"Interest-On-Reserves Regime" Will Rule Monetary Policy For The Foreseeable Future

When the Fed began paying IOR and IOER on October 9, 2008, the Fed Funds rate stood at 1.5%. With the US financial system already experiencing a liquidity crisis, the Fed was actively engaged in providing liquidity through various operations (see this Financial Turmoil Timeline). The rising demand for reserves was making it increasingly difficult for the Fed to maintain its interest rate target, through reserve management, while simultaneously ensuring liquidity. A clear solution, implementing an “interest-on reserves regime”, had been laid out by the Federal Reserve’s Marvin Goodfriend several years earlier in a paper on Interest On Reserves and Monetary Policy.

Goodfriend noted that:

the interest-on-reserves regime would differ from the Fed’s current operating procedures in one important respect. Open market operations would cease to support the interbank rate in the new regime. (p.3)

Instead, the rate of interest-on-reserves would maintain the interest rate target while:

open market operations would have the potential to manage productively the aggregate quantity of broad liquidity in the economy independently of interest rate policy. A central bank could increase broad liquidity in the economy by using newly created reserves to acquire less liquid assets or by financing a temporary government budget deficit. (p.3)

Previously the Fed’s ability to:

manage broad liquidity...by changing the composition of its assets, for example, by selling liquid short-term Treasury securities and acquiring less liquid longer term securities... [was] strictly limited by the size of its balance sheet. (p.4)

Changing the Fed’s operating procedures to use interest-on-reserves in setting interest rates, therefore allowed the Fed to engage in massive balance sheet expansion, via QE, and to increase the size of Operation Twist. Through these unconventional measures the Fed not only continues to increase liquidity and “finance” the federal budget deficit, but also manages to lower long-term interest rates.

Following the ECB’s decision to stop paying interest-on-reserves, proponents of monetary stimulus within the US are calling for the Fed to adopt a similar stance or potentially make the nominal rate negative. While I previously examined the potential fallout from a negative IOER rate, in light of the above information, a reversion back to previous monetary policy procedures seems even less probable.

The Federal Reserve’s decision to implement an “interest-on-reserves regime” has clearly been beneficial in permitting the use of previously conventional measures for unconventional purposes, including the provision of liquidity and “financing” of federal budget deficits. Eliminating the payment of interest-on-reserves will not prevent the Fed from continuing to use open market operations in this manner, as long as the Fed Funds rate remains at zero. However, departing from this new regime will ensure that any future rate hikes be preempted by a reversal of the balance sheet expansion (or excess sale of Treasuries). Balance sheet contraction, through open market operations, could very well depress asset values and raise long-term interest rates. If this occurs, the Fed would be effectively causing a new crisis just as the economy is becoming increasingly stable. Separately, a 25 basis point reduction in short-term interest rates is unlikely to cause a noticeable rise in credit demand but would reduce financial sector profits. Given that any decision to cease paying interest-on-reserves would likely be temporary and the potential benefit is limited, there is seemingly little reason for the Fed to change course. An “interest-on-reserves regime” appears likely to rule monetary policy for the foreseeable future.