George Selgin on the Fed’s Balance Sheet

The Fed’s balance sheet may never get smaller and why the Fed is sticking with a floor system.

George Selgin is the director of the Cato Institute for Monetary and Financial Alternatives. He has written extensively and testified before Congress about the future path of the Fed’s balance sheet and how to properly do interest rates on excess reserves. George joins the Macro Musings podcast to report on his findings.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: George, welcome back to the show.

George Selgin:  Oh, thanks for having me, David. It's always a pleasure.

Beckworth: Well, it's great to have you on. You're now the most frequent guest of Macro Musings. This is your third time on the show.

Selgin:  This is my third. Yes.

Beckworth: Yep. So welcome back.

Selgin:  Thank you.

Beckworth: And you've been doing a lot of work as I mentioned on the direction of the Fed's balance sheet. And we want to get into that. So let's talk about, what is the Fed doing? The Fed seems to have set the speed of production but on its final destination, so tell us about that.

Selgin:  Well, I've called what the Feds doing Operations snail. Trying to remember now what the acronym stood for. I think it's start... as it was being originally planned, it stood for stall now an inch along later. Anyway, they're now inching along. I don't have too much just say by way of criticism of the general strategy of going slowly, though it is pretty slow. They could certainly shrink their balance sheet faster. My big concern is that this aspect of this policy normalization, to call it that, isn't part of a more complete normalization process. The end result of which would be if I had my druthers returned to cord or type operating system where interest on reserves can be there. But it's below the prevailing short term interest rates.

Beckworth: Yeah, so the Fed's been very clear about the amount of reduction. And just to be specific, they said they will reduce their Treasury holdings by 6 billion per month, three month intervals, and they'll still the increase that until it's 30 billion and then with GSEs, the agency securities 4 billion per month until it's a 20 billion cap until keep doing that. And the question is, how small will the reserve portion of the monetary base get? We know over time, the currency portion is growing as the size of the economy grows. No matter what happens, that will be the largest portion of the monetary base in the future. But the question is, how small will the bank reserve portion of the monetary base become?

Beckworth: And I have in front of me here a note done by some Federal Reserve staffers at the Board of Governors. They have two scenarios. And they even say it's very unclear what the final outcome will be. But they have it at either 100 billion dollars, and that would be that small scenario where they get few reserves or as much as couple trillion, 1 to 2 trillion. So there's a big wide range there.

Selgin:  Yeah, it is not going down to 100 billion. I'd be surprised if it went down to anything less than 2 trillion. The total size of the Fed's balance sheet, my best guess is it'll never get smaller than 3 trillion if they keep on with this plan. After which it'll rise according to the rate of roughly the rate of growth of currency demand. And the reason it's not going to get any smaller is twofold. First, most importantly, no matter what else may be true, the Fed has now come out and said, Yellen has said, others have said, that they are determined to keep a floor system and you can't have a floor system without a large quantity of excess reserves in the system. You can't go back 100 billion in reserves unless you're going to go back to an old corridor system, which is what I wish they do.

Selgin:  But they have indicated no intent of doing that. So their normal has a new normal that involves keeping a floor system where the chief instrument and monetary control is the interest rate paid on excess reserves. But the other reason why they won't go below a fairly large quantity of reserves is that if they have any kind of crisis, again, we'll eventually have another crisis because we haven't done much in the way things that could prevent that from happening despite Dodd Frank, if we ever have another crisis involving a surge in demand for liquidity, my belief is that they'll be more quantitative easing for the same reason we resorted to it during the last crisis which is, once you have an interest floor in place, then, and you don't want to move it much lower that you inevitably have to create vast quantities of reserves to get very small stimulus effects, which is what happened last time.

Selgin:  For that reason I've started to refer to powerless the $6 trillion dollar man. I think there's a good chance we go instead of down to 2 trillion, we end up at 6 trillion if anything really goes wrong and in under his term. But in the event, I don't see any reason, real probability that will get much below $3 trillion in reserve in Fed balance sheet.

Beckworth: So the Fed has been explicit? I thought they were still open to what the final choice will be. I know there's been some who have expressed a preference for floor. But I thought that was still an open question.

Selgin:  I wish it were. Maybe it is. I hope it is. I think it isn't.

Beckworth: Okay. Well, I know we interviewed Neel Kashkari. And he seemed like it was an open question. But he was leaning towards the floor system. I do think the default position is to stick with the floor system. So if you want to go otherwise, it's up to people like George Celgene to convince them.

Selgin:  Yeah. There'll be a fight to get rid of the floor system. I think the board is set on it. Whereas there may be some members of the FOMC who aren't but the board of course, they hold the majority in these matters. And quite apart from the fact that it's the board that actually sets interest on reserves, therefore can set it so as to maintain a floor system. But my reading of things is that unless somebody really, really pushes them to do otherwise, we're going to be stuck in this floor system and will probably even be foolish enough to keep it when the next crisis breaks out.

