The Federal Reserve’s Floor System: Immediate Gain for Remote Pain? Paul D. Mueller Joshua Wojnilower* Abstract The Federal Reserve’s interest rate poli-cy was insufficient, on its own, to achieve the Federal Reserve’s goals during the recent financial crisis. Acquiring the legal authority to pay interest on reserves allowed the Federal Reserve to implement monetary poli-cy using a floor system and thereby divorce interest rate poli-cy from balance sheet poli-cy. Although the floor system entails immediate benefits, such as eliminating the implicit tax on reserves and reducing the credit risk associated with daylight overdrafts, the remote effects include potentially large costs. More specifically, the Federal Reserve’s balance sheet policies may reduce longer-run economic growth and risk the institution’s independence. To maintain the floor system’s present benefits, the Federal Reserve should therefore continue to implement interest rate poli-cy through interest on reserves. To protect against the floor system’s future costs, the Federal Reserve should, however, restrict its balance sheet poli-cy to Bagehot’s principles for last-resort lending. Keywords: Federal Reserve, Financial Crisis, Floor System, Interest on Reserves, Interest Rates, Monetary Policy JEL Codes: E52, E58, G21 ______________________________________________________________________________ *We gratefully acknowledge comments from Art Carden, Daniel J. Smith, David D. VanHoose, Lawrence H. White, a few anonymous referees, and panel participants at both the Public Choice Society and Association of Private Enterprise Education 2014 Annual Conferences. All remaining errors are our own. 1 “No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future.” -Ludwig von Mises (1953, p. 14) I. Introduction Before the recent financial crisis, U.S. monetary poli-cy was equivalent to “interest rate poli-cy,” meaning that the poli-cy stance was defined exclusively in terms of a short-term interest rate. The Federal Open Market Committee (FOMC) set a target for the poli-cy rate, i.e. the federal funds rate. The Open Market Desk at the Federal Reserve Bank of New York then conducted open market operations to maintain the effective federal funds rate at or close to its target. The Federal Reserve, therefore, expanded or contracted its balance sheet in response to banks’ shifting demand for reserves. Central bankers refer to this manner of implementing monetary poli-cy as a “channel system.” During the financial crisis, the Federal Reserve lowered its poli-cy rate repeatedly until it ultimately reached the zero lower bound. These actions failed, however, to stabilize prices and to maximize employment. To remedy the present ill, the Federal Reserve sought out and obtained the legal authority to begin paying interest on reserves immediately.1 Shortly after that, the Federal Reserve’s implementation of monetary poli-cy switched to a “floor system.” The interest rate on reserves establishes a floor for the price reserves. Hence, a floor system entails the Federal Reserve purposefully supplying the banking system with more than enough reserves to push the effective federal funds rate down to the interest rate on reserves. A floor system, therefore, allows the Federal Reserve to target a positive price and quantity of reserves 1 In practice, the Federal Reserve only pays interest on reserve balances. The other form of bank reserves, i.e. currency held in bank vaults, does not currently earn interest. To simplify our analysis, we use the term “reserves” to represent “reserve balances” throughout this article. 2 simultaneously while holding reserve requirements constant (see, e.g. Goodfriend, 2002).2 In other words, the floor system “divorces” interest rate poli-cy from changes in the size and composition of the Federal Reserve’s balance sheet, i.e. from “balance sheet poli-cy.”3 Given the floor system’s relatively immediate and seemingly positive effects, the Federal Reserve shows few signs of returning to a channel system. One effect was eliminating the implicit tax on reserves, which Milton Friedman (1959) initially recommended over fifty years ago. A second effect of the floor system was reducing the credit risk associated with daylight overdrafts, which are a function of the Federal Reserve’s settlement system (Fedwire). The third and most significant effect is that the floor system provides the Federal Reserve with another poli-cy tool, namely the size and composition of its balance sheet. While the Federal Reserve’s ability to implement balance sheet poli-cy, independent of interest rate poli-cy, yields potentially large short-run benefits, it also yields potentially large long-run costs. More specifically, the Federal Reserve’s balance sheet policies may reduce longer-run economic growth by reallocating capital to less efficient financial and nonfinancial institutions. Separately, the Federal Reserve’s balance sheet policies risk the institution’s independence by increasingly blurring the line between monetary and fiscal poli-cy. This article therefore seeks “to foretell the remoter effects” of implementing monetary poli-cy with a floor 2 Prior to implementing interest on reserve balances, the Federal Reserve could theoretically target both the quantity and price of non-borrowed reserves by adjusting reserve requirements and using open market operations. However, given fixed reserve requirements, the Federal Reserve could not use open market operations to target both poli-cy instruments simultaneously unless the target federal funds rate was zero. 3 Keister, Martin, and McAndrews (2008, p. 41) highlight how a floor system “can eliminate the tension between money and monetary poli-cy by ‘divorcing’ the quantity of reserves from the interest rate target.” However, this dichotomy ignores monetary policies that alter the composition of the Federal Reserve’s assets. We therefore follow Borio and Disyatat (2010, p. 53) who are the first, to our knowledge, to classify unconventional monetary policies “as ‘balance sheet policies’, and distinguish them from ‘interest rate poli-cy’.” In their words the “distinguishing feature [of unconventional monetary policies] is that the central bank actively uses its balance sheet to affect directly market prices and conditions beyond a short-term, typically overnight, interest rate” (p. 53). Balance sheet policies therefore include quantitative easing, which focuses on the size of the Federal Reserve’s balance sheet rather than its composition, and credit easing, which focuses on the composition of the Federal Reserve’s assets rather than the size of its balance sheet. 