Modern Monetary Policy

I recently came across a great article from the Federal Reserve Bank of St. Louis. It describes the roles that banks and the Federal Reserve each play in the financial system, and how these roles have changed in modern times. The article is aimed at teachers, encouraging educators to update what concepts they teach in the classroom, but I think it is also useful for making sense of inconsistencies found in news reporting about the financial system.

How banks operate

Banks are businesses that primarily deal in financial products. Financial products divide into two categories: assets and liabilities. For a bank, the deposits it holds for its customers are liabilities (in that it is money that the bank owes to someone else) and the loans it makes are assets. A bank can also buy other financial assets, such as real estate or US Treasuries, but loans make up about half of all bank assets.

The goal of a bank as a business is to earn a profit. It achieves this by making more money from its assets than it pays out on its deposits. Generally speaking: banks offer interest (and other services) to increase deposits, then they use these deposits to make loans or buy assets that have some rate of return and some level of risk. The risk and return of an individual asset are often directly related: the greater the return, the greater the risk. To that end, banks will diversify their portfolio of assets to minimize the overall risk while maximizing the total return.

Of course banks keep some amount of their assets as vault cash for satisfying withdraws. But they also hold some amount as reserves with the Federal Reserve (the Fed). A bank’s reserve account is effectively a checking account that it uses for transactions it makes with other banks and financial institutions. When a bank needs more reserves, it can either sell some of its assets or it can borrow the needed reserves from other banks. The rate of interest banks charge each other for these reserve loans is called the federal funds rate, and it is the policy rate targeted by the Fed’s Open Market Committee (the FOMC) which is the Fed’s policy setting body.

The primary influence on the federal funds rate is the interest rate that the Fed pays on reserve balances, the interest on reserve balances rate (the IORB rate). This rate is directly administered (ie. controlled) by the Fed. When one bank needs reserves, it can offer to pay interest greater than the IORB rate to another bank that has excess reserves, allowing the other bank to make more money loaning the reserves out than it makes keeping them in its reserve account.

As an asset, reserves are essentially risk-free and thus they have a low rate of return. Indeed, through a complicated process called arbitrage, the IORB rate acts as a kind of floor rate for interest rates throughout the economy. Interest rates influence the savings and investment decisions of consumers and businesses, and by extension prices and employment. Thus, by changing the IORB rate (as well as a few other administered rates), the Fed implements its monetary policy and works towards its dual mandate of stable prices and full employment.

The old monetary regime

The effectiveness of the Fed’s monetary policy is predicated on the fact that the Fed currently employs an ample-reserves policy regime. Under this regime, there are enough reserves in the financial system that a bank can hold as many reserves as it likes. This allows for banks to easily increase or decrease their reserve holdings as the Fed changes the IORB rate.

Prior to the Great Financial Crisis of 2007–2009 (the GFC), the Fed employed a limited-reserves policy regime, wherein they used open-market operations to influence the federal funds rate. That is, they bought and sold small amounts of reserves to tightly control the total amount in the banking system. By controlling the scarcity of reserves, the Fed could influence the federal funds rate and (through arbitrage) interest rates throughout the economy. Moreover, the Fed had a reserve requirement for banks that required a certain percentage of a bank’s assets to be held in reserves. This limited the growth in a bank’s assets without access to additional reserves.

This regime came undone during the GFC when many of the assets banks were holding started losing value and banks rushed to sell them. There were effectively not enough reserves in the system, and so asset prices started to fall even further. In response, the Fed switched to a balance-sheet policy in the middle of 2008 to buy up large amounts of government-backed securities and sell more reserves into the system. This flood of reserves staunched the deflationary spiral in asset prices, and helped prevent the total collapse of the banking system.

By dramatically increasing the number of reserves in the banking system, the new policy regime eliminated the need for reserve requirements. It also nullified the effectiveness of the Fed’s open-market operations: with so many reserves in the economy, small changes in the total amount would no longer influence the federal funds rate as it once did. Therefore, in October of 2008, the Fed began paying interest on reserve balances¹ as a way to reassert influence on the federal funds rate as outlined above. And in January of 2019, the Fed announced that it would continue to use this ample-reserves regime in perpetuity.

Conclusion

The main takeaway is this: the background framework for the banking system is different today than it was prior to the GFC. In particular, any mention of reserve requirements should be ignored. What matters are short-term interest rates, which the Fed has almost direct control over through the IORB rate. Moreover, when banks make loans, or purchase any assets for that matter, they do so by considering the return and the risk of the asset/loan. There are of course regulations that must also be satisfied, but a certain level of reserves is not among them. This most often comes up in discussions of the money multiplier, which is a too-simplistic explanation of how banks create money.

I want to write about the money multiplier another day, so I won’t say more now. Suffice it to say that bankers are clever and were quick to adopt technology during the 1990’s to evade reserve requirements (using retail sweep programs). This suggests that the Fed’s tools for implementing its monetary policy were flawed or ineffective leading up to the GFC, and that the ample-reserves policy regime employed now is an improvement since it actualizes what was effectively true before.