Sunday, October 27, 2019

An Attempt to Sort out the Fed's Overnight Market Issues

First, we'll get up to speed on the state of monetary policy implementation in the United States of America, in case you haven't been paying attention. After the financial crisis, the Fed substantially increased the size of its balance sheet, primarily through the purchase of long-maturity Treasury securities and mortgage-backed securities. On the liabilities side of the balance sheet, the Fed has seen a steady increase over the last 10 years in the quantity of Federal Reserve notes (currency) outstanding, but the primary source of funding for the increase in securities-held-outright by the Fed is an increase in the reserve balances held by financial institutions. This increase in reserves outstanding necessitated a floor-system approach to targeting overnight interest rates. That is, once there is a sufficiently large quantity of reserves outstanding, the interest rate on reserves (IOER) should, in theory, peg all overnight interest rates, through financial arbitrage. Basically, financial institutions should be indifferent in a floor system between lending to the Fed overnight and lending to other financial institutions overnight. Whether this approach to day-to-day overnight credit market intervention is better or worse than the approach taken before the financial crisis was not a matter of concern for the Fed when it embarked on its balance sheet expansion. The floor system simply came with the large-scale asset purchases (QE) that were part of the Fed's post-financial crisis approach. The initial understanding, going back at least to 2011, was that the Fed would eventually revert to "normal," that is the Fed's policy rate would rise, and the quantity of reserves outstanding would revert to the neighborhood of, say, $10-$15 billion, as before the crisis.

Well, normalization never happened, either with respect to interest rate policy or balance sheet policy. The Fed backed off its interest rate hikes, reversed direction, and certainly does not seem on the road to pegging short term interest rates in the ballpark of what would be commensurate with sustaining 2% inflation. Remember, sustained low nominal interest rates just creates sustained low inflation. Just ask the Bank of Japan. On balance sheet policy, there was a modest reduction in the Fed's total assets between late 2017 and this August, of about $600 billion:
Better still, we can look at Fed assets minus currency outstanding, which is the quantity of non-currency Fed liabilities, along with reserves:
What this shows is that, while reserves outstanding have declined substantially to less than $1.5 trillion, the quantity of Fed liabilities other then currency and reserves has grown substantially. In the last Fed balance sheet snapshot, those liabilities included $293 billion in the foreign repo pool - that's effectively reserves held at the Fed by foreign central banks and other foreign institutions - and $378 billion in the Treasury's general account held with the Fed. More about that later.

How does the FOMC think about overnight interest rate determination in a floor system? Typically, they're relying on this:
In the figure, R is the fed funds rate, and Q* is the quantity of reserves that is the threshold between "abundant" reserves and "scarce" reserves. So long as the supply of reserves is larger than Q*, according to this story, if the Fed wants to target the fed funds rate at R*, it simply pegs the interest rate on reserves (IOER) at R* and then the market clears at R*.

You can see how, if this is your view of how overnight markets work, then the mid-September episode when the overnight repo rate spiked well above IOER would be interpreted as a symptom of reserves being less than Q*. As a reminder of what has happened to overnight interest rates in the US since interest rate hikes began in December 2015:
The chart shows IOER, the effective fed funds rate and, later in the sample (when the Fed started collecting the data for the repo rate series), the secured overnight financing rate (SOFR), i.e. a measure of the overnight repo rate. The data in the chart certainly doesn't conform to the simple model in the figure above. Note in particular that, early in the sample, the fed funds rate was lower than IOER, and exhibited downward spikes at the end of each month. Then, later in the sample, when we can see what is going on in the repo market, as measured by SOFR, the repo rate is for a while close to to IOER and the fed funds rate, then starts to exhibit more volatility, with spikes at month-end occurring even prior to the large spike in mid-September. So, if we judge the performance of an interest-rate-targeting regime by success in pegging all overnight rates to the FOMC's target, then this floor system worked well for only a few months in late 2018. And, recall that, in the pre-2018 period, the floor system had substantial support from the Fed's overnight reverse repo (ON-RRP) facility, under which the Fed was a borrower (and sometimes a large borrower, to the tune of several hundred billion dollars overnight) in the overnight repo market, at a rate 25 basis points below IOER. So I wouldn't call this floor system a well-oiled machine.

When the repo market went crazy on September 17, much to everyone's surprise, the Fed intervened by lending in the repo market. That intervention has continued. Here's the Fed's overnight repo activity since then:
As well, the current Fed balance sheet data indicates that there is about $191 billion in repos held by the Fed, which includes term repos of 14 days, in addition to the overnight repos in the chart. So, if you thought that whatever was causing the September 17 repo rate spike was temporary, it wasn't, as the Fed has had to maintain a substantial presence in the repo market in order to hold overnight rates down.

The FOMC's model of overnight credit market intervention, in the third figure, is misleading for a number of reasons. First, it's not a good idea to think that there's some stable demand for reserves in the financial system. Reserves are necessary for clearing and settlement of interbank transactions during the day, but intraday velocity is so high, basically, that a small quantity of reserves can support a very large quantity of intraday transactions. For example, before the financial crisis $10 billion in reserve balances could support a volume of intraday transactions on the order of annual U.S. GDP. So, issues related to reserve balances in excess of $1 trillion, as is the case currently, relate to the role reserves play as overnight assets, and we can safely ignore issues to do with the functioning of intraday wholesale payments. How useful banks find overnight reserve balances is determined by regulation, and by the stocks of other assets, particularly Treasury securities, which play an important role as collateral in the repo market, and as a liquid asset in banks' asset portfolios. A possibly superior way to look at the overnight market is to think in terms of the demand and supply of overnight credit. For example:
In this figure, by setting IOER at R* the Fed is lending perfectly elastically, over the relevant range, in the overnight credit market by supplying reserves. We're still thinking in terms of a frictionless world in which secured and unsecured credit are perfect substitutes (more about that later).

We can then think about all systems for pegging overnight interest rates in exactly the same way as in the last figure. The Fed has to intervene in such a way that either overnight credit demand, or overnight credit supply, is perfectly elastic at the target interest rate. For example, in this context, the operating regime for the Fed before the financial crisis looks like this:
That is, before the financial crisis, the Fed intervened in the repo market, as an indirect way of pegging the fed funds rate, under the theory that secured and unsecured lending are close substitutes. By varying the amount of repo market intervention each day to peg the fed funds rate, the Fed was effectively making the supply of overnight credit perfectly elastic at the targeted rate. If they had wanted to, they could have intervened through reverse repos, which we could represent as in the previous figure - this works just like the floor system, except the variability is in a different Fed liability. Thus, there's nothing special about the floor system - it fits in a class of intervention mechanisms that work through variability in Fed liabilities rather than Fed assets (as in repo market intervention on the lending side).

But there's more to it. The Econ 101 approach to the overnight market in the last couple of figures isn't a good way to analyze a market with substantial frictions. For example, if there were no significant frictions in the overnight credit market, then it would make no difference whether the Fed permanently swapped, say, $100 billion in reserves for $100 billion in T-bills, or intervened by lending $100 billion in the repo market every day forever, taking T-bills as collateral. Clearly, the Fed thinks there's a difference, as they're now planning to buy about $60 billion in T-bills every month until the second quarter of next year, which looks like a potential planned purchase of $300 billion or more in T-bills. Somehow the Fed thinks that's better than continuing to intervene in the repo market at the current intensity - note that current repos outstanding, including term repos, amounts to about $191 billion.

So what's the Fed up to, and why? For more information, let's go to a recent speech by John Williams, President of the New York Fed. Williams says:
The key benefit of this approach is that it’s a simple, effective way of controlling the federal funds rate and thereby influencing other short-term interest rates.
Well, in my book, "simple" means easy to explain. It's actually quite complicated to explain features of the current floor system, such as the ON-RRP facility, and why it's there, or why the repo market went phooey on September 17. A lot of people are spending valuable time trying to figure this out. Nothing simple about it. Further, "effective," I think, means it works. The floor system definitely does not work as advertised. Simply setting IOER should peg overnight rates, but that only happened (roughly) for just over a year. Before early 2018, the ON-RRP facility was holding up overnight rates from below, and after mid-September 2019 the Fed was lending in the repo market to hold down overnight rates from above. The floor system does not work, except in some sweet spot. And that sweet spot isn't determined only by reserves outstanding. There is a host of other poorly understood factors that matter for whether the floor can work on its own.