The Difference between a Floor and Corridor System

Beckworth: Well, you raised an interesting point there about the legality of interest and excess reserves. We'll come back to that. There's several issues there. But just to flesh out this idea that there's a difference between a floor and a corridor system. Why don't you explain to our listeners what that means?

Selgin:  Well, a corridor system is what we had a version of before the crisis here in the United States and what many countries have still today. Most operating systems, central bank operating systems or corridor. And in that system, you have a federal funds market, a market for interbank overnight lending of reserves balances. That is a free market in the sense it's an active market. Banks don't have in general excess reserves on hand, some may occasionally and some others are short. And so they're trading actively on this market to make the best use of available reserves. But they're certainly not all sitting or most of them are not sitting on vast excess reserves.

Selgin:  And monetary policy in that system is affected by through open market operations designed to make the market determined a federal funds rate reach a certain target level. So if it seems to be getting too high, the instructions to the open market desk or to sell securities and reduce available reserves to bring that Fed funds rate down. If the effective funds rate is below target, they can do the opposite.

Selgin:  Of course, a lot of the movements in the open market, a lot of open market operations are meant to head off movements away from target. And then of course, the target can be changed to make adjustments in the policy stance or to make it more consistent with prevailing market conditions that have changed. So that was the old monetary policy.

Beckworth: That's a corridor system?

Selgin:  That's the corridor. Now our corridor was a so called asymmetric corridor where the bottom of the corridor, the low end was a zero interest rate on excess reserves and the upper end is as it usually is, the discount rate. The Fed's discount rate. But the effective federal funds rate was always in between. And of course, with zero interest on excess reserves, particularly before the crisis, that meant that reserves continued to have an opportunity cost, right? It is generally speaking, banks had no incentive to accumulate excess reserves, which is why if the Fed created more of them, with the open market purchases, say it could count on the banks to put those to use by disposing of them in the reserve market initially in the overnight market, but ultimately they would build their balance sheets, their portfolios in other directions as well.

Selgin:  And so that's the old operating system. In more generic corridor systems, the most common form of which is a symmetric corridor, you have lower bound that may be a positive interest rate on excess reserves. So there's no inconsistency between paying interest on reserves or excess reserves and having a corridor system is perfectly possible. And then the upper end would be a discount rate where the target rate was exactly halfway between those two bounds. And that's quite a common arrangement too. So the different strain of floor system which is what we have now and a corridor system is not whether or not interest is paid on reserves, it's whether the target policy rate is equal to more or less the administered interest rate on reserves, or whether it's something else. Whether it's above that rate.

Beckworth: Okay. And some things that come up when we talk about this difference between a corridor system and a floor system. One is this term that you often read people associate with these two different systems, and that is reserve scarcity. So you often hear people talk about reserve scarcity with a corridor system and then reserve abundance with a floor system. But you've written many times that's incorrect.

Selgin:  Well, it's not the best terminology to put it this way.

Beckworth: Okay.

Selgin:  It's certainly true that in a floor system, you have a large holdings of reserves. And in the US context, excess reserves because we have a distinction between minimal required reserves.

Beckworth: Yes.

Selgin:  And the reserves that are held voluntarily. It's true, there's a lot more reserves being held and a lot more excess reserves. But in a sense, in a very fundamental sense, reserves are just as scarce in floor system because the reason banks are holding more reserves is because you've encouraged them to hold more. You've increased the quantity of reserves demanded by largely doing away with the opportunity cost of reserve holding. You're making reserves more attractive so the demand for them goes up. But that's same to say that if you make any good more attractive other things equally make the demand go up, but we don't say that the good is becoming more scarce in that price.

Beckworth: Right.

Selgin:  We say that we just got a new demand as a new price as it were. And so but it is true that on the floor system, banks don't go around fine tuning their reserves and getting them overnight when they need to. Because they're not for the most part ever finding themselves short because they're so happy to hold plenty of reserves. To have plenty on hand where those reserves are now as attractive as other short term assets that would usually outside of a floor system, would have been judged more attractive than reserves.

Beckworth: Yes. I guess the point I want to stress here is, reserve scarcity is not about the absolute quantity of reserves, whether you have a lot or you've got few. It's the supply relative to the demand. So you could have a lot of reserves like we have today, but if you shift that demand curve out sufficiently, you can still have relative scarcity of reserves, even if you got a bunch of them.

Selgin:  Indeed. Another way to put it is that what really ultimately creates a floor system isn't the nominal stock of reserves it's put out there. For example, we created trillions of additional reserves during the period when our floor system existed. It is whether banks have an exceptionally high demand for reserves. And so our floor system for example predated quantitative easing. We put the floor system on October 2008. And we put interest on reserves and it quickly became a floor system. This is before most of the reserve creation took place. And because we had eliminated the opportunity cost of reserve holding, as the quantity of reserves grew thereafter, the expansion of total reserves was reflected in increase in excess reserves because the demand for reserves was growing thanks to interest on reserves.

