Sunday, November 23, 2008

Has the Fed changed its policy unannounced? PART 2

This post continues an article from last week titled Has the Fed changed its policy unannounced: Poole says yes. Further evidence - a huge shift in nonborrowed reserves since October - suggests that the Fed may have shifted its policy target away from the federal funds rate.

The Fed’s balance sheet is usually only followed by a few policy gurus, but with the Fed’s $1.3 billion in new liquidity measures, everybody is interested. Many questions have been raised regarding the Fed’s actual objectives, as the effective federal funds rate - which closed at 0.49% on November 20 - veers miles away from its target set by the Federal Open Market Committee (FOMC), currently 1%. Accordingly, William Poole suggests that the Fed has changed it policy target without announcement. If you need a refresher, see Poole's interview on Bloomberg here.

A closer look at the construction of banking reserves (the H.3 tables) gives further evidence that Poole may be right.

The chart illustrates the level total reserves, excess reserves and nonborrowed reserves on a weekly basis since the beginning of 2008. Nonborrowed reserves (reserves acquired through methods other than borrowing from the Fed's discount window, like interbank lending or deposits) have surged $290 billion since the two-week reserve period ending on October 22, 2008. An upward swing in nonborrowed reserve positions indicates that interbank lending activity has picked up substantially, which could signal that credit conditions are improving with the Fed’s aggressive liquidity actions.

I don't buy it. Excess reserves are rising precipitously alongside the surge in nonborrowed reserves, as banks continue to hoard the Fed’s $1.3 trillion in new liquidity over the year. Credit conditions remain tight with new consumer and firm lending coming to a grinding halt (Calculated Risk gives a market-based argument that there has been little progress in credit improvement over the last few days).

A closer look at the construction of aggregate reserves shows that since October 22, nonborrowed reserves are surging while the growth in borrowed reserves is generally slowing.

With such dynamic shifts in borrowed and nonborrowed reserve positions, and little or no progress in keeping the effective federal funds rate in line with its target, I have to wonder if the Fed is targeting reserves again.

Paul Volcker targeted nonborrowed reserves in the 1970’s and early 1980’s, and borrowed reserves until the late 1980’s when Greenspan phased into interest rate targeting in the 1990’s. Nonborrowed and borrowed reserves appear to have taken a discrete jump, giving credence to Poole’s accusation that the Fed has changed its policy without announcement.

But the Fed made no such explicit announcement in the 1990's. When the Fed shifted its gears back in the late eighties from a borrowed reserve target to an interest rate target (targeting the effective funds rate), it did so gradually. From Meulendyke (1998):

”The return to effectively targeting the funds rate occurred gradually because other alternatives ceased to work as expected, rather than as a result of specific decision by the FOMC.”

RW: The minutes in the 1990’s do not show any indication that there was an explicit announcement by the Fed until 1997 when the minute reporting changed. The first sentence of the FOMC minutes from the late 1908's through July 1-2, 1997 always started with the following sentence (or some variant of it):

“In the implementation of policy for the immediate future, the Committee seeks to maintain the existing degree of pressure on reserve positions.”
RW: But at the next chronological FOMC meeting on August 19, 1997, the first sentence of the FOMC minutes switched to:
“In the implementation of policy for the immediate future, the Committee seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5-1/2 percent.”
RW: The only announcement made, indicating that the Fed had indeed changed its policy target, occurred in the minutes of that particular FOMC meeting on August 19, 1997.
“In particular, the directive would in the future include specific reference to the federal funds rate that the Committee judged to be consistent with the stance of monetary policy. The Committee also modified the present sentence relating to the intermeeting bias in the directive to recognize that changes in the stance of policy are now expressed in terms of the federal funds rate. These changes were not intended to alter the substance of the directive or the Committee's operating procedures."
As far as my research goes, the Fed never made an official announcement regarding Greenspan’s move to target an interest rate before 1997. But Meulendyke (1998) suggests that the FOMC had been targeting – at least partially – the federal funds rate for some time.
The trend in nonborrowed reserves has changed markedly, and as Poole suggests, may be the result of new and unannounced Fed policy.

Furthermore, I am not sure if we will ever get an official announcement of such a policy shift until well after the FOMC has phased out the old policy. At least for now, transparency (or lack there of) is not one of the Fed's primary policy concerns.

Just a little food for thought.