Here's something else Williams said in his speech:
In light of these events, we have learned that the ample reserves framework has worked smoothly with a level of reserves at least as large as we saw during summer and into early September. Although temporary open market operations are doing the trick for the time being, anticipated increases in non-reserve liabilities would cause reserves to decline in coming months without further actions.
The "events" he's referring to are all included in the charts above. It's certainly not correct to say that everything worked smoothly prior to September. As I've pointed out, things were creaky before 2018, even given the ON-RRP intervention, and month-end spikes in the repo rate were apparent before the blowup on September 17. But, the key problem with Williams's statement here is that he doesn't tell us why the Fed prefers to buy T-bills rather than to intervene in the repo market every day - as he says, that's "doing the trick," so what's the problem?


1. If the answer to the problem of overnight interest rate control is more reserves, that can be achieved by reducing the size of the foreign repo pool and the Treasury's general account, which together currently come to a total of about $672 billion. That's a lot larger than the $300 billion in T-bills the Fed plans on purchasing. The size of the foreign repo pool and the Treasury's general account are purely discretionary, and both were tiny before the financial crisis. None of the communications coming from the Fed have explained what these items are about. Why is it important to the Fed's goals that foreign entities, including central banks, hold what are essentially reserve accounts at the Fed? How does it help monetary policy that the Treasury carries a large and volatile reserve balance with the Fed? Why can't foreign central banks park their overnight US dollars elsewhere? Why can't the Treasury park its accounts with the private sector, as before the financial crisis?

2. Experience with a floor system in the U.S. since December 2015 should tell us that it's ineffective for the Fed to attempt to intervene in overnight markets by narrowing their engagement with the financial sector to commercial banks. The fed funds market is a small market, and reserve accounts are held by only a fraction of financial institutions. The repo market is a large market, and intervention by the Fed in that market reaches all the nooks and crannies of the financial sector. A more effective approach, as many other central banks have discovered, is to peg a repo rate - stop worrying about the fed funds market - and intervene in the repo market, either on the lending or borrowing side, depending on circumstances.

3. The only advantage reserves have over Treasury securities, as a liquid asset, is that reserve balances can be transferred among financial institutions with reserve accounts, on Fedwire during the day. Otherwise, Treasuries are more widely held, and they're the primary form of collateral in the repo market. In general, if the Fed takes Treasuries out of financial markets and replaces those assets with reserves, that will make the financial sector less efficient. Some people have tried to argue that post-financial crisis banking regulations somehow make banks prefer reserves to Treasuries. I don't buy it. Treasuries and reserves are equivalent as high-quality liquid assets in banking regulation. And I've never seen a bank "living will" that articulates a special role for reserve balances. And if regulators are encouraging banks to hold reserves rather than Treasuries as liquid assets, there's no good reason for them to do that, given what seems to be written in the law.

So, the Fed seems to be floundering on this issue. Balance sheet policy seems to be more about the FOMC sticking to what they decided in early 2019, than with responding to what they should have learned since then.

Thursday, September 26, 2019

The Fed's Failed Experiment

Last week, on Tuesday September 17 in particular, overnight credit markets were misbehaving. Since then, various folks have been struggling to understand what is going on, with little assistance, apparently, from the Fed, whose job it is to prevent such misbehavior, and to tell us exactly what is going on. Here's what happened. On Tuesday of last week, the market in overnight repos became very tight:
The chart shows the repo rate (secured overnight financing rate), the effective fed funds rate, the interest rate on reserves, and the four-week T-bill rate. On September 17, these interest rates were, respectively, 5.25%, 2.30%, 2.10%, and 2.06%. It's important to note that the repo "market" and the fed funds "market" are not markets in the Econ 101 sense. Some repo and fed funds trades are done through intermediaries (tri-party repo for example), but much trading overnight is over-the-counter, that is bilateral exchange. As a result, there is typically dispersion in market prices, and on September 17 that dispersion was much higher than normal. Roughly, repo market trades were between 2.25% and 9.00%, and fed funds trades were between 2.05% and 4.00%. Further, on September 17, the interest rate on reserves was 2.10%. So, apparently, banks holding reserves were foregoing large profit opportunities to lending in the repo market and fed funds market, and fed funds market lenders were similarly lending unsecured overnight and foregoing large profit opportunities to secured lending in the repo market.

The New York Fed attempted to intervene to push down repo rates on September 17 but, due to some unexplained glitch, couldn't do the job. However, Fed intervention continued - it was still happening yesterday:
Three points to note are: (i) The Fed has now controlled the problem; the repo rate has been brought down, and fed funds are currently trading within the Fed's 1.75%-2.00% target range. (ii) At from $50-$60 billion in repos outstanding on the Fed's balance sheet, this is a large intervention; (iii) Whatever is causing this is persistent; it's not a one-day event.

Why am I saying $50-$60 billion in repo market intervention is large? In the old days, prior to the financial crisis, the Fed controlled the fed funds rate through repo market intervention:
In the chart, you can see some unusual stuff going on during the financial crisis, but pre-financial crisis, repos outstanding varied between about $20 billion and $40 billion. So, if the New York Fed's lending on the repo market goes from zero to $50 billion in a couple of days, that's a huge intervention relative to what used to happen in normal times.

So, what's going on? Essentially all central banks in countries with well-developed overnight credit markets intervene so as to peg some overnight rate, under a directive from the decision-making body in the central bank. The Fed likes to articulate the directive in terms of a target range for the fed funds rate, and then it's the job of the New York Fed to achieve that target, through whatever means it has at its disposal. So, in terms of the policy directive, which last Tuesday was to target the fed funds rate in a range of 2%-2.25%, the New York Fed failed - but the top of the range was exceeded by only 5 basis points. So why the panic? The Fed's unstated short-run goal is to control all short-term market interest rates. And the repo market is a much larger market than the fed funds market, and potentially more important in terms of the transmission of monetary policy. Further, volatility of any kind in financial markets is typically perceived to be bad. If such volatility can be avoided through central bank intervention, then the central bank should probably do it.

But what caused the spike in the repo rate, and why didn't the New York Fed's ongoing approach to pegging overnight rates work? Sometimes we like to differentiate between corridor systems (e.g. how central banking currently works in Canada) and floor systems (how it currently works in the U.S.). But in any system of monetary policy implementation, the central bank stands ready, typically on a daily basis, to intervene either on the demand side or the supply side of the overnight credit market - basically, either demand or supply is perfectly elastic at the central bank's interest rate target. Before the financial crisis, the Fed intervened on the supply side of the overnight credit market by varying the quantity of its lending in the repo market so as to peg the fed funds rate. Typically, we would call that a corridor system, as the central bank's interest rate target was bounded above by the discount rate, and below by the interest rate on reserves, which was zero at the time. But, the Fed could have chosen to run a corridor by intervening on the other side of the market - by varying the quantity of reverse repos, for example. Post-financial crisis, the Fed's floor system is effectively a mechanism for intervening on the demand side of the overnight credit market. With a large quantity reserves outstanding, those financial institutions holding reserves accounts have the option of lending to the Fed at the interest rate on reserves, or lending in the market - fed funds or repo market. Financial market arbitrage, in a frictionless world, would then look after the rest. By pegging the interest rate on excess reserves (IOER), the Fed should in principle peg overnight rates.