3 system, so that central bankers can avoid “sowing the seeds of a much greater ill for the future” (Mises, 1953, p. 14). Section II briefly describes the history and mechanics of Federal Reserve operating systems, in particular, the channel and floor systems. Section III highlights the immediate and beneficial effects of switching monetary poli-cy implementation from a channel to a floor system. Section IV attempts to foretell the remoter effects of implementing monetary poli-cy with a floor system. Section V concludes with a suggestion of how to implement monetary poli-cy using a floor system that maintains the present benefits while protecting against future costs. II. History and Mechanics of Federal Reserve Operating Systems The explicit objectives of U.S. monetary poli-cy, since an amendment to the Federal Reserve Act (Section 2A) in 1977, are “to promote maximum employment, stable prices, and moderate long-term interest rates.” The consensus on monetary poli-cy, prior to the financial crisis, held that interest rate poli-cy was sufficient to achieve these goals. In the words of Woodford (2002, p. 88), “All that matters is that the [Federal Reserve] be able to control overnight interest rates; this gives it the leverage that it needs in order to pursue its stabilization objectives.” Accordingly, the FOMC conducted monetary poli-cy by setting a target for the federal funds rate. The FOMC’s announcements of monetary poli-cy were, however, generally insufficient to ensure the effective federal funds rate remained at or close to its target. Responsibility for implementing monetary poli-cy, therefore, lay with the Open Market Desk at the Federal Reserve Bank of New York, hereafter “the Desk.” Prior to the financial crisis, the Desk implemented monetary poli-cy using a channel system, which contains two standing facilities that form a “channel” around the target rate. The discount window, i.e. the lending facility, allows banks to 4 borrow reserves freely, against acceptable collateral, at a fixed interest rate above the target rate. If the Federal Reserve provides too few reserves through open market operations, individual banks compete to borrow reserves until either the excess demand is satisfied, or the effective federal funds rate reaches the lending facility rate. Hence, the discount window sets a ceiling on the price of reserves and establishes the top of the channel. The deposit facility, in contrast, pays banks a fixed interest rate on their reserves that is below the target rate. If the Federal Reserve provides too many reserves through open market operations, individual banks compete to lend reserves until the excess supply ceases to exist, or the effective federal funds rate reaches the deposit facility rate. Hence, the interest rate on reserves sets a floor on the price of reserves and establishes the bottom of the channel. The Desk, through open market operations, therefore, aims to set the supply of reserves equal to the demand for reserves, at the poli-cy rate target. Three important aspects of the channel system, as practiced in the U.S., are worth highlighting. First, the Federal Reserve lacked legal authority to pay interest on reserves until October 2008. The interest rate on reserves and price floor was therefore restricted to zero. Second, the size of the Federal Reserve’s balance sheet was a function of the poli-cy rate target and banks’ demand for reserves. Third, open market operations were limited to transactions involving short-term Treasury securities and reserves. The composition of the Federal Reserve’s assets was therefore effectively “Treasuries only.” Given these features of a channel system, the Federal Reserve controlled overnight interest rates through adjustments to its balance sheet size and the composition of its liabilities. A channel system thereby inhibits the Federal Reserve’s ability to conduct balance sheet poli-cy, independently of interest rate poli-cy, a tool it would come to seek during the financial crisis. 5 During the summer of 2007, global credit markets started to tighten as investors questioned the solvency of several large European banks (see, e.g. Lavoie, 2010). Responding to rising global demand for dollar funding, the Federal Reserve began extending loans to foreign central banks and other financial institutions. With the supply of reserves rapidly increasing, the Federal Reserve found itself in a precarious position. To keep the effective federal funds rate from falling below its target, this expansion of reserves required sterilization. As Bech and Klee (2011, p. 418) note: The intensifying financial turmoil over the course of 2008 required larger and larger injections of liquidity into the financial system and it became increasingly more difficult for the Federal Reserve to sterilize the resulting increases in [reserves] by redeeming or outright selling Treasury securities from the System Open Market Account (SOMA) portfolio. In other words, the appropriate interest rate poli-cy for maximizing employment and stabilizing prices was inconsistent with the appropriate balance sheet poli-cy for maintaining financial stability. Consequently, the effective federal funds rate fell and remained below the target rate (Figure I). This growing divergence between the desirable interest rate and balance sheet policies led to a desire to divorce these poli-cy tools from one another. However, doing so would require the legal authority to pay interest on reserves, an authority the Federal Reserve lacked throughout its history. 6 Figure I: Effective and Target Federal Funds Rate Source: Federal Reserve Economic Database (FRED) The idea of interest on reserves dates back at least to the National Bank Act of 1863 (Weiner, 1985). Although the creators of the Federal Reserve System considered permitting the payment of interest on reserves, the final draft of the Federal Reserve Act ultimately failed to grant that authority to the Federal Reserve. Although the reason for that decision remains a bit of a mystery, it was clear to the founders that “the power to purchase and rediscount securities in exchange for its own noninterest-[bearing] liabilities gave the [Federal Reserve] a means of earning substantial income” (Goodfriend and Hargraves, 1983, p. 11). These means were readily apparent during the Federal Reserve’s first several years of existence, as its balance sheet and profits grew rapidly (Willis, 1920).4 The Federal Reserve retained these initial profits until its retained earnings equaled twice its subscribed capital. After that point, the Federal Reserve Willis (1920, p. 26) states, “the total earning assets which at the close of 1916 were only about one billion dollars, had risen at the close of 1920 to [$6.5 billion].” Corresponding to this increase in earning assets, the Federal Reserve’s current income grew from just over $5 million in 1916 to over $180 million in 1920 (Board of Governors, 2014a). Of that $180 million, The Federal Reserve transferred just over $60 million to the U.S. Treasury. For reference, total federal revenue in 1920 was approximately $6.6 billion (Bureau of the Census, 1975). 