Selgin:  So let's look at what this boils down to. It wasn't the creation of reserves that was essential to having a floor system. It was the establishment of return on reserves that made reserve holding more desirable. That came first. That's what gives you the floor. Then of course, the more reserves you put in, the larger the reserve cushion is. But as long as banks find reserve holding more desirable than other kinds of lending, you could just have a sufficiently high IER rate, interest on excess reserves rate wait a while, and eventually you will have banks holding plenty of excess reserves even if you don't change the nominal quantity.

Beckworth: Yep.

Selgin:  Yeah.

Why has the Fed stuck with a Floor System?

Beckworth: So again, we need to be more careful when we say reserve scarcity and associate with the particular system. Also, just a couple of points to reiterate that you mentioned. There are many central banks around the world and most of them use a corridor system. In fact, Canada is a good example. Canada temporarily had a floor system then it went to a corridor system. ECB has a corridor system. So the Fed is unique in the fact that it's still sticking with a floor system, right?

Selgin:  And the Bank of New Zealand I believe.

Beckworth: Okay. Bank of New Zealand too. But those are the only two of the advanced economy central banks.

Selgin:  I don't want to bet on it but I think that's right.

Beckworth: Yeah, I think that's right. Most central banks...

Selgin:  Unless some central bank somewhere I haven't paid any attention to is gone to a floor system.

Beckworth: Okay. A majority of central banks.

Selgin:  Certainly, yeah.

Beckworth: That have introduced some interest and excess reserve type rate have moved toward a corridor system and I guess this begs the question, if a floor system is so awesome, why have most central banks gravitated toward a corridor system? There's got to be some answer, some insight in that experience.

Selgin:  Well, David, my answers, I don't think a floor system is very awesome. And I'd like to think that some of these other central banks just happened to take my perspective on all this. I mean, we are a peculiar system. Remember, we're also one of the only central banks that has persisted in paying positive interest on reserves while many were moving towards negative interest rates, or at least trying to do what they can in that direction.

Beckworth: Yeah.

Selgin:  So we have the peculiar honor of having the only central bank that was determined by hook or by crook to raise interest policy rates during the crisis. That is interest rate and reserves to higher levels and it never been seen before the crisis, which sounds a little counterintuitive. And the only one that has not only created a floor system in the process, but has obstinately clung to that floor system, which the technocrats at the Fed are now unarmored with because they say it gives them more flexibility. And I'd like to say something about this argument.

Beckworth: Sure.

Selgin:  Because what they're really saying is that the flexibility consists of the fact that now you have two set independent instruments. You have the interest rate on reserves. I'm not talking about the lower bound of the... it's the sub floor. That's the overnight repo rate. We could talk about that but it's a sideshow. Let's just pretend we don't have a leaky floor. And so it's all about interest rate on excess reserves, which is really the star of the show anyway. The fact is that you've created this regime. And their claim is, now we can set the policy rate which is interest on excess reserves anywhere we want it to be and we don't have to change the quantity of reserves to do that. We don't have to engage in open market operations. We don't have to change the Fed's balance sheet.

Selgin:  Whereas under the old corridor system, as I mentioned, the way you adjust the policy rate, the way you keep your rate and you keep your target is through open market operations. Now you have a separate parameter. This is size of the balance sheets. You can freely choose what your policy rate is. That's the IOER rate and you can have whatever balance sheet you want. You have it bigger, smaller, within limits. And it's true. You now have two free parameters if you like instead of one because there's-

Beckworth: There's a great paper that has been titled Divorcing Money from Monetary Policy.

Selgin:  Yeah, from Monetary Policy. Which the authors of that paper consider a great accomplishment and I consider a great disaster. But in any event, let me make an analogy, right? You have an automobile. Now in an automobile, you have a steering wheel. You can turn the steering wheel left, you can turn it right. You also have a throttle or gas pedal, which you can push on it more or less. The problem is when you're driving a car usually, you really have to coordinate how you turn the wheel, particularly how sharply you've turned it and how fast you're going. In a sharp turns with a foot all the way on the gas, it's asking for trouble.

Beckworth: Right, right.

Selgin:  What if you could turn the steering wheel any way you wanted it with the throttle as hard as you wanted it at any time and you didn't have to worry about coordinating those things? That would be a great accomplishment.

Beckworth:Great car.

Selgin:  I got these two instruments that are totally disentangled from each other and you have a lot more possible combinations of them you can achieve. It's great. Can you do that? The answer is you can. You can. Put it in neutral. You could sit in your driveway and do all the combinations of the gas pedal and the steering wheel that you like. All right. What is this got to do a monetary policy. What did we do in 2008? We put it in neutral. We put the transmission mechanism in neutral. And then the Fed stepped on the gas. Could step on the gas all they wanted, they didn't have to worry about its policy rate target because now that's controlled by interest on excess reserves, right? That was the whole point.

