New Monetarist Economics

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This post is a bit on the long side. If you want the executive summary, here goes. Recently, overnight financial markets have tightened up considerably, in the sense that the interest rate on excess reserves (IOER) is close to all overnight interest levels. The floor system of central bank or investment company involvement that the Fed designed, before interest rates went in late 2015 up, is now working as floor systems should.

Why are things working better? Because the Fed is phasing out its big-balance-sheet program finally, that was hindering the functioning of overnight markets. The FOMC has not seen the light yet, though. They love QE, and appear to be on a road to long term big-balance-sheet. First, let’s review where the Fed’s balance sheet was, where it is, and where it might be heading. The more-than-five-fold nominal upsurge in the Fed’s securities holdings, along with near-zero nominal interest levels, was viewed by the FOMC as a crisis policy, which it would eventually exit from – in some fashion.

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Well apparently that crisis lasted a very long time. The Fed did not begin increasing its focus on range for the given money rate until past due 2015 – seven years following the financial crisis. 50 billion cover would bind infrequently given the current size of the Fed’s collection, and would stop binding as the size of the portfolio falls entirely.

But that gets us to the liabilities aspect of the Fed’s balance sheet, which is where the action is actually, in terms of this post particularly. Before “liftoff” happened in October 2014, I wrote about how exactly the implementation was likely to work, in a large-balance-sheet world. The FOMC was uncertain about how exactly liftoff would work, as they had never before done anything such as this, and some idiosyncratic features of US financial marketplaces made liftoff a complicated business. Theoretically, a floor system – when there are excess reserves excellent in the financial system – should work in a very simple way.

The Bank of Canada did this for a year-long period from Spring 2009 to Spring 2010, with no problems. Inside a floor system, the central bank sets IOER, and arbitrage in the overnight market should equate all safe overnight rates of interest to IOER more-or-less. Because they had the cheapest costs.

When liftoff occurred, the big concern was whether the fed money rate would go up when IOER went up actually. In the immediate pre-liftoff period, the effective fed funds rate is at the number of typically .05-.15%. The IOER/given funds rate differential of 10-20 basis factors was considered to reflect balance sheet costs.

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