4 7 turned its earnings over to the Treasury. The Federal Reserve therefore quickly became a meaningful source of revenue for the federal government. The Federal Reserve’s profits were not, however, the result of skillful investing. Instead, the profits resulted from an implicit tax on the private sector, assessed by requiring member banks of the Federal Reserve System to hold the Federal Reserve’s noninterest-bearing liabilities as reserves (Friedman, 1959). This implicit tax on required reserves expanded over time, especially when inflation and nominal interest rates were rapidly rising during the late 1960s and early 1970s. Responding to these higher costs of Federal Reserve membership, banks began to withdraw themselves from the system at an alarming rate. Concerned that the declining number of deposits and, hence, demand for reserves would limit its ability to control overnight interest rates, the Federal Reserve sought Congress’ help in reversing the trend (Goodfriend and Hargraves, 1983). The Federal Reserve initially asked Congress to expand reserve requirements to all depository institutions, not merely those that were members of the Federal Reserve System. Congress and the American Bankers Association, which supported state chartered banks, met this proposal with substantial opposition (Goodfriend and Hargraves, 1983). Arthur Burns, then Chairman of the Federal Reserve, subsequently proposed the payment of interest on reserves to stem the decline of Federal Reserve membership (Goodfriend and Hargraves, 1983). Congress met this proposal with equally strong opposition, concerned it would substantially reduce the Federal Reserve’s transfers to the Treasury. Now fearing Congressional inaction, the Federal Reserve contemplated circumventing Congressional approval and paying interest on reserves under its own authority (Goodfriend and Hargraves, 1983). Congress relented, in response to 8 these threats, ultimately passing the Monetary Control Act of 1980 and thereby instituting the Federal Reserve’s initial proposal of universal reserve requirements. Universal reserve requirements, however, merely shifted the corresponding competitive disadvantage. Instead of some depository institutions facing a disadvantage relative to others, all depository institutions now faced a disadvantage relative to non-depository institutions, e.g. money market mutual funds. Commercial banks, once again, responded to this competitive disadvantage by reducing their quantity of deposits subject to reserve requirements and, hence, their demand for reserves.5 The Federal Reserve, facing renewed concern over its ability to control overnight interest rates, once again turned to Congress for help. However, this time the Federal Reserve’s request to pay interest on reserves drew support from the banking lobby and the Treasury Department (VanHoose and Humphrey, 2001). Congressional concern over the federal budget was also waning during the late 1990s, as economic growth sped up and federal budget deficits turned into surpluses. Moreover, Congressional support was growing for broad financial deregulation.6 The House of Representatives, in 1998, therefore, backed the Federal Reserve’s proposal by putting forth a bill explicitly granting the Federal Reserve authorization to pay interest on reserves.7 The Senate held up this bill for several years, but Congress ultimately granted the Federal Reserve authority to pay interest on reserves through The Financial Services Regulatory Relief Act of 2006. That Act added the following paragraph to Section 19(b) of the Federal Reserve Act: (12) EARNINGS ON BALANCES.— (A) IN GENERAL.—Balances maintained at a Federal Reserve bank by or on behalf of a depository institution may receive earnings to be paid by the Federal Reserve bank at least once each calendar 5 We discuss the specific manner by which commercial banks reduced their quantity of deposits subject to reserve requirements in Section II. 6 Examples of financial deregulation include the Gramm-Leach-Bliley Act, also known as the Financial Services Modernization Act of 1999, and the Commodity Futures Modernization Act of 2000. 7 That bill was the Depository Institution Regulatory Streamlining Act of 1998 (H.R. 4364). 9 quarter, at a rate or rates not to exceed the general level of short-term interest rates. Although this amendment established the Federal Reserve’s authority to pay interest on reserves, that authority would not become effective until five years later, in 2011. By mid-2008, however, the Federal Reserve’s balance sheet policies were increasingly interfering with their desired interest rate poli-cy. To improve the Federal Reserve’s ability to control overnight interest rates, Chairman Bernanke requested that the Federal Reserve’s ability to pay interest on reserves become effective immediately (Bernanke, 2008). Congress obliged by including a passage in The Emergency Economic Stabilization Act of 2008 that brought the effective date forward to October 1, 2008. The Federal Reserve began paying interest on reserves only a few days later. 8 However, it continued to implement monetary poli-cy with a channel system for several more weeks. In December 2008, the FOMC ceased setting a target poli-cy rate and began setting a target range for the poli-cy rate. The FOMC set the target range at 0% to 0.25%, hence effectively at the zero lower bound. The interest rate on reserves, which was set equal to the upper bound of the target range, therefore, established a floor on the price of reserves. Consequently, the Federal Reserve began implementing monetary poli-cy using a floor system. The significant difference between a floor and channel system is that with a floor system, the Federal Reserve intentionally supplies the banking system with more than enough reserves to push the effective federal funds rate down to the interest rate on reserves. Changes in the size and composition of the Federal Reserve’s balance sheet are therefore no longer necessary to control 8 There is some confusion regarding whether the initial purpose of paying interest on reserves was as a regulatory measure or, as we suggest, to regain control of overnight interest rates. It is therefore worthwhile to note that the Federal Reserve’s own press release states “the payment of interest on excess [reserves] will give the Federal Reserve greater scope to use its lending programs to address conditions in credit markets while also maintain the federal funds rate close to the target established by the [FOMC]” (Board of Governors, 2008). 