Selgin:  The hitch is, you don't go anywhere. And our quantitative easing the Fed's large scale asset purchases were like stepping on the gas in neutral. Banks didn't lend the reserves that came their way. They piled them up. I don't want to stretch the analogy but imagine gas spilling into the driveway. But the banks aren't... the money multipliers been killed by interest on reserves. And so you're not adding to broad money when credit creation or bank lending when you're stepping on the reserve gas, reserve supply gas. The only way you're going to get anywhere, if you get anywhere at all is going to be through some portfolio effect, portfolio balance some subtle, non monetary transmission mechanism.

Selgin:  And if you asked me and a lot of people who look at the empirical evidence, the stimulus effect of all those large scale asset purchases, not the interest rate effect but the actual effect on spending, employment, all this, pretty meager. That's the cost of having all this freedom that proponents of a floor system boast about. But wait, another way to put this is, a floor system is just an above zero liquidity trap. That's what it is. You're engineering deliberately a liquidity trap where you normally wouldn't be in one. Normally wouldn't be in one until market rates are at zero. But if you put IOER rate above, at a positive level, above zero, IOER rate, what you've got is a liquidity trap right there.

Beckworth: Well, that's interesting. So if you ask someone on the street or one of our listeners, probably not someone on the street, one of our listeners, liquidity trap, good or bad. That's a bad. Then I had a second question, why is it bad? Then say, well, interest rates are getting stuck at the zero lower bound, the neutral rates falling beneath that. So there's a gap between the two. And what you're saying is that is exactly what happens with the floor system. That the administered rate is going to be persistently higher than equilibrium what the market rate is. And so no matter where you are, you're effectively creating a liquidity trap above that value.

Selgin:  It's a knife edge. You could get it just right. The funny thing about a floor system and one of the bad things is you can maintain a floor system by having things too tight, but you can't having them too loose. Because then the floor wants to come apart. Because banks are finding reserves no longer so tempting to hold. You can only have the policy rates be so low.

Beckworth: Interesting.

Selgin:  The IOER rate is low enough that banks find it tempting to use their reserves rather than sit on them. Then your floor system goes away. So if you consistently stay with the floor system, you can make the interest rate on reserves whatever you want it to be.

Beckworth: So by design, to have a floor system you have to have that administrative interest rate above market rates to keep the floor system intact?

Selgin:  Yeah, that's right. It's not a floor system unless reserves have a very low or practically non existent opportunity cost relative to other short term.

Beckworth: Okay. And just to be clear, what you're saying is it forces them to fall apart in this scenario? Let's say the economy heats up, it starts growing really rapidly, high return on capital, investment returns go up and so there's an increased demand for loans. So banks provide them, they need more reserves, they're utilized, they're turning these excess reserves into required reserves. Maybe currency demand is going up as well. And what you're saying is if the Fed just keeps excess reserves at its current value does nothing, then that floor system, poof is gone?

Selgin:  That's right. So but what has actually happened is we've had recovered. We've had an increase in bank activity, but the Fed has in fact kept raising the IOER rate and its companion in order to keep the floor system going. Well, that's one explanation, right? The other explanation is that they're raising the rate to meet their inflation target. The only problem with that explanation is they're not really… that explanation doesn't work very well. Normally, you change policy rates to hit your target, right? But in this case, it didn't seem to fit, but it does. The movements in the Interest Rate on Excess Reserves (IOER) rate seem to be consistent with a determination to make sure you keep your floor system in place. Which if they'd left the IOER rate at 25 basis points or even 100, by now, the floor system would be coming apart because the short term rates and other short term rates are high. And banks would not be tempted to sit on all these excess reserves if the IOER rate hadn't also been up as much as it has.

Beckworth: I mean, based on your description the floor system, another way I would think of saying this is the Fed's determine to not hit its inflation target.

Selgin:  I would say that's not the goal.

Beckworth: I know. I'm being a little bit jaded and cynical there.

Selgin:  It's a situation where maintaining the flow system is not-

Beckworth: Consistent.

Selgin:  Consistent with hitting the inflation target. And the Fed has chosen, I think unfortunately, to make sure that they maintain the floor system.

Beckworth: I want to be clear. I'm aligning their motives and stuff. In fact-

Selgin:  Usually, that's my job.

Is the Fed Misunderstanding the Floor System?

Beckworth: Having fun here with you, George. But maybe that does raise a question, though. Do you think the FOMC just hasn't thought through this process? I mean, I don't think they're consciously undermining their own inflation target or consciously trying to slow things down on the margin. But the story you're telling me is that they are. So it's just a misunderstanding of the floor system?

Selgin:  I think that's part of it. I really honestly think that the people at the Fed are sold on the virtues of this system. I don't think they realize that what they've been doing is raising rates in a manner that's better for maintaining the system than for achieving the Fed's targets. We know from their pronouncements about inflation that they're deeply confused about it. At least that's what they tell us. I'm prepared to give them the benefit of doubt.