The problem is that overnight markets - particularly in the United States - are gummed up with various frictions. First, fed funds credit is not the same thing as repo market credit. The former is unsecured and the latter is secured with collateral - primarily Treasury securities. The timing can be different for when funds go out one day and are returned the next. Only financial institutions with reserve accounts at the Fed participate in the fed funds market, whereas the repo market has a wider array of participants. Second, there are regulatory constraints. New Basel III requirements, particularly the liquidity coverage ratio (LCR) requirement, constrain banks to holding liquid assets that can finance specified funding outflows, should they arise. Dodd-Frank regulations for systemically important financial institutions have resolution plans that include providing for sufficient liquidity. There are capital constraints, etc. Finally, as mentioned above, much of the trade in overnight credit markets is over-the-counter. Market participants develop long-term relationships with counterparties, but there can be shocks to markets that disrupt those relationships, making it difficult to find a counterparty for a particular desired trade.

Friction in U.S. overnight credit markets, and its implications for monetary policy, is nothing new. Indeed, the big worry at the Fed, when "liftoff" from the 0-0.25% fed funds rate trading range occurred in December 2015, was that arbitrage would not work to peg overnight rates in a higher range. That's why the Fed introduced the ON-RRP, or overnight reverse-repo, facility, with the ON-RRP rate set at the bottom of the fed funds rate target range, and IOER at the top of the range. The idea was that the ON-RRP rate would bound the fed funds rate from below. During 2016, these were the paths of short-term interest rates:
Until the December 2016 meeting, the ON-RRP rate was set at 0.25% and IOER at 0.5%. But the fed funds rate was 9-12 basis points lower than IOER, and the one-month Treasury bill rate was typically in the 0.1% to 0.3% range. As well, note the downward spikes in the fed funds rate, which occur at month's end. There were some stories to explain that configuration of interest rates, but in retrospect, I'm not sure any of those make sense. ON-RRP intervention by the Fed looks like this:
That chart isn't picking up everything, as it's only for Wednesdays, but this gives you some idea what was going on. This makes the recent repo intervention by the Fed (on the other side of the market) look small. Until early 2018, it was considered normal for the takeup on the ON-RRP facility to be anywhere from $100 billion to $200 billion each day, with spikes of $500 billion or $600 billion (not in the chart, as again it's only Wednesdays) at the end of the quarter. This was basically borrowing by the Fed on the repo market to hold up the repo rate.

But note that, in early 2018, the ON-RRP facility became moribund - zero takeup essentially. What happened then?
During 2018, the Fed's floor system actually seemed to have been working properly. Particularly in the September-December 2018 period, IOER appeared to be pegging the fed funds rate, the repo rate, and the one-month T-bill rate - arbitrage seemed to be working. But, beginning in 2019, funny things started happening in the repo market. Those downward month-end spikes in the fed funds rate that you can see in the 2016 data started to appear as upward month-end spikes in the repo rate. The one at year-end 2017 is particularly large. As yours truly pointed out (with some prescience) in May of this year,
Well, it appears there is something wrong with the Fed's ability to control short rates. I'm actually less concerned with the fed funds rate, and more concerned with repo rates, as the Fed should be. Those end-of-month spikes in repo rates shouldn't be happening.
There's something else that's odd in the last chart, which is that the one-month T-bill rate has dropped below the interest rate on reserves, even if you account for market anticipation of Fed rate cuts.

So, how to make sense of this? There are several aspects of the problem we need to be concerned with:

1. Every central bank needs to be concerned with fiscal authority actions. For example, if the fiscal authority holds its available cash as deposits at the central bank, then inflows into that deposit account due to tax receipts or government security issuance have monetary implications. There has to be a mechanism in place to deal with that. For example, the Bank of Canada auctions these funds off in the repo market.
2. Large scale asset purchases (QE) by the Fed had, and have, implications for how the overnight market works.
3. How do new bank regulations (LCR and resolution liquidity) matter?
4. Central bankers, for good reasons, want to project confidence, and they don't like to admit errors. Large scale asset purchases were a large-scale experiment, and there appear to be no strong voices on the FOMC that question the efficacy of QE, and the current floor system. Indeed, the committee decided early this year to stick with the floor system indefinitely, and the revinvestment program, that replaces Fed assets as they roll off, was resumed in August. Given this, you'll find plenty of Fed employees - management, economists - supporting the party line. If there are no good reasons for justifying a large balance sheet indefinitely, folks at the Fed will make them up.

Let's start with fiscal actions and how they matter here. Here's the Treasury's general account with the Fed.
Before the financial crisis, Treasury parked its deposits in the private sector - so that inflows and outflows from those accounts wouldn't mess with monetary policy. You'll notice that, after the financial crisis, the balance in the Treasury's general account became substantial, and became quite large on average in 2016, and much more volatile. Recently, this account balance has been anywhere between $38 billion and $420 billion. Note that, if total reserves outstanding are constant and general account balances go up, then reserve balances held in the private sector must go down by the same amount. The Fed permits these large and fluctuating Treasury balances, apparently because they think this won't matter in a floor system, as it shouldn't. But, if anyone at the Fed suggests that the answer to the problem highlighted by the repo market dysfunction last week is to purchase more assets, someone should tell that person that if the problem is too little reserves, more reserves can be had if the Treasury parks its deposits in the private sector, just like in the old days.

Another drain on private sector reserve balances is the foreign repo pool:
This balance isn't as volatile as the Treasury general account, but it's large and growing, and it's unclear what its purpose is. Like the Treasury account, it's purely discretionary. The Fed once had caps on this, which for some reason were lifted. All very murky. Some of this could be foreign governments and central banks which are permitted by the Fed to hold what are effectively interest-bearing reserve balances at the Fed - much more attractive than previously given low or negative government security yields in other countries. But again, if the problem is low reserve balances in the private sector, those balances could be increased by about $300 billion if the Fed eliminated the foreign repo pool.

Some people blame new bank liquidity requirements, at least in part, for the repo fiasco last week. The problem here is that, for both LCR and resolution liquidity requirements, Treasury securities and reserves are essentially equivalent - both are high-quality liquid assets (HQLA). Thus, if the problem is that liquidity is being hoarded, creating pressures in the repo market, it's a dearth of Treasuries plus reserves that's the problem. That can't be fixed by having the Fed swap reserves for Treasuries - that has zero effect on the total. Some people have tried to make the case that reserves are somehow significantly superior liquid assets to Treasury securities, and that liquidity requirements have increased the demand for reserves in particular. But that notion is inconsistent with what we see in the data. As I pointed out in this blog post, banks have accumulated a lot of Treasuries, and a lot of reserves, but are not demanding a premium in the market to hold Treasuries - indeed, it's currently the other way around. That is, T bill rates are below IOER.

In the past, I've made the case that QE causes dysfunction in overnight markets. In the 4th chart above, the 2016 interest rate data can be viewed as reflecting a collateral shortage in the overnight market. That's what kept the Fed's ON-RRP program alive. The Fed had sucked up a large fraction of the securities useful as collateral in overnight markets, so that it could turn around and borrow in the overnight repo market - at a rate below IOER. That shortage appears to have gone away in early 2018. But one might then expect that, with plentiful collateral in overnight markets, that things would settle down. But now there appears to be sporadic high demand for overnight loans in the repo market, and things are going the other way.

What I'm leading up to is the conclusion that we shouldn't characterize the problem here as a "scarce reserves," particularly as some seem to think that implies the Fed needs to buy more assets. The key problem is that the Fed is trying to manage overnight markets by working from the banking sector, through the stock of reserves. Apparently, that just won't work in the American context, because market frictions are too severe. In particular, these frictions segment banks from the rest of the financial sector in various ways. The appropriate type of daily intervention for the Fed is in the repo market, which is more broadly-based. If $1.5 trillion in reserve balances isn't enough to make a floor system work, without intervention through either a reverse-repo or repo facility, then that's a bad floor system.