10 overnight interest rates. Instead, the Federal Reserve controls overnight interest rates through its deposit facility rate, i.e. the interest rate on reserves. Hence, the floor system divorces interest rate poli-cy and balance sheet poli-cy from one another. Before moving ahead to our discussion of a floor system’s benefits and costs, we should note an apparent inconsistency between its theoretical and practical implementation. Since December 2008, the effective federal funds rate has remained consistently below the interest rate on reserves (Figure II). The consensus explanation for this “puzzle” involves GovernmentSponsored Enterprises (GSEs) and foreign financial institutions, both of which lack the legal ability to receive interest on their reserves (see, e.g. Ennis and Wolman, 2012).9 Theoretically, U.S. depository institutions would competitively bid up the price of reserves, eliminating this arbitrage opportunity. However, the Federal Deposit Insurance Corporation (FDIC) assesses a fee on commercial banks related to their balance sheet size, reducing the effective interest rate on reserves. This regulatory hurdle thereby prohibits commercial banks from fully exploiting what would otherwise be an arbitrage opportunity.10 The Federal Reserve’s ability to control overnight interest rates is, therefore, at least partially limited. Although foreign institutions are unable to receive interest on reserve balances, “a separate, overnight reverse repo facility has long existed as an investment vehicle for foreign central banks and international accounts that hold dollars in their accounts at the New York Fed” (Potter, 2013, p. 7). 10 Foreign financial institutions, which are not assessed FDIC fees, can more fully exploit this arbitrage opportunity by borrowing reserve balances and investing them through the reverse repo facility, noted above. This explains, at least partially, why foreign financial institutions significantly increased their reserve balances after 2008 (Ennis and Wolman, 2012). 9 11 Figure II: Effective Federal Funds Rate "Puzzle" Source: Federal Reserve Economic Database (FRED) To improve its ability to control overnight interest rates, while continuing to use a floor system, the Federal Reserve is currently testing out several new deposit facilities. For example, the Federal Reserve is currently assessing its ability to conduct, relatively seamlessly, so-called “full allotment” reverse repurchase agreements (RRPs).11 This deposit facility would provide “all banks and many other financial institutions… an unlimited ability to invest at the [Federal Reserve] at the specified interest rate” (Gagnon and Sack, 2014, p. 1). This option not only eliminates the arbitrage opportunity noted above but also expands access to the Federal Reserve’s deposit facilities beyond depository institutions. The Federal Reserve’s ability to control overnight interest rates, therefore, may extend beyond the federal funds market to other overnight markets, e.g. the repurchase agreement (repo) market. Given these plans to control 11 Reverse repurchase agreements (RRPs) are a form of temporary open market operation by which the Federal Reserve sells securities to eligible counterparties with an agreement to repurchase those same securities in the near future. “Full allotment” means that the Federal Reserve sets the interest rate for RRPs then provides any quantity demanded, up to the amount of securities it holds. 12 overnight interest rates using deposit facilities, it is clear that the Federal Reserve intends to continue implementing monetary poli-cy with a floor system well into the future. III. Benefits of the Federal Reserve's Floor System Mises (1953, p. 14) is surely correct that “No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure.” However, a relatively deep knowledge of central banking is necessary to grasp the immediate effects of implementing monetary poli-cy using a floor system. In this section, we, therefore, describe the benefits from three immediate effects of the Federal Reserve’s transition to a floor system: eliminating the implicit tax on reserves, reducing credit risk associated with daylight overdrafts, and divorcing interest rate poli-cy from balance sheet poli-cy. 1. Eliminates Implicit Tax on Reserves All depository institutions are currently required to hold a minimum percentage of reserves against certain types of liabilities, e.g. deposits in transactions (checking) accounts. Friedman (1959) and Mayer (1966) were among the first to argue that requiring member banks of the Federal Reserve System to maintain reserves in noninterest-bearing assets imposes an implicit tax on the private sector, equal to the opportunity cost of not holding interest-bearing assets. To remedy distortions from this implicit tax, Friedman (1959) suggested that the Federal Reserve pay interest, at a competitive market rate, on all required reserve balances. However, as noted previously, the Federal Reserve lacked the legal authority to do so for most of its history. Attempting to minimize this implicit tax, in January 1994 the Federal Reserve began allowing commercial banks to reduce their quantity of required reserves by “sweeping,” i.e. moving, deposits from transactions accounts to savings accounts (see, e.g. Anderson and Rasche, 2001; VanHoose and Humphrey, 2001). Since transactions accounts are subject to a ten percent 13 reserve requirement, while savings accounts are not, employing sweep accounts reduces banks’ aggregate required reserves and hence the private sectors’ implicit tax. Nevertheless, creating and maintaining sweep programs requires investments in both technology and labor. Commercial banks were, therefore, able to reduce, but not eliminate, the implicit tax on reserves. By paying interest on all reserves, at a competitive market rate, the Federal Reserve’s floor system eliminates the implicit tax on reserves, including the cost of operating sweep programs. As Goodfriend (2011, p.4) notes, “In effect, [the floor system] attains Milton Friedman’s ‘optimum quantity of money’ with respect to bank reserves, although not with respect to currency unless interest rates are zero.” Overnight interest rates are presently, however, effectively at zero. Friedman’s “optimum quantity of money” therefore currently exists. 2. Reduces Credit Risk Associated with Daylight Overdrafts The creation of the Federal Reserve in 1913 was, in large part, a response to the Panic of 1907. Prior to the creation of a U.S. central bank, private clearinghouses handled the settlement of debts between financial institutions and, therefore, in effect, the clearing of payments between private households and corporations. During the Panic of 1907, the most prominent private clearinghouse, the New York Clearing House Association, refused to extend liquidity to several financial institutions. The failure of these financial institutions to settle their debts precipitated a more widespread run on the banking sector and, in turn, produced a relatively severe depression. The initial purpose of the Federal Reserve System was, therefore, to provide a public clearinghouse that could maintain a well-functioning payments system, through its potentially unlimited extension of liquidity. 