The Fed can either raise the funds rate and in turn influence other
rates across the yield curve, bolstered by the interest on reserves
floor. Or it can tighten quantitatively, just as it eased quantitatively
by taking "steps to reduce the overall level of reserve balances" per
the Monetary Policy Report.
There too reverse repurchase agreements can lend a hand. Secondly,
the Treasury could sell more "supplemental bills" and deposit the
proceeds with the Fed. "When purchasers pay for the securities, the
Treasury's account at the Federal Reserve rises and reserve balances
decline," Bernanke noted.
A third possibility, one mentioned in the staff presentation to the
FOMC, would be for the Fed to offer to let banks -- but not GSEs -- put
their reserve balances in term deposits. That would have the effect of
immobilizing those reserves for the duration of the term.
Term deposits at the Fed "would pay interest but would not have the
liquidity and transactions features of reserve balances," the Monetary
Policy Report said. "Term deposits could not be counted toward reserve
requirements, nor could they be used to avoid overnight overdraft
penalties in reserve accounts."
Goodfriend agreed that term deposits could be helpful in keeping
some liquidity out of the money market and helping the Fed tighten
credit, but he said it could be "a little tricky."
"The Fed could offer a rate above the overnight rate in return for
tying up reserves, but the question is how much of a premium should it
pay," he said. "If you're in an exit strategy where everybody expects
the funds rate to move up over time, you'd have to pay enough to cover
anticipated increases in the funds rate."
One way around that problem would be to offer only term deposits
with a short maturity of a week or so, but then "you're not impounding
reserves by very much."
An added complication is the spread between the federal funds rate
and the primary credit (discount) rate, which the Fed narrowed from 100
basis points to 25 basis points in the course of combatting the
financial crisis. To avoid firms potentially "arbitraging the window,"
i.e. borrowing at the window and lending into the funds market or making
term deposits at the Fed, it might be necessary to widen the spread
between the discount rate and the funds rate back out.
Doing so was mentioned in a broader context by Brian Madigan,
director of the Fed's Division of Monetary Affairs, in a presentation at
the Kansas City Federal Reserve Bank's recent Jackson Hole symposium:
"When market conditions normalize, a wider spread of the primary credit
rate over the funds rate may be needed to provide incentives to all
banks to seek market sources of funds," he said.
Of course, the different methods of tightening are not walled off
from each other. For example, by pushing up the rate paid on reserves,
the Fed would not only support a higher funds rate target, it would
discourage lending.
Nevertheless, given the availability of two policy channels, might
the Fed tighten in one and leave policy loose in the other? In a sense,
it would be doing that by raising the funds rate and the interest paid
on reserves while keeping its balance sheet large. But officials are
skeptical about pursuing an explicit two-track tightening strategy.
Asked earlier this week whether the Fed might conceivably nudge up
the federal funds rate at some point to signal its desire to normalize
rates and prevent inflation, St. Louis Federal Reserve Bank President
James Bullard told me, "I haven't' seen anything that's going to lead me
to that sort of policy."
Bullard made the point that the credit easing policy is designed to
narrow spreads between "segmented" asset markets, where yields on
mortgage backed securities, for example, diverge from yields on, say,
Treasury securities. As Fed Vice Chairman Donald Kohn commented in
Jackson Hole, assets become less substitutable in a financial crisis and
this gives the Fed "scope" to affective relative asset prices -- and in
turn yields.
The conventional policy of changing the federal funds rate target,
on the other hand, depends on the assumption of "perfect asset
substitutabiliity all across the asset spectrum," so that a change in
the funds rate filters through the whole yield curve.
So Bullard suggested it would be "inconsistent" to try to tighten
by raising the funds rate while continuing to conduct credit easing
through asset purchases. Other officials have been similarly skeptical,
telling MNI they expect the Fed will likely need to "do both" rate hikes
and reserve reduction at more or less the same time.
That was also the suggestion of the Monetary Policy Report:
"Despite continued large holdings of assets, the Federal Reserve will
have at its disposal two broad means of tightening monetary policy at
the appropriate time. In principle, either of these methods would
suffice to raise short-term interest rates; however, to ensure
effectiveness, the two methods will most likely be used in combination."
However, it will be difficult for the FOMC to be completely
even-handed in its use of the two methods. Looking at it more
positively, the Fed will have the flexibility to choose among the best
methods of tightening as the situation demands.
"If you're thinking about signaling an exit, you can signal it by
increasing interest rates or by trying to affect spreads," said
Goodfriend. "You can do either one in principle, but you have to choose
where you want the signal to come from depending on the nature of the
economy."
"If you think credit markets are improving, but labor markets are
not, you might want to pull back on credit easing as a signal, but if
labor markets are better but credit markets are not you could use the
funds rate," he continued. "It depends on where the improvement is
taking place, and it's a reasonable horse race right now. Credit markets
are improving slowly, but we're still seeing a contraction in jobs."
Much as the Fed dotes on interest on reserves, officials recognize
it is just one arrow in the quiver.
"It's a tool, but we can't just rely on interest on reserves to do
everything for us going forward -- not with the size of the balance
sheet," Bullard told me.
"We may be able to buy time on that, because it may be awhile
before we raise interest rates or have to raise interest rates on
reserves," he went on. "Right now we're at a quarter of a percent, but
if we get up to 3% or 4% on $1 trillion it starts to be a lot. So I
think it's a tool, but probably not the only one."
"We can't rely just on interest on reserves to manage the balance
sheet," Bullard said. "We're going to have to sell off a portion of our
portfolio when the time comes."