Beckworth: It's a puzzle, mystery, a conundrum.

Selgin:  Yeah, yeah. And so for all these reasons, I really don't think that they are consciously trading off hitting their target for the sake of technocratic preference for a floor system but they really do like having a floor system. They are convinced that it is a superior arrangement. There are by the way some public choice reasons why a floor system is preferable. Churning large quantities of interest on reserves has its advantages. Essentially, it boils down to the Fed having a larger budget that divide us the money it doesn't send to the Treasury out of all the money it earns. And though it's true that it's having all this extra revenue over to the banks in interest payments on reserves, this is not necessarily a bad investment.

Beckworth: For the Fed. Right.

Selgin:  So now I'm getting a little cynical, but still.

Beckworth: Yes. Okay. And I want to just go back to the corridor system. Again, most countries have moved toward that. And also another point to stress about the corridor system that you brought up earlier is, even if the Fed were to go to the corridor system, they could still keep interest in excess reserves. It would still address this implicit tax on reserves. You can still cover that.

Selgin:  Absolutely.

Beckworth: You would still have the interest rate control because you'd have interest on excess reserves at the bottom, your discount rate at the top, symmetric corridor system. So it would be different than what we had before 2008. And yet, we still have interest in excess reserves.

Selgin:  Yeah, the way a corridor system works is that you've got these upper and lower bounds, you've got the discount rate and you've got the lower bound below market interest on excess reserves. And what you're hoping will happen is that neither of those administer greats will ever be relevant, right?

Beckworth: Yeah.

Selgin:  In a perfect world, you're not going to go all the way down to whatever your opportunity. You're not going to be in a situation where reserves with the interbank rate is that low. That's probably a crisis. By the same token, you don't want to find banks borrowing your high discount rate because that's means trouble too. So in a corridor system, these boundaries are things you don't want to touch. You touch them then, okay, for a little while you might be in Florida, for example, but you don't want to stay there. The way Canada was there for just a little while and it was very bad news at the time. And by the way, they got the sharpest deflation ever in modern post war history, I believe.

Selgin:  But anyway, it's the corridor system you usually try not to use those boundaries. They're there, but policy isn't really about them. It's about open market operations and the market rate, overnight rate. The other thing though, was that as far as efficiency is concerned, generally speaking, a corridor system can allow reserve to be remunerated enough to overcome the inefficiencies that are implicitly appealed to, thinking about Friedman rules and all that. Let's remember that when the Fed originally got permission to pay interest on reserves, which was in the 2006 financial efficiency something or other act, there was no thought at the time of a floor system.

Selgin:  The idea was that they would be continuing to use open market operations, it would continue to have a corridor but it would be a corridor with a positive interest on reserve floor. That's all. And the extensive purpose of that legislation was to eliminate the inefficiency of reserve holding particularly on unrequired reserves by paying some interest on those. So you can do that without a floor system. Moreover, if you believe as I do, that taking all the necessary transaction costs and other things into account, the interest rate on reserves that's required to achieve the Friedman rule or general efficiency is not going to be the same as interest rates on other short term assets because of various administration costs, et cetera.

Selgin:  There's a paper that I think is very good by Mackenzie Neary and a couple of co authors. A recent paper with the title something, Should the Fed Pay a Competitive Interest Rate on Reserves. And they look at things very carefully and come to the conclusion that the optimal tax on bank reserves is 20 to 40 basis points, at least in their baseline now. Which means that according to that baseline study, and most of the other tweaks on the model still yield some tax, positive tax and reserves. There should be a gap. The interest rate on reserve should be 20 to 40 basis points lower than the corresponding overnight rate. So market overnight rate. So in that case, we're paying banks too much on reserves. And I think that's generally going to be true when you maintain a floor system. You're not being efficient. You're making reserves too tempting, too desirable.

Beckworth: So just to be clear, the Friedman rule properly understood what actually imply a corridor system, not a floor system?

Selgin:  I didn't quite say that.

Beckworth: Okay. Well, seems to be pointing in that direction.

Selgin:  But I think that I implied it and I think the implication is correct.

Beckworth: Yeah.

Selgin:  In order to have a floor system, you really have to pay banks enough on reserves to make reserves as or more attractive than the closest corresponding assets. So in the present system we've been paying more interest on reserves and even three month treasury bills pay. And it's completely cost free. It takes more effort for banks to buy treasury bills than for them to sit on reserves. Just there.

Beckworth: And just to be clear, the Friedman rule is about the opportunity cost of money, right?

Selgin:  Yeah.

Beckworth: One would be careful about that. And in this particular context, the banking system.

Selgin:  It's the opportunity cost of the banks holding reserves.

Beckworth: Right.

Selgin:  And so we don't want that cost to be too high, but we can make it too low too. And floor system makes it too low.

Beckworth: Okay.