The arguments for having a large Fed balance sheet are two-fold. First, it's supposed to make monetary policy implementation easy. Just set IOER, and arbitrage looks after the rest. Second, Fed asset purchases are supposed to be "stimulative," increasing inflation and aggregate economic activity. Well, apparently, the first argument is wrong - nothing easy about this at all. In this respect, the implementation has left people scratching their heads and wondering if the people at the New York Fed and the Board have their heads screwed on properly. On the second, there's no evidence that QE is helpful in achieving any of the Fed's ultimate goals, and it may just be harmful, in that the Fed swaps inferior reserves for superior Treasury securities. The reserves are crappy assets because they're only held by a segment of financial institutions, and because of the market frictions I've been discussing. If the Fed takes away good collateral and gives the financial market crappy assets, nothing good happens.

Conclusion? For now, the Fed needs to be intervening in the repo market on a regular basis, and it's possible that the intervention could go back to the other side of the market, with an active ON-RRP facility. Intervention - either way - should be at IOER. None of this target range nonsense. In the long run, the Fed should get rid of the large balance sheet. Please. Make the secured overnight financing rate the policy rate, and run a corridor system. That's what normal central banks do.

Monday, August 5, 2019

Is the Fed Doing Anything Right?

I'm not sure the Fed has many friends these days. Donald Trump is unhappy with it, and the financial media seems puzzled by what the Fed is doing. Can we make sense of the Fed's behavior, particularly its change in policy last week, or is the Fed simply incoherent?

It might help to start with first principles. What would good central bank policy look like, were we ever to have the good fortune to observe such a thing? A central bank should have clearly-stated goals. Those goals could be stated in the legal structure that constrains the central bank, or they could be in the central bank's interpretation of the law. For example, in the US the Fed's structure is defined in the Federal Reserve Act, and the Fed's dual mandate is in the Employment Act of 1946 and the Full Employment and Balanced Growth Act of 1978. The Fed's interpretation of what Congress stipulated is in the "Statement on Longer-Run Goals and Monetary Policy Strategy," which says, basically, that the Fed has a symmetric 2% inflation target, and that it seeks to achieve a "maximum level of employment," without being precise about what that might mean. A central bank's goals should be such that they can be stated in an easily understandable way. That means that the public should be able to understand what the Fed thinks it's doing, and the Fed should be able to understand what it's supposed to be doing. So, the 2% inflation target seems OK in that sense. It's simple, and we'll be able to tell if the Fed is succeeding or not, with respect to that specific goal. However, "maximum level of employment" is a poor goal. Fed officials are free to define it however they like, and it's impossible to evaluate performance in terms of something that's not precisely defined.

Once the central bank has dealt with what its goals should be, it has to decide on how to achieve those goals. For 40 years or more, it's been well understood among macroeconomists that achieving policy goals is about choosing a policy rule. That policy rule takes all available current information and generates a setting for some targeted variable the central bank can control. In typical modern central banking practice, that targeted variable is an overnight nominal interest rate - the fed funds rate in the Fed's case. The Fed need not write down its policy rule. In fact, writing it down would be a bad idea, in spite of what John Taylor thinks. What the central bank needs to do is to explain carefully what it is doing, and why, every time it takes an action. Over time, if central bankers make those decisions in a consistent way, and explain them well, then their actions become predictable. As it's generally understood by macroeconomists, that predictability is a wonderful thing. Eventually, central bank pressers should become so routine that they're boring as hell. In fact, boring as hell is the nirvana of central banking. Of course, the policy rule should be the best available rule for achieving the central bank's goals. There should be a theory that says it's the best thing around, and we should be able to evaluate the rule's performance in practice.

Finally, once the central bankers have figured out their policy rule, they have to have an operating strategy for achieving their short term target. For example, the Fed needs an operating strategy for targeting the fed funds rate. Currently, that operating strategy is to simply fix an interest rate on reserves, in the context of a large central bank balance sheet with a very large quantity of reserves outstanding - a floor system. Basically, the operating strategy should successfully achieve the target. Not much more to it than that.

So, what happened last week at the FOMC meeting? They decided (with a couple of dissents) to reduce the target range for the fed funds rate by 0.25% to 2.00-2.25%. That seems to represent a change of plan, since in September 2018, the median FOMC member was thinking that the fed funds rate by the end of 2019 would be 3%. So, something important must have changed since last September. What was it? From the FOMC statement and Powell's presser after the meeting, it seems there were 5 things bothering the committee:

1. Weak global growth.
2. Trade policy uncertainty.
3. Muted inflation.
4. The neutral rate of interest is down.
5. The natural rate of unemployment is down.

Let's deal with the second part of the Fed's mandate first - the maximum level of employment. On the real side of the economy, things seem to be going quite well. Real GDP has been growing smoothly for the last 10 years:
That's an average growth rate of 2.3% vs. 3.3% for the 1947-2009 period, but if we calculate per capita real GDP growth rates, it's not as large a difference, i.e. 1.6% for 2009-2019, and 2.1% for 1947-2009. Of course, there's also a level drop in real GDP from peak to trough in the last recession of about 5%. But in terms of GDP growth, we're not looking worse than last September. In the labor market, a standard measure of labor market tightness is the ratio of job openings to the number of unemployed:
So, it looks like the labor market is no less tight than it was in September, when it was tighter than it had ever been since the JOLTS data has been collected by the BLS. There was some talk by Powell in the presser about weak investment, but I don't see that either:
No significant weakening in year-over-year real investment growth since September, as far as I can tell.

So, things must be really bad in the rest of the world, and maybe we should be worried about that affecting us? Here are real GDP growth paths for the Euro area, Japan, UK, Canada, and the US:
So, I don't know about you, but I don't see "weak global growth" there, relative to September, when everyone was so optimistic. Maybe this is showing up in labor markets? Certainly not in Japan:
Or the Euro area:
Or the UK:
But, I can certainly understand that there's "trade policy uncertainty." More like "Trump uncertainty," I think. But that's been with us since January 2017. And for North America, which we could argue is more relevant for the US, the trade uncertainty is actually lower than it was in September. The USMCA was signed by Mexico, Canada, and the US on November 30, 2018, though it is as yet not ratified. Brexit anxiety is with us of course, but again that's nothing new. So, I think you have to be more specific if you want to make a general case about policy uncertainty. And what's the hurry? You can't wait for resolution?

If you're like me, you're now more puzzled than when you started reading this. Typically central banks lower interest rates in the face of observed decreases in aggregate economic activity - somewhere. But we haven't seen any such thing. Must be some very weird policy rule at work here.

But what's the story with inflation?
So, I guess "muted" is as a good a word as any for that, relative to the 2% inflation target. The Fed's chosen measure - headline PCE - is at 1.4%, and stripping out food and energy gives us 1.6%. Not low, certainly, and well within what you might think is reasonable tolerance, but definitely below target. So, that's clearly a change from September, when inflation was roughly on target, though a deviation of 0.6% below target, possibly pushed down temporarily by energy prices, doesn't seem like a big deal.

But, suppose we thought that the only problem here is a slightly-below-target inflation rate. What would the corrective action be? Well, we need to go back to the policy rule stage to answer that question. What's the relevant theory to bring to bear on the problem, and what does the theory tell us the Fed should do? A below-target inflation rate says the target fed funds rate moves in what direction? Standard central bank practice says the answer is down. Why? Inflation-targeting central bankers argue that they have built up credibility with the public, who believe that the inflation rate will be 2% indefinitely. That's what a central banker means by "anchored expectations." Then, if inflation expectations are anchored, and assuming there is a stable Phillips curve, everyone knows that lower nominal interest rates imply lower real interest rates in the short run. And lower real interest rates, as everyone knows, makes "aggregate demand" go up. Further, as everyone knows, output is demand-determined, so output therefore goes up. Then, by Phillips curve logic, inflation goes up.