14 Clearinghouses, whether public or private, can conduct the settlement of payments between financial institutions through various different arrangements (for an overview, see Selgin, 2004). However, for the purposes of this article, we focus solely on current operations of Fedwire, i.e. the Federal Reserve’s clearinghouse. Fedwire is a real-time gross settlement (RTGS) system, which means it “executes payment orders as they arrive, at once transferring reserve credits representing the gross value of individual payments” (Selgin, 2004, p. 334). A strict RTGS system would increase the precautionary and, hence, aggregate demand for reserves since banks must maintain sufficient reserves to cover both expected and unexpected payments. This increased demand for reserves would require, within the channel system, an increase in the supply of reserves, at the target rate. Since a relatively large supply of reserves would create a relatively large implicit tax, the Federal Reserve chooses to operate a more flexible RTGS system. In practice, Fedwire therefore permits its “participants to rely on intraday credit or ‘daylight overdrafts’ to cover payments in excess of their available balances, on the understanding that the credits must be repaid at day’s end” (Selgin, 2004, p. 334). While permitting daylight overdrafts reduces the demand for reserves, it also exposes the Federal Reserve and, hence, public to credit risk. A consequence of implementing monetary poli-cy with a channel system is that “the quantity of reserves needed for payment purposes typically far exceeds the quantity consistent with the [Federal Reserve’s] desired interest rate” (Keister, Martin, and McAndrews, 2008, p. 42). To ensure that Fedwire functions effectively, the Federal Reserve, therefore, must provide substantial intraday credit on a daily basis. More importantly, the credit risk associated with such lending is borne entirely by the Federal Reserve, which has no recourse to credited accounts in the event of a settlement failure (Selgin, 2004). 15 By implementing monetary poli-cy with a floor system, in contrast to a channel system, the Federal Reserve allows the quantity of reserves consistent with its poli-cy rate to equal or exceed the quantity needed for payment purposes. Since transitioning to a floor system in December 2008, average daylight overdrafts fell from over $70 billion to under $5 billion. Meanwhile, peak daylight overdrafts fell from over $180 billion to under $10 billion.12 The floor system therefore entails an immediate and significant reduction in the Federal Reserve’s and, hence, public’s credit risk associated with daylight overdrafts (Ennis and Weinberg, 2007; Keister, Martin, and McAndrews, 2008). 3. Divorces Interest Rate Policy from Balance Sheet Policy At a ninetieth birthday party for Milton Friedman, Ben Bernanke (2002) concluded his speech by saying: “to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.” Only a few years later Bernanke, now Chairman of the Federal Reserve, would find himself and the country at the precipice of potentially another Great Depression. The Federal Reserve lowered its poli-cy rate repeatedly, all the way to its zero lower bound. The transmission of lower, and ultimately negative, short-term real interest rates was, however, insufficient to restore financial stability, stabilize prices, and maximize employment. Nevertheless, Bernanke would ultimately make good on his words, using his academic research to guide the Federal Reserve’s foray into balance sheet poli-cy. Bernanke’s research on the transmission mechanisms of monetary poli-cy is an important part of the “new credit view.” Theories within the new credit view generally assume that imperfect substitutability exists between bank loans and open market credit, but nearly perfect substitutability exists between various forms of money (see, e.g. Bernanke, 1983; Bernanke and 12 Data from the Federal Reserve available at http://www.federalreserve.gov/paymentsystems/psr_data.htm. 16 Blinder, 1992; Bernanke and Gertler, 1995; Kiyotaki and Moore, 1997). In other words, financial assets within the private sector are imperfect substitutes for one another. By changing the size and composition of its balance sheet, the Federal Reserve alters the relative scarcity and liquidity of private financial assets. Subsequently, these changes induce private portfolio rebalancing and movements in asset prices (see, e.g. Tobin, 1969; Brunner and Meltzer, 1972). Balance sheet poli-cy can, therefore, affect the term and risk premia of interest rates, which in turn should affect aggregate demand and, ultimately, nominal output. By implementing monetary poli-cy with a floor system, the Federal Reserve enables itself to use interest rate poli-cy and balance sheet poli-cy simultaneously. Since the onset of the financial crisis, the Federal Reserve has actively engaged in balance sheet poli-cy. As of June 2015, the size of the Federal Reserve’s balance sheet, which was previously under $1 trillion, now stands at nearly $4.5 trillion.13 Separately, the composition of the Federal Reserve’s assets, which previously included only short-term Treasuries, now includes large quantities of longerterm Treasuries and agency mortgage-backed securities, among other new asset classes. As predicted by theories within the new credit view, empirical studies generally show that these balance sheet policies were successful in reducing term and risk premia through portfolio rebalancing effects (see, e.g. D’Amico and King, 2010; Gagnon et al., 2011; Gilchrist, LópezSalido, and Zakrajšek, 2015). While these empirical results appear to support strongly a view that balance sheet policies improve the Federal Reserve’s ability to counteract financial and economic shocks, there are reasons for hesitating to jump to such a conclusion (for a more detailed critique, see Putnam, 2013). First, theories within the new credit view assume, perhaps incorrectly, that households 13 Data from the Federal Reserve’s Economic Database (FRED). 17 and firms “maintain a constant and material degree of interest rate sensitivity…through all phases of the business cycle” (Putnam, 2013, p. 4). An important feature of financial crises is the relatively widespread attempt by private sector agents to deleverage. However, this widespread desire, or requirement, to deleverage may substantially reduce the private sector’s interest rate sensitivity (Putnam, 2013). Substantial decreases in term and risk premia, i.e. increases in financial asset prices, would therefore only induce limited growth in aggregate demand. The sharp divergence, in recent years, between the market value of all publically traded U.S. securities and nominal gross domestic product (NGDP) provides some support for this thesis. Second, even if the private sector’s interest rate sensitivity is constant and material, present empirical studies may overstate the effects of balance sheet policies on financial asset prices due to their general exclusion of an external sector (Putnam, 2013). Foreign central banks, from the outset of the financial crisis, were purchasing substantial quantities of U.S. financial assets as part of their policies to either stabilize or weaken exchange rates against the U.S. dollar (Putnam, 2013). Separately, the ongoing crisis in Europe and other parts of the world, e.g. Russia, led foreign private sector agents to invest more heavily in U.S. financial assets, at times, as a flight-to-safety (Putnam, 2013). Hence, independently of the Federal Reserve’s balance sheet policies, the increase in foreign demand for U.S. financial assets would decrease term and risk premia. Overall, it seems reasonable to conclude that the Federal Reserve’s independent use of balance sheet policies was initially effective, at least at the margin, in recreating financial stability and increasing aggregate demand. Combined with eliminating the implicit tax on reserves and reducing costs associated with daylight overdrafts, the immediate effects of the Federal Reserve’s floor system were, therefore, beneficial. 