Selgin:  You're making reserves not only onerous to hold but you're making them seem better assets than other short term assets. And that's what you need to do if you want banks to actually sit on trillions of dollars worth of reserve. But that is not consistent with a properly applied Friedman rule where we want banks to be not holding inefficient amounts of reserves, but we still don't want them to hold oodles of them.

Beckworth: So maybe to summarize, it seems that now we're paying banks too much relative the Friedman rule for reserves. Maybe before 2008, we're paying too little.

Selgin:  Oh, yeah. We certainly paying them too little before 2008, when we were paying zero. And other rates were higher than they are now.

Beckworth: So there was this opportunity cost. This implicit tax on banks for the reserve.

Selgin:  Yeah. So one way to sum this up, I would have been perfectly in favor of the 2006 measure to give the Fed the authority pay interest on reserves, assuming I didn't anticipate how they would abuse that right later. But I would have been opposed and I was opposed to the 2008 acceleration of that power to pay interest on reserves at exactly the wrong time. Let's remember why they did that. They were making a lot of emergency loans and the Fed at that time was determined to keep its policy rate, which was still at that point determined with the usual mechanisms at what was then a 2% target. After Laymen failed, they were going to be making vast increases in their balance sheet and additional emergency loans.

Selgin:  They had been sterilizing their emergency loans by selling off treasuries from their balance sheets. That treasuries had come down to the point where they didn't want to sell anymore. So Bernanke and company asked for this acceleration of the right to pay interest on reserves in order to be able to keep making these emergency loans, but not have the reserves impinge on their interest rate target by being dumped into the federal funds market by the banks that got hold of them. So the idea was to make reserves more attractive than federal funds and incidentally, more attractive than a lot of things. So banks would just pile them on. And that was the purpose. And at that time, they weren't worried about making policy too tight, they were worried that it would be too loose. Problem is that they seem to be not worried about making it too tight still. And when you put that mechanism in place, you put it in place in October 2003 because you're worried about inflation.

Beckworth: 2003 or 8?

Selgin:  2008, pardon. Because they were worried about inflation. Because they were worried about missing a target. In the meantime, the economy's just going downhill, just circling bold, to put it crudely. And then they decide at some point, of course, they've lowered their funds right now, but their target, but it doesn't mean much of anything. They decide, well, maybe we need more stimulus after all. The inflation scare has finally gone away. It's clear that what's needed is stimulus and now they're getting ready to do large scale asset purchases. In the meantime, they've let this thing in place that they put there to make sure that any reserve expansion doesn't lead to any general increase in bank lending. But what's it going to do now?

Selgin:  Same thing, right? So the odd thing is in October, they want to have interest on reserves so banks won't use extra reserves that come their way. Won't use them to make loans, won't use them to put in the marketplace. And then now they want a stimulus, but they leave that in place. They won't get rid of it as if they're stuck with it. But they're not. They don't have to do this. And now they're going to create trillions of dollars of reserves, which are going to pile up. And of course the reason they create it works both ways, right? We have to create trillions now because they're piling up. And they're piling up because we're paying interest on reserves. And you could show. Anybody who claims interest rate on reserves has nothing to do with the piling up. It's got some statistical fancy work to do.

Selgin:  So they rendered monetary policy potent, at least as far as the usual transmission mechanism is concerned. Then they created trillions of dollars in reserves as a way of trying to overcome the potency of policy that was their own doing. And this is the system that they're calling a great technological breakthrough.

Beckworth: Yes. So the Fed itself was clear that they were doing this to maintain control over monetary policy.

Selgin:  Initially, yeah.

Beckworth: They foresaw the banking system turning those excess reserves into acquired reserves, maybe also into currency and they wanted to prevent that from happening, at least initially.

Selgin:  The immediate concern was funds market of course, because if the reserves are put into the Fed Funds market, so you make emergency loans, banks get the reserve.

Beckworth: Right.

Selgin:  And then they put it in the Fed Funds market because they don't need it. That's going to undermine the Fed Funds target, which of course, the Fed Funds target was collapsing.

Beckworth: Yeah.

Selgin:  Anyway...

Beckworth: The irony of it is of course, they introduced it at the very time the natural rate was falling and just, I want to put some numbers on this. Make this concrete. I looked this up before the show, said October 15, 2008, right around when interest in excess reserves introduced at 75 basis points, the one month Treasury yield was .05%. So 70 basis points spread and of course, the outlook was getting worse. Then October 24, interest in excess reserves goes up to 1.15, one month Treasury was .33 so a spread of 82 basis points.

Beckworth: Then from November 7 to December 15, it goes to 1% but the one month Treasury was at .05 for 95 basis points spread. So, in addition to all these other issues you're bringing up, where they were putting it was much higher than the natural rate. Now, in fairness to the Fed, I do think there were some challenges because GDP wasn't reflecting the huge collapse in real time. I do think on the other hand, there were asset prices that were clearly screaming or going over a cliff, breakevens, other asset prices.

