The new normal

Also included in Federal Reserve Chair Ben Bernanke’s statement to Congress last week were some guidelines for what we might expect Federal Reserve decisions and communications to look like as we make the gradual adjustment to more normal conditions.

In recent years, the Fed had gotten very good at communicating its intentions to the market. FOMC statements came down to a routine in which the Fed announced at each FOMC meeting a target for the fed funds rate that Fed watchers had usually figured out well before the meeting. But the fed funds rate has become an essentially irrelevant number for the last year, and given the Fed’s apparent intention to keep a huge volume of reserves outstanding, will likely remain irrelevant for some time to come. Hence one purpose of Bernanke’s statement was to communicate what we should be looking for in the way of a new format for policy decisions and announcements from the Fed:

As a result of the very large volume of reserves in the banking system, the level of activity and liquidity in the federal funds market has declined considerably, raising the possibility that the federal funds rate could for a time become a less reliable indicator than usual of conditions in short-term money markets. Accordingly, the Federal Reserve is considering the utility, during the transition to a more normal policy configuration, of communicating the stance of policy in terms of another operating target, such as an alternative short-term interest rate. In particular, it is possible that the Federal Reserve could for a time use the interest rate paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance, while simultaneously monitoring a range of market rates. No decision has been made on this issue; we will be guided in part by the evolution of the federal funds market as policy accommodation is withdrawn. The Federal Reserve anticipates that it will eventually return to an operating framework with much lower reserve balances than at present and with the federal funds rate as the operating target for policy.

In other words, instead of watching for an announcement by the Fed of a target for the fed funds rate, we may be anticipating announcements about the interest rate that the Fed chooses to pay on reserves. Bernanke noted that the value chosen for interest on reserves might come to move other interest rates around in the same way that the fed funds rate used to:

By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates, as banks will not supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at the Federal Reserve Banks. Actual and prospective increases in short-term interest rates will be reflected in turn in longer-term interest rates and in financial conditions more generally.

So perhaps instead of a fed funds futures contract on the Chicago Board of Trade, we’ll need an interest-on-reserves futures contract to tell the rest of us what the savviest Fed-watchers have figured out.

Bernanke signaled that the Fed may also dip its toes further with operations on reverse repos
and the Term Deposit Facility, though I think he was cautioning us not to read too much into any initial steps in these programs, as the Fed may want to simply try using these facilities on a larger scale to see how they’re going to work out before making any real policy changes:

The sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments. One possible sequence would involve the Federal Reserve continuing to test its tools for draining reserves on a limited basis, in order to further ensure preparedness and to give market participants a period of time to become familiar with their operation. As the time for the removal of policy accommodation draws near, those operations could be scaled up to drain more significant volumes of reserve balances to provide tighter control over short-term interest rates. The actual firming of policy would then be implemented through an increase in the interest rate paid on reserves. If economic and financial developments were to require a more rapid exit from the current highly accommodative policy, however, the Federal Reserve could increase the interest rate paid on reserves at about the same time it commences significant draining operations.

Still, the Fed is seeing all of this as potentially still far in the future, with Bernanke’s statement repeating a phrase that has become boilerplate for recent FOMC statements:

economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.


8 thoughts on “The new normal

  1. Cedric Regula

    Time for some comic relief. The Onion reports on the true Benron Congressional meeting.
    I’m still hoping someone in Congress suggests that the Fed turns over its interest profit on MBS to the Treasury instead of banks as they always have done in the past, and the world passes a new Basel 3 so banks just need to hold capital for the sake of financial stability, but I’m on my second beer right now, so I’m more optimistic than normal.