But, as everyone knows, I think, there are issues with the Phillips curve. AOC knows it, and Jay Powell knows it, as we can see in this exchange. Powell seems to be telling AOC what his staff told him, which is that the Phillips curve is currently very flat. The Phillips curve is still there though, or so Powell seems to think, though he seems a little confused about how the whole thing works. But, if you're a Phillips curve person, as Powell seems to be, how do you think you're going to get any action in the current environment from an interest rate reduction? You're convinced the Phillips curve is flat, and it's hard to see how the labor market could get any tighter, so where is this Phillips curve inflation going to come from. Expectations? It certainly doesn't look like financial market participants, who had been primed for this interest rate reduction, think so.
That is, the current breakeven inflation rate, at a 10-year horizon, is 1.6%, so market participants don't appear to anticipate a return to 2% inflation.

So, this rate decrease seems very hard to justify, even in terms of how the typical FOMC participant looks at the world. And you can see that in the presser with Powell. The reporters are trying hard to understand what the Fed is up to, Powell is struggling to explain it, and everything is coming out muddled. For example, this exchange:
MICHAEL MCKEE. [inaudible] question is how does it do that? How does cutting interest rates lower, or how does cutting interest rates keep that going since the cost of capital doesn’t seem to the issue here.
CHAIR POWELL. You know, I really think it does, and I think the evidence of my eyes tells me that our policy does support, it supports confidence, it supports economic activity, household and business confidence, and through channels that we understand. So, it will lower borrowing costs. It will, and it will work. And I think you see it. Since, you know, since we noted our vigilance about the situation in June, you saw financial conditions move up, and you saw, I won’t take credit for the whole recovery, but you saw financial conditions move up. You see confidence, which had troughed in June. You saw it move back up. You see economic activity on a healthy basis. It just, it seems to work through confidence channels as well as the mechanical channels that you are talking about.
Well, there's no confidence channel running from Powell to me, that's for sure. The rest of the presser is more of the same. Powell started off well when he was appointed. He opted for press conferences after every FOMC meeting, reduced the wordiness of FOMC statements, and generally seemed to be communicating well. But this decision makes clear what his limitations are. Powell is an attorney whose experience with monetary policy comes from sitting on the FOMC since 2011. You may think that puts you at the center of things. Sorry, it doesn't. There's a lot Powell doesn't know, and it shows.

The other piece of FOMC decision making at this last meeting was to move up the date when the Fed would resume asset purchases. That is, for the time being the Fed intends to maintain the size of its balance sheet, in nominal terms, at its current size. To do this, the Fed will purchase assets (mainly Treasury securities) each month to replace the assets that mature. Earlier this year, the Fed decided it would retain its current floor system operating procedure. Why exactly is unclear. As far as I can make out, the justification seems to be that this makes interest rate control easier. But the Fed claims to be committed to running a floor system with the least possible amount of reserves outstanding that permits the system to work efficiently. Here's some quantities on the Fed's balance sheet.
In nominal terms, the "normalization" in the balance sheet that was promised years ago by the Fed never materialized. The reduction in securities held outright was modest, to about $3.6 trillion. This asset quantity is much more than enough to back the current stock of currency outstanding, which is about $1.7 trillion, and there is still $1.5 trillion in reserves outstanding. That anyone thinks this could be anything close to the minimum amount required to run a floor system is bizarre. Even if $1.5 trillion in reserves were considered about right, there is about $500 billion in other liabilities that the Fed has outstanding for no good reason. This $500 billion includes what is in the Treasury's general account with the Fed, and what are effectively reserve accounts (these are called "reverse repos") of foreign entities, including foreign central banks. All of that $500 billion could go to the private sector, in various forms, which would increase reserves outstanding by $500 billion. That is, it would make no difference if $500 billion in securities were allowed to run off, and the $500 billion in foreign-held reverse repos and Treasury balances went to the private sector.

Another issue is that the floor system does not appear to be working as advertised. So, in contrast to what the Fed seems to want to tell us, interest rate control is not easier with a floor system. The fed funds rate, which previously was below the interest rate on reserves, is now somewhat above it, and interest rates on overnight repos are misbehaving. A potential solution to this, discussed at the June FOMC meeting, is a standing repo facility. Effectively, this would be a lending facility, possibly for banks and/or primary dealers, with the rate set above the interest rate on reserves. Maybe you're wondering why we need this, given that we have a discount window. But, the claim is that this would somehow make Treasury securities more liquid and reduce the demand for reserves, while also eliminating some upside volatility in overnight repo rates. So, that puzzles me. Why?
In the chart, you can see month-end spikes in the overnight repo rate. But you can also see that the 3-month T-bill rate, and the 1-month T-bill rate, are typically lower than the interest rate on reserves through this period. If Treasuries were so illiquid, relative to reserves, then banks would be asking for a premium to hold Treasuries. But that's not what we see. But maybe banks aren't holding much in the way of Treasuries? No, that's not the case.
So, this idea makes no sense. I could see someone making an argument for a standing repo facility on the grounds that, for some well-articulated reason, the discount window isn't working well. But that's not the argument.

So what's going on here? The Fed announced a normalization plan, which started at the end of 2015. Under the plan, interest rates would normalize. What's that mean? Normal means that short-term nominal interest rates are high enough to be consistent with 2% inflation over the long term. Under current conditions, the real short-term interest rate is persistently low, so a "normal" short-term interest rate would be lower than in the past. That's just the logic of Irving Fisher, which we all learned as undergrads. But, if the nominal interest rate is too low on average, then inflation will be too low, on average. That's abundantly obvious given the post-1995 Japanese experiment. Late last year, the FOMC was thinking that a normal fed funds rate is about 2.5-3.0%. I think that's about right. Basically, they aborted normalization. And, if the FOMC thinks an important goal is hitting 2% inflation, it should have kept its target fed funds rate range constant, or moved it up.

Balance sheet reduction was also to be a part of normalization, but obviously that's not happening, and the FOMC is not providing us with good reasons for retaining its floor system, which has never behaved according to what the people at the Fed predicted. The recent surprises in the overnight interest rate structure are just another example of that.

Where does all that leave us? Not in a really bad place. The central banks of the world are going to model themselves on the Bank of Japan. Barring a Trump recession, things will be OK. We'll have inflation below 2%, a large central bank balance sheet in perpetuity, odd behavior in overnight markets, and puzzled central bankers who can't explain what's going on. Oh well.

Friday, June 21, 2019

Libra: Financial Inclusion for the World's Poor, or Scam?

In case you haven't heard, Facebook has recently set up a financial subsidiary, Calibra, and has issued a so-called "white paper" which is a proposal to issue a cryptocurrency, Libra. As stated in the white paper, "Libra's mission is to enable a simple global currency and financial infrastructure that empowers billions of people." Sounds rather lofty, don't you think? Financial innovation that's going to make a significant fraction of human beings, particularly the world's poor, significantly better off. Makes me want to give Mark Zuckerberg a big hug.

But hold on. What is Facebook actually proposing? The "white paper," which is obviously, in part, a public relations document, is long on vague descriptions of inclusion, working together, integrity, blah, blah, blah - and short on some critical details. So what is Libra exactly? It's a bank. Let's just call it the Facebook Bank. This bank will have assets, liabilities, capital, and shareholders. And, what makes it a bank is that its liabilities - Libra - are intended to function as means of payment. So what's the problem the Facebook Bank is trying to solve? Given the available technology, our payments systems are remarkably slow and costly to use, particularly the ones that involve international transactions. God knows that domestic payments in the United States are particularly slow and costly, but try to move money between countries and you'll have spend some time and energy in figuring out how to do it at the lowest cost. And you probably won't be happy with the best thing you can find.

Some of the people who want to move money between countries are poor people, for example immigrants come to Canada from poor countries and want to send transfers to their relatives. But most of the money moving around the world is moved by rich people, so they would certainly benefit in principle from what the Facebook Bank claims to offer. And of course, plenty of shady people move money between countries. For example, people in the US who import street drugs from wherever need to get money to the suppliers of those drugs, and it would be a lot cheaper to send it electronically than running currency across the border. Or Don Jr. needs a vehicle for getting his money from the Russian oligarch, the Saudi Prince, or whoever. If regulation of the Facebook Bank is lax, plenty of shady people will be using it for sure.