Selgin:  And the inflation wasn't there. The only inflation which they were worried about from June on, June to October is critical paper, they're worried about it. The only inflation is in the headline inflation, which they should not have according to their own understanding.

Beckworth: Right. Absolutely. Of course shouldn't involve this.

Selgin:  They should not have been paying that much attention to that. They shouldn't have been worried about it. But the fact that they were acting as if they're still worried about it in October, I think is particularly strange.

Beckworth: Well, in September to-

Selgin:  In September, sorry.

Beckworth: Yeah, that's-

Selgin:  September. October.

Beckworth: Yeah, the August. I've looked at transcripts from both those meetings, even in August, there were a number of members who were saying that they felt it was more likely than not it would be raising rates at the September meeting.

Selgin:  But by October 15, when this device is put into effect, because it takes till the second, third week of October for the actual interest rates to begin. By the time they're actually making sure banks aren't going to do anything with extra reserves that could ease monetary conditions, they have no reason to be not wanting to ease monetary conditions.

Beckworth: We know Ben Bernanke in his book says he regrets this decision too. And I think there are probably some people in the FOMC he had to work with that were-

Selgin:  I don't think he was the main person.

Beckworth: Yeah. In some ways I feel bad. I criticized the Bernanke Fed. I think there's certain characters inside the Bernanke Fed that made life difficult for him. All right. Well, let's move on to the legality issues surrounding interest in excess reserve. Neary touched on one part of it. There's two parts I want to go over. The first one is, what's the intent on the law for excess reserves?

Selgin:  So as I mentioned, the 2006 law which initially authorize the Fed to pay interest on reserves was designed simply to have the Fed reduce the opportunity cost but not to zero of holding required reserves mainly. They really weren't concerned about excess reserves because they were contemplating a regime that would be the same as what had been in place all along where excess reserves are minor. Nevertheless, they did give the power to pay interest on excess reserves as well. But the statute said that the interest rate on reserves excess or required was, quote, not to exceed the general level of short term interest rates. Not to exceed the general. So it could be at that level, or it could be below that level but couldn't exceed that. So this is clearly contrary to a floor systems requirement. Floor system, you generally put the rate above so the banks are piling up for service even when they have the option of buying three months treasuries of 10 months treasury bills had less lower yield for considerable length of time after this measure went into effect, then the interest on reserve.

Selgin:  So anyway, that was the spirit of the law. That didn't change when they accelerated the date for implementing it, didn't change. None of these rules changed. But what happened was the Fed just decided as the law allowed them to do. To interpret the statute. And they published their interpretation and turned out their interpretation listed a bunch of rates that for purposes of implementing the statute could be considered short term market rates. And most of them were long term market rates. There's no overnight rates listed in the Fed's definition.

Beckworth: Oh, that's how they justify it being so high.

Selgin:  No, no, but they had another ace up their sleeves. They also included on the list of representative short term rates their own discount rate. The premium credit rate which is by design as you know.

Beckworth: Higher.

Selgin:  Yeah, it's always 75% higher than the target. So basically, they were defining the meaning of short term interest rates so that they could have the interest rate on reserves above all the rates most normal human beings would consider market short term interest rates and still be meeting the requirements of the statute particularly because it would be impossible and be literally impossible for them to have the interest rate on reserves not be lower than the premium credit rate. Because their operating procedures still calls for the discount or premium credit rate to be 75 basis points above target. So they meet the statute legally, only because they decided how to interpret the law.

Beckworth: They changed the meaning.

Selgin:  The Congress should do something about them.

Beckworth: Hasn't Congress called them out on that?

Selgin:  Well, they've questioned them about it. Janet Yellen more this, did one of these hand waving things, but it's absurd. It's absurd. It's absolutely absurd. If you're an economist and you don't know that the Fed's primary credit rate is not representative of the general level of short term interest rates, then you need to have your license to teach economics taken away. So they've cheated. But frankly, this is a problem with the way we let statutes be enforced. By letting the agency that's supposed to be regulated interpret the statute, and now it's in the civil go. This is what this means. And the Fed wrote it so they wrote it to satisfy their own wishes.

Beckworth: Okay.

Selgin:  Congress can and should fix that if it's serious about the original laws intent. And there's some talk of trying to do something about it and I've been urging them to. There are plenty of very nice representative race. I've recommended the Federal Reserve Bank of New York has developed an index of private repo rates, treasuries collateralized. So these are low risk, obviously, and their overnight. That's pretty close. You want something that's a market rate that's comparable in risk and maturity to reserves. That would be a good one.

Beckworth: Okay. So that may at some point happen. We have to wait and see.

Selgin:  It'll be the end of the floor system.

Beckworth: It'll be the end of the floor system. And again, everything we've talked about though, this isn't something to be feared or some cataclysmic change. It would still again and tell keeping index excess reserves, you'd still get interest rate control, you'd still get some fixe to the implicit tax on reserves. But let's go on to the second legality issues. The first one you mentioned is the Feds not actually following the true intent, original meaning of law.