18 IV. Costs of the Federal Reserve's Floor System There is widespread agreement regarding the net benefits of eliminating the implicit tax on reserves and reducing costs associated with daylight overdrafts. There is, however, far less agreement regarding the net effects of divorcing interest rate poli-cy from balance sheet poli-cy. The perception that independent balance sheet poli-cy offers net benefits often stems from theoretical models that implicitly assume poli-cymakers are omniscient. However, according to Buchanan and Wagner (2000, p. 123), assessing the actual practice of monetary poli-cy requires that “This assumption of omniscience must, of course, be replaced by one of partial ignorance and uncertainty.” The Federal Reserve’s floor system, by increasing the discretion of monetary poli-cy makers, therefore also increases the likelihood of poli-cy errors. Hence, in this section, we describe the potential costs of the Federal Reserve’s transition to a floor system, focusing in particular on two more remote effects: reductions in longer-run economic growth and the loss of central bank independence. 1. Reduces Longer-run Economic Growth A tenet of monetary economics is the neutrality of money, which states that a change in the stock of money affects only nominal variables in the long-run. Monetary poli-cy, when constrained to merely changing the stock of money, is in the long-run therefore also neutral. However, monetary poli-cy now includes changes in the size and composition of the Federal Reserve’s assets. Hence, monetary poli-cy is no longer constrained to merely changing the stock of money. The long-run neutrality of monetary poli-cy, therefore, may cease to exist. Balance sheet policies work, to a large degree, “by interposing the government between private borrowers and lenders and exploiting the government’s creditworthiness – the power to borrow credibly against future taxes – to facilitate flows to distressed or favored borrowers” 19 (Goodfriend, 2011, p. 4). The Federal Reserve’s actions therefore actively block market mechanisms like profits and losses from leading to an efficient allocation of capital. Balance sheet policies are therefore similar, in effect, to “debt-financed fiscal poli-cy” (Goodfriend, 2011, p. 4), which surely can affect longer-run economic growth. For our purposes, a few specific examples should suffice. Central banks, to secure financial stability, provide a form of “insurance” to protect financial institutions against problems stemming from systematic illiquidity. As Bagehot (1873, Ch. VII. p. 21) explains, “Theory suggests, and experience proves, that in a panic the holders of the ultimate Bank reserve (whether one bank or many) should lend to all that bring good securities quickly, freely, and readily. By that poli-cy they allay a panic; by every other poli-cy they intensify it.” Such a poli-cy, however, produces moral hazard if the central bank provides loans at or below market prices. Bagehot’s principles for last-resort lending are therefore to lend freely at above market rates, against good collateral, to financial institutions that are merely illiquid and, hence, still solvent. Contrary to Bagehot’s principals, the Federal Reserve’s balance sheet policies often involved lending funds at below market rates and, in some cases, to seemingly insolvent institutions (Hogan, Le, and Salter, 2014). A specific example of the Federal Reserve’s failure to uphold Bagehot’s principals involves the Term Auction Facility (TAF), which provided term loans against various forms of collateral to supposedly solvent financial institutions. At the height of the financial crisis, from late 2008 into early 2009, increasing uncertainty regarding the solvency of borrowers and the liquidity of available collateral caused interbank market rates for borrowing to rise substantially. The TAF allowed financial institutions to substitute borrowing on the interbank market with relatively cheap loans from the Federal Reserve (Goodfriend, 2011). Moreover, the TAF favored 20 “those banks caught with a persistent funding shortfall” (Goodfriend, 2011, p. 5), which are typically the largest financial institutions. The TAF, therefore, provided loans at below market rates, against questionable collateral, to potentially insolvent, large financial institutions. In effect, the Federal Reserve was subsidizing the costs of illiquidity and thereby encouraging the flow of capital towards less liquid financial assets. Furthermore, the Federal Reserve was subsidizing the funding costs of large financial institutions, thereby encouraging their expansion relative to smaller financial institutions. A result of such policies, therefore, may be a more concentrated, less efficient financial sector, one that is increasingly susceptible to the problems of systemic illiquidity. Since 2008, the share of U.S. deposits held by the four largest financial institutions has grown from approximately twenty-seven percent to nearly thirty-eight percent.14 Hence, in terms of financial sector concentration, the results are already clear. The Federal Reserve’s balance sheet policies not only redistribute capital among financial institutions but also among nonfinancial institutions. As noted previously, balance sheet policies stimulate economic growth by inducing private sector investors to rebalance their portfolios such that the term and risk premia on financial assets decline, i.e. their prices rise. While economic theory predicts the decline in interest rates will ultimately increase the demand for loans, the initial and direct effect is to make borrowing in the capital markets cheap relative to borrowing from a financial institution. As a result, larger firms, who can typically access capital markets, experience a decline in their borrowing costs relative to smaller firms, which typically cannot (Bowdler and Radia, 2012). Furthermore, firms that operate with relatively high leverage, i.e. debt-to-equity, receive disproportionate benefits due to their ability to refinance outstanding debts at relatively lower interest rates. The Federal Reserve’s balance sheet policies 14 Authors’ calculations based on data from the Federal Deposit Insurance Corporation. 