So, just in case this isn't totally obvious, Mark Zuckerberg cares about making a profit. If this enterprise flies, it's not because it's just helping poor people, though some of them might benefit. Mark Zuckerberg makes big money by serving rich people and, maybe, crooks.

Next, to the details of what's in the "white paper." First, note that "white paper" is a term first used by the British government for proposals it was floating prior to writing legislation. Callting the Facebook Bank proposal a "white paper" of course lends an air of authority to this marketing effort, which has also included consultation by Facebook with some financial regulators - the Fed included (Powell mentioned this in his last press conference). Zuckerberg understands that regulation is a potential obstacle to big profits, so he wants to stay on the good side of people like Jay Powell.

We need to look at the proposed financial structure of the Facebook Bank. In contrast to typical cryptocurrencies, the Facebook Bank will have assets backing Libra. Bitcoin for example is more like a commodity money. It's fundamentally costless to create Bitcoin, but the Bitcoin mechanism is set up to make Bitcoin scarce - there's an upper bound on supply, and creating more Bitcoin currently requires competing as a miner to update the blockchain, and this competition burns phenomenal quantities of electricity. New Libra will be created by someone exchanging balances denominated in some standard currency, Canadian dollars for example, for Libra. Then, those balances would be used to buy assets. No mystery there, as that's what banks do. But what are the assets? The section in the "white paper" on the "The Reserve" tells us that these assets will be "stable and liquid," more particularly the short term debt of countries not deemed to be likely to default or inflate, and "bank deposits."

So this is starting to sound a bit like a narrow bank. An example of a narrow bank would be a bank that issues demand deposits, subject to withdrawal, one-for-one, in U.S. currency, backed by a portfolio of 3-month US Treasury bills. But the Facebook Bank is not a standard narrow bank. First, its assets will have payoffs denominated in different currencies. In principle, the asset portfolio could be diversified, but the riskiness of the whole enterprise will depend on the nature of the liabilities.

Facebook Bank liabilities - Libra - is where the action is in this proposed operation. Ultimate users of the means of payment will not actually interact directly with the Facebook Bank. There will be "authorized resellers" who transact with the Facebook Bank. If you and I want to acquire Libra, or sell Libra in exchange for Pound Sterling or Mexican Pesos, we have to interact with an authorized reseller. Though this is vague in the "white paper," it appears that resellers can exchange Libra for various currencies, and vice versa, with the Facebook Bank. So, as the "white paper" says, the Facebook Bank "mints and burns coins." The key question is, at what prices can a reseller "mint and burn?" It seems that Libra is a demand liability. This is what makes every successful banking system work. Bank liabilities are convertible into something at a fixed rate. In the very old days, there was convertibility into precious metals, and in modern times banks convert deposits one-for-one into domestic currency. If the convenience of the Facebook Bank comes from having demand liabilities that are convertible at fixed rates into a set of currencies, then the Facebook Bank is potentially unstable, in the same sense any bank is. We know how we overcome that. We have regulation, deposit insurance, central bank lender-of-last-resort facilities, capital requirements. If there aren't fixed rates of conversion of the liabilities, then the Facebook Bank is more like a mutual fund, which makes the liabilities less convenient as a means of payment. An interesting feature of the Facebook Bank is that the liabilities won't pay interest. How come? There's inflation in the world, so one might think it would be in the interest of an profit-seeking financial institution to offer liabilities that are going to compensate for inflation - by paying interest.

Don't be fooled by the use of the word "cryptocurrency" in the "white paper" to describe the Facebook Bank's liabilities. This is similar to how some security issuers use the word "coin" to mask what they're doing. For example, an "initial coin offering" or ICO is just the issue of a security that typically has features that look like simple debt or equity. What makes these securities different is that they're traded using a decentralized ledger. A complete record of ownership and trades is in the blockchain. Similarly, the Facebook Bank's liabilities - Libra - are just bank deposits traded on a distributed ledger instead of through the conventional system of bank recordkeeping, supported by interbank transfers on the central bank's books. What we should be wary of is the possibility that, by issuing a cryptocurrency, Facebook is just evading regulation, in the same way that "coin offerings" evade securities regulation. It's well-known that ICOs are a cesspool of fraud.

And why trade the Facebook Bank's deposit liabilities using blockchain? From what I can tell, all the experiments with blockchain have been a bust. It's very exciting to sort out how blockchains work, and to talk about it at dinner parties, but decentralized ledgers have thus far been a failure. Basically, providing the incentives that prevent manipulation of the blockchain for individual gain is too costly. Unless Facebook has some technological breakthrough they're hiding from us, what we know about blockchain makes the "white paper's" claims of low-cost financial services seem like wishful thinking.

Is there anything regulators should be doing about the Facebook Bank, or should we just let Facebook take its chances and let them worry about the consequences? Well, in banking we have a long history of regulation. Sometimes regulators, and the people setting up the regulatory structure, make mistakes. But there's never been a successful banking system that didn't have a strong regulatory hand behind it. Laissez faire banking is only an idea, not demonstrated best practice. So, regulators should be paying attention to this, asking questions, and figuring out what to do about it.

Thursday, May 2, 2019

Can the Fed Control Overnight Rates?

The mechanism under which central banks peg overnight nominal interest rates typically relies on having a sufficiently large buffer of some asset or liability, then supplying that asset or liability inelastically at the desired overnight rate. Financial market arbitrage then looks after the rest - the pegged nominal interest rate effectively sets all short-term interest rates. Before the financial crisis, the buffer for the Fed was a stock of overnight repos, supplied at a rate that would peg overnight repo rates. But, that was a tricky game, as the Fed's ultimate interest rate target was the unsecured fed funds rate. The New York Fed had to make daily adjustments in its repo market trading strategy to account for the factors that might cause differences between market repo rates and the fed funds rate. So, with the advent of interest payments on reserves in October 2008, and the large Fed balance sheet, some may have thought that controlling overnight interest rates would be comparatively easy.

Under the floor system the Fed now operates under, the buffer is a large stock of reserve balances held by commercial banks. The Fed sets the interest rate on reserves, IOER, and in theory this should determine all overnight rates. That is, the Fed now pegs an interest rate on one of its liabilities, rather than one of its assets. But, as it turns out, arbitrage in US financial markets does not work like arbitrage in theory. In spite of the very large stock of reserves outstanding, setting IOER does not always do a good job of pegging overnight rates of interest.

When the Fed began "normalization," by raising its interest rate target, in December 2015, it established a "leaky floor" system, under which IOER would be viewed as an upper bound on the fed funds rate, and the lower bound would be the ON-RRP rate, an interest rate on reverse repurchase agreements, which the Fed would supply elastically in a daily auction. Initially, the margin between the IOER and the ON-RRP rate was 25 basis points. Until early in 2018, the fed funds rate fell between the ON-RRP rate and IOER. Overnight repo rates, along with short-term T-bill rates, tended to fall around the ON-RRP rate.

But, by early 2018, things changed. All short-term interest rates moved up to the vicinity of IOER, and the Fed's ON-RRP facility became effectively dormant. I discussed these developments in this post, in this one, and in this one. My interpretation of events is that, from 2009 to early 2018, collateral was scarce in overnight markets, making repo rates low relative to the fed funds rate and IOER. This scarcity was primarily due to the Fed's asset purchases (quantitative easing), and when the Fed phased out its reinvestment policy (replacing maturing assets on its balance sheet), the scarcity went away. The Fed blamed the Treasury, citing increased Treasury issues. It's possible that contributed to the easing of the collateral scarcity, but I'm not sure.