Selgin:  That's right.

Beckworth: The second one though, is the way that interest in excess reserves is implemented. It effectively moves power from the FOMC to the Board of Governors. Least on paper, hasn't been exercised that way but to talk about that.

Selgin:  It's hard to tell because the Board of Governors has a majority vote on the FOMC and then they work very hard to try to...

Beckworth: Yes.

Selgin:  Have their way anyway they like. They don't like dissent. But here now with the twist is that it's literally the case at the most important policy rate setting, is the legal responsibility of the board only. And that means that you could conceivably have a circumstance where several of the bank presidents vote for a different great setting then the board wants and because the... and even though you have some people on the board who dissenting with the other board members, you could conceivably have a situation where a majority of the FOMC favors rate X but a majority of the board favors rate Y and the board would not have to go along with the majority of the FOMC in the current legal situation.

Beckworth: That's a pretty striking observation that at the end of the day, the board can overrule the FOMC if it needed to, in terms of setting the interest on excess reserves rate.

Selgin:  Yes, it could happen. It's not highly likely, but it could happen.

Beckworth: It could happen though.

Selgin:  And remember, when the law was originally designed, the interest on excess for sure was not conceived as something that would be used as a policy tool, let alone the Fed's most important policy rate tool. That was not what was planned or intended. So under the circumstances, given the limited purpose of interest on reserves at the time, it didn't. It wasn't inconsistent with the general way monetary policies been conducted for the right to set that, the responsibility for setting that rate to be placed with the board rather than with the FOMC. But now that interest on reserves has become the chief mechanism or instrument of monitory control, it's the fact that the FOMC isn't allowed to be as fully responsible for it as it is responsible for say, open market operations is something of an anomaly in the present Fed setup. Assuming that we agree that the way things had evolved with the FOMC being the group responsible for steering monetary policy. If we believe that then we have to believe that something's gone wrong.

Beckworth: Yes. And so there could be some scenario in the future where maybe a crisis emerges where you need someone to act quickly. And so we huddled together a few board members to make the decision and then cut the rate without consulting the entirety. And this reminds me of a story from Mike Palangio in a paper he tells that Alan Greenspan... so this might sound like this an academic concern, academic debate, but Mike Palangio tells the story of Alan Greenspan. When he was the chairman of the Fed, that there was an occasion where the FOMC voted for a change in federal funds rate target that he didn't want. And he went around their backs using a very similar technique. He went and got the board to change the discount rate.

Selgin:  Which it has control over.

Beckworth: Right. The board has control over like it does the interest on excess reserves. So Greenspan got the board to move the discount rate. And by default, the Federal fund rate had to follow that move because there's a certain spread between the two. And that's a real world example. Aware, determine chair or something comes up or a board. Governor or group of them decide to make a rate cut independent with FOMC has voted. So there's a real world application.

Selgin:  Oh, yeah. And Bernanke is written about this issue saying, oh, this is not really important. That we have these long traditions and we're just going to follow the tradition even though the law has technically changed. To which my response is, well, if the Fed was... does he really think that we should be confident that the Fed's going to stick to all its old traditions? Because it seemed to me that it's changed a lot of its traditions in the last 10 years.

Beckworth: Yeah.

Selgin:  Right? So what basis do we have for being confident that the Fed wouldn't make an innovation here as well? They've been innovating.

Beckworth: Right.

Selgin:  It's not like they're a bunch of tradition bound...

Beckworth: I mean, and this excess reserves we've been talking about is a big innovation.

Selgin:  Yeah. Right. They innovated that.

Beckworth: Interest rate, but it is now the main interest rate.

Selgin:  Yeah, no, you can't just... and he says, that's why we have laws, right? That's why we have rules. So we want things to be done according to the way we think they ought to be done not, not leave it to people to just do the right thing. We've got too much of that in monetary policy as it is.

Beckworth: Yes. So going forward, do you think this conversation about interest rate and excess reserves will continue to other people who share your interest and revisiting this issue?

Selgin:  So I keep running tabs on how many people are concerned about this. It's very easy because enough of them, but there are. I think there's at least a dozen now which is good.

Beckworth: Uh huh (affirmative).

Selgin:  And there may be more I don't know about. But I sure hope to do what I can keep the conversation going because I think this is a big issue. I don't want us to find out in the next crisis what the shortcomings of this operating system are. And I do think it's on the side of sufficient expansion that its shortcomings are most clear. It's very good at keeping things tight. It is a doubtful system for making sure they're not too tight. And that's why not worried about it causing inflation. I'm not worried about it causing booms. I'm worried about the opposites.

Beckworth: Okay. Well, our time is up. Our guest today has been George Selgin. George, thanks once again for coming on the show.

Selgin:  You're very welcome, David. Thank you for having me.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.