  2. ppcm

    Management of banks reserves by a central bank subject to implicit assumptions:
    Interbank lending and borrowing fluidity and a lesser dependency on CB QE, interbank fluidity predicated upon a better and safer readings of the banks balance sheets, contingency items, off balance sheets assets.
    Liquidity ratios in full compliance with Basle regulations predicated upon:
    The stability of bonds ratings, themselves subject to a stability of the primary fiscal deficits and or the financial soundness of bonds issuers.
    A true recognition of the derivatives content in the banks balance sheets.Off balance sheets items are not liquidity consuming,but when translated in profit and losses they may impair Banks financial net worth.
    Reverse repos as additional liquidity drains, themselves subject to legal proof reading of the repos contracts. Are they CB good faith against Banks good greed ( a recent reverse repo test is rumoured to have been without follow up)
    May be Mr Volker propositions on banks reforms could help stabilizing few of the above mentioned unstable variables?
    When are legislators going to understand that 99.9 % of the world population cannot make a difference between banks bonuses and profits but feel uncomfortable when seeing their savings wiped out.

  3. Cedric Regula

    Here John Hussman starts with referencing JDH’s charts of the Fed balance sheet, then gives a step by step outline of how the $1.5T of Fed MBS and GSE corp debt get transformed to Treasury debt over time, and we the taxpayers make good on the “implicit” GSE guarantee, at face value of course. No haircuts for investors, and the Fed uses the “interest profit” from MBS to pay interest on the funny money created and given to banks so banks can have reserves and get interest paid on it to boot.
    No votes used in the process. At least not as many as should be. Worst case scenario is if there are eventually $1.5T worth of defaults on the roughly $6T of GSE MBS, the entire Fed stock of MBS and corp debt would make a stealth transfer to taxpayer liability. Cheers, we are making the economy better. And we have kept the GSE tradition alive going forward (even ramped up FHA) for more lending in the present and future too.

  4. GNP

    Federal fund rates and discount rates are near negative 2% if one assumes that the hazy 2% inflation target is credible. Couldn’t or shouldn’t the federal reserve raise short-end rates to less negative real rates, i.e., -1.5% or -1%, and in the process, clearly signal a recovering economy yet still provide ample monetary stimulus?

    Or is the American economy behaving like an elderly obese person with COPD who outright refuses to stop eating kilos of red meat, refuses to exercise, and refuses to stop chain-smoking tobacco? Are the human health equivalents of diet pills and emergency surgery the only feasible options? Even people, suddenly immobilized with excruciating back pain (typically thanks to flaccid stomach muscles)are usually advised by doctors to start moving at some point.

    I’m expecting new distortions to continue building in the economy in response to US federal reserve price signals. Higher commodity prices such as higher oil prices are one such example that JDH has aptly discussed in previous posts. Should not US wealth preservation and growth become a policy priority at some point and clearly overshadow short-term GDP growth and labour market performance?

    Will confidence in American economic institutions be restored by those same institutions constantly pursuing the short-term goal of prioritizing the minimization of inevitable adjustment costs?

  5. flow5

    Excuse my banter: Interest rates have nothing to do with the equation of exchange: the product of unit prices, and quantities of goods and services exchanged, is equal (for the same time period), to the product of the volume, and velocity, of money.
    John Maynard Keynes dogma advises the Feds technical staff that interest is the price of money, not the price of loan-funds (his liquidity preference curve). This resulted in the FED manipulating interest rates, as a method to control the money supply.
    Lawrence K. Roos, Past President Federal Reserve Bank of St. Louis was quoted in the WSJ in April 1986: I do not believe that the control of money growth ever became the primary priority of the Fed. I think that there was always, and still is, a preoccupation with the stabilization of interest rates.
    Using IORs as a monetary policy tool, investors and savers can expect the escalation of: business stagnation accompanied by inflation, or escalating stagflation.

  6. TheMoneyDemand blog

    The IORs are a just a cheap bone Bernanke is throwing to Fed hawks. Imagine a situation – IORs are increased to 1%, and other short term rates are still stuck at zero due to credit crisis. Hawks might even agree to expand QE to ensure the transmission of 1% to other credit markets.

  7. K

    So the Fed moves from influencing the money market by participating to outright control of the money market. subtle. Considering how their prior strategy has benefitted the economy, I can’t wait to see what this does.

  8. Tom

    Yes, the interest paid on reserves has been de facto the most important Fed interest rate since they started paying it, so why not make it de jure.
    Notice though that Bernanke said nothing at all in that speech about how interest rates will be kept as low as they are after the MBS purchases stop.

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