Recently, something unexpected has happened. These are daily observations on the fed funds rate and a Treasury repo rate:
This shows daily data from December 20, 2018, just after the last FOMC interest rate hike, through April 29. IOER is set at 2.4% through the whole period. You can see that, until recently, IOER was pegging the fed funds rate at 2.4%, but in recent weeks the fed funds rate has eased up to, to at most 5 basis points above IOER. The repo rate I've shown exhibits a similar pattern, though there's more volatility in the repo rate. As well, the repo rate exhibits spikes at month end - particularly pronounced at year-end 2018. The other two Treasury repo rates the New York Fed reports show essentially identical behavior.

For good measure, the next chart shows 1-month and 3-month T-bill secondary market yields.
So, T-bills are actually trading lower than fed funds recently - for the most part.

So, what could be going on here? It cannot be the case that reserves are somehow becoming "scarce." There's still about $1.5 trillion in reserves outstanding, and even extreme floor-system enthusiasts don't seem to think that $1.5 trillion isn't a lot. Why would banks forego a five-basis-point profit opportunity to lending on the fed funds market rather than holding reserves? What's changed in the last few weeks? Whatever is going on, the Fed is not controlling overnight rates as it anticipated, or the way it should.

There's an easy fix, however, and that's Andolfatto and Ihrig's standing repo facility (see also this post) - though Andolfatto and Ihrig (A/I) are offering the wrong reasons for the right action. The A/I argument is that a standing repo facility is necessary to make the Treasury holdings of large banks more liquid in the event of financial stress and wholesale funding outflows. Large banks hold liquid assets in line with their Dodd-Frank resolution plans, as well as to fulfill liquidity coverage requirements. One might think that Treasury securities are just as good as reserves for these purposes, but A/I argue to the contrary. The idea is that a stressed large bank might have trouble unloading a large quantity of Treasuries, or borrowing against them on the repo market. This argument might seem odd as: (i) A time of heavy stress for a large bank would typically be associated with aggregate stress. And - again typically - what happens in such episodes is that market participants are fleeing to safety, and safe assets include Treasury securities. So, there's not likely to be a problem in unloading Treasuries or in borrowing against them during a period of stress. (ii) It's the Fed's job to smooth fluctuations in short safe rates of interest. So, is there something wrong with the Fed's ability to control short rates?

Well, it appears there is something wrong with the Fed's ability to control short rates. I'm actually less concerned with the fed funds rate, and more concerned with repo rates, as the Fed should be. Those end-of-month spikes in repo rates shouldn't be happening. Here's what would fix overnight markets. The Fed should go back to the sort of repo intervention they did before the financial crisis - fine if they want to call this a standing repo facility, or whatever. Use the same counterparties as for the Fed's reverse repo facility - a broad-based approach is ideal. A/I are suggesting that the targeted repo rate be above IOER, but why not set it equal to IOER?

This then raises two questions: (i) Why the focus on the fed funds rate? Most central banks target a repo rate. (ii) Why the large balance sheet? The floor system isn't working.

Thursday, February 21, 2019

Balance Sheet News

The FOMC minutes for the January 29-30 meeting, released yesterday, contain some important information about the Fed's balance sheet, and plans for the FOMC's future operating strategy. Let's unpack this, to try to understand what they're up to.

The key information is in the section in the minutes on "Long Run Monetary Policy Implementation Frameworks." This section deals with presentations from staff economists (in part from the previous FOMC meeting), and discussion of that material. The minutes say:
The staff briefing also included a discussion of factors relevant in judging the level of reserves that would support the efficient implementation of monetary policy.
The key word is "efficient." It's not clear why we would just look at the level of an item on the liabilities side of the Fed's balance sheet to determine what would permit "efficient" monetary policy. It's also not clear what "efficient" means. But whatever it is, some people seem convinced that the Fed has almost attained it:
Some recent survey information and other evidence suggested that reserves might begin to approach an efficient level later this year.
So, what to do?
Against this backdrop, the staff presented options for substantially slowing the decline in reserves by ending the reduction in asset holdings at some point over the latter half of this year and thereafter holding the size of the SOMA portfolio roughly constant for a time so that the average level of reserves would fall at a very gradual pace reflecting the trend growth in other Federal Reserve liabilities.
Note that, at that point in the meeting, this is all coming from staff economists. There's a statement about the objective, which is efficiency, a conclusion that we're close to efficiency, and a recommendation as to what to do once efficiency is achieved. That is, later in the year, the Fed should start buying securities again, so as to maintain the size of the balance sheet at a constant nominal level, until further notice. Ultimately, the minutes indicate that the FOMC agreed to that.

What's going on? Total securities held outright by the Fed look like this:
So, in terms of the nominal quantity of securities held, there hasn't really been much "normalization" of the asset portfolio. And it's not like we would arrive at a different conclusion if we were to look at total Fed assets as a percentage of GDP:
That is, 20% of GDP is lower than the peak of 25% of GDP, but it's a lot higher than the pre-crisis 6%. If 6% was OK before the financial crisis, why is something a little less than 20% "efficient" now?

It might help to look at what is happening on the liabilities side of the balance sheet. Two key Fed liabilities are currency and reserves, of course, but there are also a couple of weird items that we wouldn't normally be concerned about, which are reverse repos of foreign institutions (including foreign central banks), and the Treasury's general account with the Fed. First, currency:
The stock of currency in circulation has more than doubled in nominal terms since before the last recession. Even more impressive is what we see if we look at the currency/GDP ratio:
U.S. currency held in the world has increased from about 5.5% of U.S. GDP before the financial crisis, to over 8% of GDP today. Thus, the Fed now needs an asset portfolio of 8% of GDP just to support the demand for U.S. currency. Still, that's far short of 20%.

With respect to those weird Fed liabilities, look at this:
First, what are those reverse repos, "foreign and international accounts?" Details on this are on the New York Fed's website. These are "accounts" held by "250 central banks, governments and international official institutions." The accounts are reserve accounts. The accounts are reserves during the day, and then become Fed reverse repos overnight, secured by securities in the Fed's portfolio. Thus, like the Fed's domestic reverse repo (ON-RRP) facility, this basically permits the Fed to pay interest on a reserve account to an entity which is not permitted to receive interest on reserves given the rules set up by Congress. Calling this "reverse repurchase agreements" is just a convenient fiction to get around the law. The key point is that these reverse repos have grown from about $50 billion before the financial crisis to about $250 billion today. What's driving that? The New York Fed says:
Like other factors affecting the level of reserves in the U.S. banking system, an increase in investment in the foreign repo pool results in a corresponding decrease in reserves. Given that a change in the size of the foreign repo pool alters the availability of reserves in the U.S. financial system, the New York Fed can manage the overall size of the foreign repo pool or individual account participation in the foreign repo pool in order to maintain orderly market or reserve management conditions. In addition, the New York Fed may choose to limit the overall size of, or individual account participation in, the foreign repo pool based on other factors, such as the amount of available securities held at any time in the SOMA.
This recognizes that more reserves held by these foreign entities means less reserves held by domestic entities, and that this could mess with the Fed's monetary policy actions. But, the quote tells us that the quantity of outstanding reverse repos of this type is purely discretionary. So, for some unspecified reason the Fed decided to increase the "foreign repo pool," and presumably there is no reason outstanding reverse repos could not be reduced to their pre-crisis levels or lower.

Next, consider the balance in the Treasury's General Account, in the last chart (in blue). It's become large, and it's highly variable. For any central bank, managing reserve balances of the fiscal authority at the central bank is an issue. Whenever tax revenue flows into the fiscal authority's reserve account, that reduces reserves held by the private sector. And, when the fiscal authority issues more debt, that also reduces reserves in private hands. So, if the central bank is running a conventional corridor system, as for example in Canada, with zero reserves held overnight, inflows and outflows in the fiscal authority's reserve account can thwart monetary policy, unless these inflows and outflows are offset. For example, the Bank of Canada conducts a twice-daily auction of government of Canada reserve balances. Some of these auctions involve secured funds, some are unsecured, and the funds are lent out at various maturities.