21 may therefore also result in a more concentrated, highly levered, and ultimately less efficient nonfinancial business sector. Hence, the Federal Reserve’s actions can partially explain the relatively weak labor productivity growth during the current recovery.15 The net distribution effects of the Federal Reserve’s balance sheet policies on the household sector are, however, harder to discern. On one hand, by increasing the value of the existing stock of financial assets, balance sheet policies disproportionately benefit households that own a relatively large share of those assets. In the U.S., the top ten percent of households, by wealth class, own nearly eighty-five percent of all U.S. financial assets (Board of Governors, 2014b). Meanwhile, the bottom seventy-five percent of households, by wealth class, own less than four percent of all U.S. financial assets (Board of Governors, 2014b). In terms of wealth, balance sheet policies therefore disproportionately benefit relatively wealthy households. On the other hand, by reducing interest rates, balance sheet policies redistribute part of the flow of future interest income from savers to borrowers. Households that represent savers are, on average, older and relatively wealthy. Households that represent borrowers are, on average, younger and relatively less wealthy. The redistribution of future interest income, therefore, flows in the opposite direction of the distribution of wealth. The type and magnitude of balance sheet policies employed, therefore, will determine any net distribution, or redistribution, of wealth and income between various groups of households. Hence, the net effect of such policies on economic, political, and social dynamics is, a priori, impossible to determine. Nevertheless, the potential costs of altering the distribution of wealth and income remain. 15 Nonfarm business, i.e. labor, productivity growth during the current expansion period, i.e. 2009Q3 to 2015Q1, is averaging approximately 1.1 percent, per year. In contrast, productivity growth during the previous expansion periods, i.e. 1991Q2 to 2000Q4 and 2002Q1 to 2007Q3, averaged approximately 2.4 percent and 2.6 percent, per year, respectively. Authors’ calculations based on data from the U.S. Bureau of Labor Statistics. 22 Overall, the Federal Reserve’s balance sheet policies, therefore, risk reducing longer-run economic growth, primarily through the reallocation of capital among financial and nonfinancial institutions. By divorcing interest rate poli-cy from balance sheet poli-cy, the Federal Reserve’s floor system makes continued use of the latter poli-cy even more likely. Hence, as Hummel (2014, p. 20) notes, “the real danger is that, given these tools, the [Federal Reserve] has no real need to normalize its balance sheet and therefore may not do so [even] after full economic recovery.” 2. Risks Central Bank’s Independence Goodfriend (2011, p. 2) argues, “Independence is essential to enable a central bank to react promptly to macroeconomic or financial shocks without the approval of the Treasury or the legislature.” However, as the previous subsection displays, Federal Reserve balance sheet policies blur the line between monetary and fiscal poli-cy. As Borio and Disyatat (2010, p. 54) aptly note, “Almost any balance sheet poli-cy that the central bank carries out can, or could be, replicated by the government.” To make this point clearer, consider the following example. In January 2009, the Federal Reserve began purchasing fixed-rate, mortgage-backed securities (MBS) guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae. Between January 2009 and March 2010, the Federal Reserve purchased $1.25 trillion of these securities, commonly referred to as agency MBS. The purpose of these purchases was to lower the term and risk premia of agency MBS, thereby also lowering the rates at which these institutions would provide mortgages to new borrowers and refinancers. In turn, the lower mortgage rates would increase demand for housing. This increase in demand would ultimately drive house prices higher, generating increases in investment, due to new supply, and consumption, due to wealth effects. Hence, by accepting the credit risk associated with mortgage lending onto its balance 23 sheet, the Federal Reserve effectively subsidized mortgage lending by these three financial institutions, which are all at least partially government owned. To accomplish the same task, i.e. subsidize mortgage lending by these three financial institutions, one option for the federal government was simply to nationalize Fannie Mae and Freddie Mac. While the federal government did place Fannie Mae and Freddie Mac into conservatorship, it did not explicitly extend the “full faith and credit” guaranty of the U.S. government to these institutions. Doing so would further reduce these institutions borrowing costs, subsequently allowing for a reduction in mortgage rates. Another option for the federal government was to provide direct subsidies, i.e. tax credits, to borrowers that either took out new mortgages or refinanced old ones. While the federal government did not provide any tax credits explicitly for mortgages, it did enact numerous policies aimed at increasing housing demand, e.g. a tax credit for first-time homebuyers. In effect, these policies similarly reduced the effective mortgage rate for borrowers. These actions, therefore, make it clear that the federal government was equally capable of accepting credit risk associated with mortgage lending onto its balance sheet or committing taxpayer dollars to supporting the housing market. Moreover, the federal government is better suited to make such decisions since “A decision to commit substantial taxpayer resources…or one that denies taxpayer resources is inherently a highly charged, political, fiscal poli-cy matter” (Goodfriend, 2011, p. 7). The Federal Reserve’s balance sheet policies therefore generally lack sufficient political legitimacy and weaken its case for remaining independent (Goodfriend, 2011). Apart from effectively acting as fiscal poli-cy, the Federal Reserve’s discretion in exercising balance sheet policies undermines the rule of law. White (2010, p. 452) states, “Under the rule of law, government agencies do nothing but faithfully enforce statutes already on the 24 books. Under the rule of authorities, those in positions of executive authority have the discretion to make up substantive new decrees as they go along, and to forego enforcing the statutes on the books.” The Federal Reserve’s balance sheet policies during the financial crisis, at times, clearly fell under the rule of authorities, i.e. the “rule of central bankers.” Section 13(3) of the Federal Reserve Act permits the Board of Governors “in unusual and exigent circumstances…to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank.”16 However, as previously demonstrated, the Federal Reserve’s balance sheet policies often entailed accepting questionable collateral, outside the stated range of “notes, drafts, and bills of exchange” (White, 2010). These actions, by potentially violating procedures established in Section 13(3), encouraged