Rebecca Wilder


  1. If this is an issue, why has the Fed not announced it?

  2. This is the 2nd major catastophe that Bernanke's team has made. The first was the market crash on Feb 27th 2007. The 2nd was the debacle in stocks during the last 2months.

    The FOMC has introduced a channel/corridor/bracket reserve system, with 3 interest rate tiers:
    (1)deposit rate/floor &
    (2) target/market rate &
    (3), penalty/ceiling rate.

    The lowest tier for excess reserves was initially -75 basis points below the target, then the FED changed the rate paid on excess reserves to 35 basis points below the target (i.e., the average targeted federal funds rate in a reserve maintenance period).

    Interest paid on excess reserves serve to drain the money stock and market liqudity from the banking system. Bernanke's team inadvertantly caused a multiple contraction of bank credit. I.e., excess reserves grew faster than they were needed to offset their "policy tools" funding requirements.

  3. The "tax rebate" obviously needs to be lowered. This rate is a "moving target".

    It has the potential to cause more damage than pervious procedures.

  4. Hi Paul,

    Thank you for reading! And thank you for the Poole clip.

    You said, “If this is an issue, why has the Fed not announced it?”

    I honestly cannot say. As I stated in the article, Greenspan is believed to have been targeting an interest rate long before it became explicit. It kind of feels like the Fed has "something up its sleeve", which is why Bloomberg is suing them:

    In my opinion, this obvious disregard for transparency is frightening. I mean, we are talking about $trillions here.

    Thank you for reading!

    Hi Flow 5,

    Good to hear from you again!

    I completely agree – part of the story is the new interest paid on reserve balances, which as you point out, has been changed three times since the policy was initiated on October 6 (I think). But it can’t be the whole story.

    Thanks for reading,


  5. Poole was right to highlight the differences in Fed policy. The key is that they have done it without communicating it to the market. And that is inconsistent with their history and their stated objective of transparency.

    Are they attempting to reflate the economy to offset the size of the U.S. debt? I don't think so. This would be silly for them to even try, as I see no reason to be concerned about it.

    Are they (the Fed) spooked by Deflation?

  6. Fed communications strategy is paramount now. The question is, how do they want to shape expectations? Krugman argues they should do it by being irresponsible; i.e., promising never to take back the growth in reserves. Krugman's point is that the markets factor in not just current Fed policy, but also expected future policy. As such, the Fed will not convince the markets to stop hoarding cash until it promises to stop acting responsible in order to squelch FUTURE inflation.

    In contrast, the Fed seems to want to proceed by stealth so as not to ignite inflation fears.

    You can't it both ways. If you want hoarding to stop and velocity to rise, you have to promise inflation. If you refuse to acknowledge even the shift to quantitative easing, the impact on expectations will be small.

    The problem is the Fed has promised that deflation-fighting comes at little cost to future inflation. It refuses to acknowledge a trade off. Time to face reality.

  7. Something is seriously wrong.

  8. Rebecca:

    Concerning bank credit, the drop in loan/investment demand was exclusively the consequence of setting the interest-on-reserves rate, equal to market rates (Friedman's rule). I.e., bank portfolios would have been repositioned from making consumer loans, to purchasing governments, that is, if there was a shortage of credit-worthy-customers (likely).

    Prior to the DIDMCA, the assets of non-member banks compared to the member commercial banks, in the Federal Reserve System, dropped below 65%. Legislative changes since then have moved towards eliminating member commercial bank legal reserves altogether.

    Money creation is a system process. CBs grow at relatively similar rates of expansion. If they attempted to grow significantly faster, they would lose their due from banks items.

    In current terms, if the exodus from banks that are now “bound” (where bank lending is restricted by legal reserves), to “unbound” (where there are no constraints on bank credit expansion) continues to decline, it will be difficult for the FED to control the money supply (expand at a non-inflationary rate).

    I would guess that the 10 largest banks are defined as “bound”, and that cumulatively, they hold the majority of assets in the banking system ”. The banks still lend/borrow (redistribute idle reserves) in the fed funds market. The FED still calculates seasonal adjustments. And bank credit expansion, still is still responsive to adding or draining “sterile reserves” [sic].

    I.e., monetary flows (MVt)still oscillate at fixed or constant intervals.

  9. I'm an inveterate "Fed watcher". My friend and professor: -Dr. Leland James Pritchard (Feb 20 1908 – Nov 15 1991) got his MS at Syracuse in Statistics, and his Ph.D. in Economics at Chicago in 1933.