with those ideas. Plosser argues that the unusual credit programs put in place in fall 2008 by the Fed, which were subsequently unwound, create the potential for moral hazard; financial institutions will now have the incentive to take on too much risk given the expectation that the Fed will step in as lender of last resort in the event of trouble. Further the Fed's purchases of mortgage-backed securities (MBS), to the tune of more than $1 trillion, potentially creates the demand for future interventions by the Fed in particular sectors of the economy. If the housing sector is today's problem, to which the Fed should respond by purchasing mortgage-related assets, why shouldn't the Fed respond to perceived problems, for example in the auto sector, by purchasing the debt of Ford, General Motors, and Chrysler? The political pressures, for and against sectoral interventions of this type, threatens the Fed's independence.

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.

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.
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 " 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.

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.


  1. A similar question to one I asked previously: doesn't the banking system face a perfectly elastic supply of reserves under a normal Fed Funds targeting regime? What is the difference between that and an IOR floor, either from a fiscal or monetary standpoint? I must be missing something here.

  2. "doesn't the banking system face a perfectly elastic supply of reserves under a normal Fed Funds targeting regime?"

    Roughly, yes. The mechanics of intervention in the US (in normal times) appear to be that the open market desk in New York makes a prediction every day about the quantity of reserves they need to supply, mainly through repos, to achieve the fed funds target rate. They supply that quantity and then the fed funds rate is what it is (the Fed never quite gets it right) and essentially no excess reserves are held overnight.

    With an IOR floor (what the Fed is up to right now), the Fed sets the IOR, and then targets some quantity of reserves in the system such that the quantity of excess reserves held overnight will be greater than zero. If there were no risk associated with lending on the fed funds market and arbitrage were perfect, then the fed funds rate would be equal to the IOR. Banks have to be indifferent between lending on the fed funds market and holding the reserves overnight. In practice, there is some slippage as Fannie Mae and Freddie Mac are not paid interest on reserves, the arbitrage is imperfect, and fed funds lending is risky. Currently the effective fed funds rate is less than the IOR.

  3. Plosser also called for more emphasis on total inflation. He said the argument for looking at "core" inflation is "less compelling" now as other price components are more volatile than energy and food, and a focus on core inflation will not boost public confidence either.
    Banks and financial crisis

  4. Parag,

    Yes, that's important. I think the tendency for central banks to focus on "core" inflation is nonsense. The idea seems to be that price movements that come from volatile components of the CPI are likely to be temporary and should be ignored. One problem is that today's volatile component may be different from yesterday's volatile component: you have to keep changing your definition of what the core is. Another is that there can be permanent price changes in volatile components that you should be paying attention to. It's best to stick to a broad and accurate measure of the price level. I like the implicit GDP price deflator, but of course that's only available at quarterly frequencies, which is a disadvantage.