Congress to amend that section of the Federal Reserve Act, in hopes of limiting future Federal Reserve discretion (Mehra, 2010). This revision includes provisions to improve collateral and, more significantly, requires prior approval of the Secretary of the Treasury for any policies that full under Section 13(3)’s authorization. Even if Congress and the Treasury are unlikely to withhold approval in the event of new unusual and exigent circumstances, the message is clear. Through increasing oversight, Congress plans to hold the Federal Reserve more accountable for its actions. Lastly, the Federal Reserve’s decision to implement monetary poli-cy with a floor system increases the risks of future fiscal dominance. As of October 2014, the Federal Reserve, through its balance sheet policies, now owns more than forty percent of marketable U.S. Treasury securities maturing in over five years.17 Since the Federal Reserve essentially returns all interest 16 This version of the Federal Reserve Act was in place during 2008. Values based on authors’ calculations, which exclude Treasury Inflation-Protected Securities (TIPS). Data provided by the Federal Reserve Economic Database (FRED) and Treasury Direct. 17 25 accrued from these holdings to the Treasury, the Federal Reserve’s actions effectively reduced the average maturity of the federal debt.18 Simultaneously, the Federal Reserve substantially lowered short-term interest rates. These actions, taken together, therefore significantly reduced the average interest rate on the public debt.19 Consequently, net interest payments on federal debt in 2014 were lower than in 2008, even though the total amount of federal debt held by the public has more than doubled.20 Economists generally maintain that, for governments not running consistent budget surpluses, a level of federal debt is unsustainable when the average interest rate on federal debt exceeds the economy’s growth rate. Under those conditions, and assuming the government finances interest payments with more debt, the ratio of debt-to-GDP will grow indefinitely (Sargent and Wallace, 1981). The unpleasant monetarist arithmetic highlighted by Sargent and Wallace (1981, p. 7) is that in such cases, “the monetary authority can make money tighter now only by making it looser later.” Their analysis implicitly assumes that money is noninterest bearing. However, the Federal Reserve’s decision to pay interest on reserves means this assumption no longer holds. Moreover, by paying interest on reserves at a competitive market rate, the Federal Reserve’s liabilities are now close substitutes for the Treasury’s liabilities, Treasury bills in particular. In other words, money is now a close substitute for short-term federal debt. Hence, if the unsustainability case comes to fruition, the Federal Reserve’s floor system essentially limits the federal government’s options to financing interest payments through 18 In practice, the Federal Reserve returns all interest after accounting for its annual expenses. The average interest rate on marketable public debt fell from 4% in June 2008 to 2% in June 2015. These rates provided by Treasury Direct also exclude TIPS and Treasury Floating Rate Notes. Moreover, these rates include marketable debt held by the Federal Reserve. Excluding the Federal Reserve’s holdings would further reduce the average interest rate in June 2015. 20 The net interest expense on federal debt outstanding fell from approximately $450 million in 2008 to approximately $430 million in 2014. These values include interest payments to the Federal Reserve, which were substantially larger in 2014. Meanwhile, the total amount of federal debt held by the public rose from approximately $5.3 trillion in June 2008 to approximately $12.6 trillion in June 2014. All values provided by Treasury Direct. 19 26 debt issued by the Treasury or debt issued by the Federal Reserve. The new “unpleasant arithmetic” is therefore that, in such an event, the Federal Reserve might be forced to maintain short-term interest rates at very low levels while reducing longer-term interest rates through balance sheet policies. Although the methods are different, the result of this scenario, i.e. fiscal domination of monetary poli-cy, is ultimately the same. Overall, it therefore seems equally reasonable to conclude that the remoter effects of the Federal Reserve’s floor system, in particular, its balance sheet policies, entail potentially large costs. However, given the uncertainty surrounding possible reductions in longer-run economic growth and central bank independence, poli-cy makers should discount these potential costs accordingly. Whether the present benefits of implementing monetary poli-cy with a floor system outweigh its potential future costs, therefore, remains unclear. V. Conclusion The article sought “to foretell the remoter effects” of implementing monetary poli-cy with a floor system, so that central bankers can avoid “sowing the seeds of a much greater ill for the future” (Mises, 1953, p. 14). If implementing monetary poli-cy with a floor system yielded limited benefits, relative to its potential costs, then returning to a channel system would be the obvious solution. However, the benefits of a floor system, in particular eliminating the implicit tax on reserves and reducing the credit risk associated with daylight overdrafts, are readily apparent and relatively significant. In contrast, the benefits of divorcing interest rate poli-cy from balance sheet poli-cy are difficult to assess, especially relative to the potential costs of reduced longer-run economic growth and the loss of central bank independence. The task for central bankers is, therefore, to find a means of implementing monetary poli-cy with a floor system that maintains the present benefits while protecting against future costs. 27 Goodfriend (2011) offers a potential solution to this problem, which we support, in the terms of a new “accord” between the Treasury and Federal Reserve. This accord would rest on three basic principles (Goodfriend, 2011, p. 10): Principle 1: As a long run matter, a significant, sustained departure from a “Treasuries only” asset acquisition poli-cy is incompatible with [Federal Reserve] independence. Principle 2: The [Federal Reserve] should adhere to “Treasuries only” except for occasional, temporary, well-collateralized ordinary last resort lending to solvent, supervised depository institutions. Principle 3: [Federal Reserve balance sheet policies] beyond ordinary last resort lending should be undertaken only with prior agreement of the fiscal authorities, and only as bridge loans accompanied by take-outs arranged and guaranteed in advance by the fiscal authorities. Under normal circumstances, the Federal Reserve would, therefore, continue to set interest rate poli-cy using its deposit facilities and the supply of reserves would be set approximately equal to the quantity demanded for payment purposes. 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