In the US, before the financial crisis, the Fed implemented monetary policy in a corridor system, where the lower bound on overnight interest rates was zero. In that system, part of the mechanism in place to deal with fiscal effects on reserve balances was the Treasury Tax and Loan Program, which parked tax revenues in private financial institutions rather than in the Treasury's reserve account. That solved part of the problem, and presumably the New York Fed was actively engaged in offsetting the effects of Treasury auctions and maturing government debt, which would be predictable on a daily basis. All of that is out the window, apparently, as part of the Fed's current floor system. Treasury balances are large - close to $400 billion currently - and highly volatile, with swings of up to $100-$300 billion over short periods of time. Apparently this amount of volatility is of no concern to the Fed currently.

In total, the weird Fed liabilities comprise roughly 3% of GDP, so this is significant.

What's left, in terms of Fed liabilities? Reserves, of course:
So, at the current rate of decline, reserves could be down to the vicinity of $1 trillion toward the end of the year. It appears that this is the number that the Fed people think is "efficient."

So, it appears the FOMC has decided: (i) that a floor system is better than a corridor system; (ii) that it might take $1 trillion in reserves to support a floor system. What are their arguments?

1. Transitioning back to a corridor system would be difficult. From the FOMC minutes, the argument seems to be that, given uncertainty about the level of reserves required to support the floor system, we would have to go through a period of volatile short-term interest rates in the transition period. Nonsense. The problem here follows from a poor choice of the Fed's interest rate target. If the Fed were to target a repo rate, rather than the fed funds rate, the problem goes away. Here's how to do it. For now, set the target repo rate equal to IOER (interest rate on reserves). Then, auction either repos or reverse repos at that rate - fixed rate full allotment.
2. Survey evidence indicates that the demand for reserves is large. The survey evidence comes from the Senior Financial Officer Survey. Basically, people in the banking industry respond to survey questions in a way that appears to indicate that their institutions would continue to hold large quantities of reserves, even if they were giving up 25 to 50 basis points by foregoing lending in the repo market, for example. If this were true, this indicates significant friction in overnight markets, and we should see that in market interest rates. Currently, IOER is at 2.4%, and the fed funds rate is 2.4%. The last date on which the fed funds rate was less than IOER was December 14, 2018. The repo rates measured by the NY Fed are currently 2.39%, 2.37%, and 2.37%, so right now financial arbitrage in overnight markets seems pretty good. So, I think the interpretation of the survey evidence is nonsense too.
3. Regulation has increased the demand for reserves. On this one, a speech by Randy Quarles is helpful. Quarles explains how Basel III regulatory changes regarding liquidity coverage ratios (LCR) were implemented in the United States. Basically, commercial banks need to hold sufficient liquid assets to buffer potential outflows of wholesale deposits. This is essentially a type of reserve requirement. But what's a liquid asset for regulatory purposes? It turns out that Treasury securities and reserves are equivalent, and some other assets are deemed less liquid, and get a haircut when the LCR is calculated. As Quarles says:
One could envision that as the Fed reduces its securities holdings, a large share of which consists of Treasury securities, banks would easily replace any reduction in reserve balances with Treasury holdings, thereby keeping their LCRs roughly unchanged.
It's not clear in Quarles's speech whether he buys that argument or not - he's just laying out the arguments. But I think that argument is powerful. A reduction in the Fed's balance sheet is essentially a swap of Treasury securities for reserves. In fulfilling the LCR, Treasuries and reserves are equivalent, and should be. Given a deposit outflow, a bank can reduce reserves, it could sell Treasuries, or it could borrow in the repo market with Treasuries as collateral. A financial system with a lot of Treasuries and not so much reserves is just as liquid as a financial system with not so much Treasuries and a lot of reserves. In fact, we could argue that the the first system is more liquid, since Treasuries can be traded widely while reserves are confined to those financial institutions with reserve accounts. I'd say this argument is nonsense too.
4. Short-term interest rates are more volatile in a corridor system than in a floor system.Again, this depends on what interest rate the Fed targets. Using the fed funds rate as a target has its problems, for two reasons. First, under its corridor system, the Fed did not intervene in the fed funds market - it was typically intervening in the overnight repo market. Essentially, the Fed varied the quantity of repos in order to hit a fed funds target, without being able to see the actual fed funds rate while it was intervening. You can see why that might not work so well. Further, fed funds lending is unsecured, so in times of financial market turmoil, the fed funds market is contaminated with risk. The Fed may be pegging the fed funds rate in such situations, but volatility in risk will then cause volatility in safe rates of interest. Again, these problems can be solved easily if the Fed were to target an overnight repo rate, as is done in many other countries. Here in Canada, the Bank of Canada has no problem with volatility of short-term interest rates, in running its corridor system.

Overall, the Fed is overly-focused on reserves, as if monetary policy implementation could be represented satisfactorily in terms of some static demand and supply analysis of the "market for reserves." That's very misleading. Any central bank has a lot of options in implementing monetary policy, but basically there are two broad approaches. Market interest rates can be targeted through variation in the central bank's lending, or in its borrowing. When the Fed was founded, the founders envisioned that the intervention would happen through lending, and that the key instrument would be the discount rate - with potentially different discount rates for different Fed districts. Roughly, the ECB intervenes by lending to banks in the Euro zone - it's key policy rate is its refinancing rate (at least when it's running a corridor and not a floor). Before the financial crisis, the Fed intervened day-to-day by lending on the repo market. Here's what that looked like:
So, repos outstanding fluctuated between $20 billion and $40 billion, for the most part. The Fed could have chosen to intervene by varying the quantity of reverse repos outstanding (on the borrowing side), and that would not have made much difference. In the current floor system, the Fed intervenes on the borrowing side, fixing the interest rate on reserves, and letting the private sector determine the quantity of reserves and currency to hold, given that currency can be converted to reserves one-for-one.

However the Fed intervenes, this involves varying the quantity of some Fed asset or liability, so as to peg the market interest rate on that asset or liability. This intervention is most effective if the Fed can essentially set that market interest rate, and then let the market determine the quantity. For that to work, the relevant market should be sufficiently liquid, and the Fed needs to have an adequate buffer stock of that asset or liability. Apparently, before the financial crisis, the Fed was successful in intervening with a stock of repos of from $20 billion to $40 billion. So why does the Fed think it needs $1 trillion in reserves outstanding to allow it to peg short-term interest rates by setting IOER?

As David Beckworth points out, between spring 2009 and spring 2010, the Bank of Canada ran a floor system with about $3 billion in reserves held overnight. As is well known, translating between Canada and the US involves multiplying by a factor of 10, so accounting for the exchange rate, that's about $40 billion in US reserves - in the ballpark of outstanding repos prior to the financial crisis. Canada has a very different institutional setup, but one would have to make the case that the US financial system has huge financial market frictions relative to Canada to justify a threshold of $1 trillion to make a floor system work.

But what's the harm in a large Fed balance sheet? The larger the balance sheet, the lower is the quantity of Treasury securities in financial markets, and the higher is reserves. Treasuries are highly liquid, widely-traded securities that play a key role in overnight repo markets. Reserves are highly liquid - for the institutions that hold them - but they are held only by a subset of financial institutions. Thus, a large Fed balance sheet could harm the operation of financial markets. As I pointed out here and here, there's evidence that such harm was being done. That is, if there's harm, it would be reflected in a scarcity of collateral in overnight financial markets - in market interest rates. Before early 2018, T-bill rates and repo rates tended to be lower than the fed funds rate, and the fed funds rate was lower than IOER. Now, all those rates are about the same. The Fed thinks the difference is more Treasury debt, but I think the end of the Fed's reinvestment program mattered, in that it increased the stock of on-the-run Treasuries. Whichever it was, apparently the quantity of Treasuries outstanding matters for the smooth - indeed, efficient - operation of financial markets, and the Fed should not mess with that. My prediction would be that, if we get to the end of the year and the Fed is again buying Treasuries, that we'll see repo rates and T-bill rates dropping below IOER. Watch for that.