Are the days of the Fed's floor system numbered? Last month I claimed that they could be if President Trump's fiscal policy continues to spawn rapid increases in the issuance of treasury bills. His administration is relying heavily on treasury bills to finance its deficits as seen below:
This increased issuance of treasury bills matters because it implies, all else equal, a rise in treasury bill yields. Below is a figure showing the DTCC overnight treasury-repo rate relative to the IOER rate. Lately, the treasury-repo rate has been bouncing above the interest on excess reserves (IOER) rate. This development could be a big deal.
If sustained, this rise of overnight interest rates above the IOER rate could spell the end of the Fed's floor system.
To see why, recall that the Fed moved to a floor operating system in late 2008 by paying interest on excess reserves (IOER) at a rate higher than comparable short-term market interest rates. This pushed banks onto the perfectly elastic region of their reserve demand curve and allowed the Fed to add reserves to the banking system without causing its target interest rate to change. The supply of reserves were thus "divorced" from the setting of monetary policy (Keister et al. 2008). This divorce was seen by many a virtue of the floor system, for it allowed the Fed to manage bank liquidity and monetary policy independently, changing the size of its balance sheet to control liquidity, and the IOER rate to alter its monetary policy stance.
Maintaining this floor system, therefore, requires keeping the IOER rate at or above comparable market interest rates, so that banks will be willing to hold on to any reserves that come their way. The recent uptick in treasury bill issuance seems to be undermining this requirement and raises the possibility that the Fed could be inadvertently forced off of the floor system by fiscal policy.
Further evidence that something may already be afoot with the rise in the overnight repo rates can be seen on the aggregate bank balance sheets from the Fed's H8 database. The figure below shows the asset category "total fed funds sold and reverse repos" as the black line. The blue line shows the same category, but just for banks transacting with other banks. This figure indicates there still is not much interbank lending, but there does appear to be a surge in nonbank lending in repos. This makes sense given the recent surge in repo rates. It may also be the first crack in the armor of the Fed's floor system as it suggest banks are beginning to invest reserves in the repo market rather than at the Fed.
Something else I showed in my piece last month was the tight fit between treasury bill issuance (normalized by the total amount of marketable treasury securities) and the IOER-Libor spread. One interpretation of this relationship is that the movement of treasury repo rates gets transmitted into interbank rates via arbitrage.
This IOER-Libor spread, in turn, is closely tied to the percent of bank assets held in the "cash" category in the H8. (Since late 2008, this category has consisted mostly of bank reserves.) The specific pattern has been that as the IOER spread rises (falls) the cash share also rises (falls) as seen below:
Conversely, when the that as the IOER spread rises (falls) the loan share of bank assets falls (rises) as seen below:
Based on the three above charts, if the treasury-repo yield continues to be above the IOER, we should expect to see a growing share of bank assets invested in loans and fewer in excess reserves.1 That would bring the end of the Fed's floor system and rise in the inflation rate.
Some worry the liquidity coverage ratio (LCR) may complicate this story. As of 2015, the LCR started requiring banks to hold enough high-quality liquid assets to withstand 30 days of cash outflow. The LCR, consequently, has increased demand for such assets of which bank reserves and treasury securities are considered the top tier. When the IOER rate > treasury repo rates, the LCR created additional demand for reservers relative to treasuries. If, however, IOER rate < treasury repo rates the additional reserve demand will disappear and further hasten the demise of the floor system.
The question, then, is will the treasury bill yields continue to stay above the IOER rate? It certainly seems possible with President Trumps budget deficits. Only time will tell.
P.S. I have a working paper on the Fed's floor system. I am beginning to wonder if it will be outdated before it gets published.
P.P.S. I see that George Selgin makes the same point near the end of this post.
1To be clear, banks cannot control total reserves, but they can control the form of the reserves. That is, banks can choose to hold excess reserves or invest in other assets like treasuries and loans that, in the aggregate, would lead to a rise in required reserves and a fall in excess reserves.
Update: One implicit assumption in my analysis is that banks are price takers, not price makers, in the overnight market. If one takes the H8 data series "fed funds sold and reverse repos" and divides it by the repo market as calculated by this New York Fed study (and updated to a more current expansion factor based on an exchange with one of the authors), one gets an average of 10 percent for the 2008:Q4-2018:Q2. Banks have been a small part of the overnight market during the Fed's floor system.
Update II: After more reflection, I am having doubts about my assumption of banks being price takers in the overnight market. I think my calculations of bank share of the repo market supports this contention, but it is hard to reconcile with the reality that overnight market rates followed movements in the IOER rate. On the other hand, if banks are able to move overnight markets then why did they fail to completely eliminate the IOER spread over comparable short-term interest for most of the past decade?
Sorry, but I think you have the causality here all twisted around. You seem to think that if yields go above the IOER rate, then the end of the floor system will result in a "rise in the inflation rate", because banks will not be willing to hold excess reserves, and that will somehow unleash a torrent of inflationary reserves upon the economy.
ReplyDeleteBut, tangibly, what will banks do if they don't want to hold excess reserves? As you mention in the footnote, they *can't* control total reserves. Rather, their desire to hold reserves rather than other assets determines the relative yields on those assets consistent with asset market clearing, given the exogenous quantity of total reserves.
If banks are upset about holding so many reserves relative to other short-term assets, then the yields on those assets will go *down* so that the spread to IOER clears the market. In other words, the recent change we have seen will reverse itself. No crisis there!
Of course as unwanted reserves are disposed of via the money market there will be a lowering of rates on money market instruments; but that effect occurs along with rather than instead of expansion in the equilibrium, nominal size of aggregate banking system liabilities. How great the expansion must be depends on the extent of the original supply-driven change in the yield on Treasury securities. In any event, growth in bank liabilities, and a consequent increase in banks' need for required reserves, plays a part in the equilibrating process.
DeleteAnonymous,
DeleteYou say "If banks are upset about holding so many reserves relative to other short-term assets, then the yields on those assets will go *down* so that the spread to IOER clears the market".
This assumes, among other things,that banks are a big enough player in the repo market to matter. Any evidence for this assumption?
Were it the case that the long-run equilibrium adjustment following an increase in the supply of Treasuries consisted ultimately in a return of money market rates to where they started, and hence to their original relation to the Fed's rate settings, then the Treasury would be able, presumably, to borrow all it likes without ever "crowding out" other borrowers and also, ex hypothesi, without triggering inflation. So, have we stumbled upon a free lunch? I rather doubt it.
DeleteGeorge: I don't actually think that money market rates will return to where they started. If the market is behaving normally, then an increase in the supply of T-bills relative to excess reserves will presumably push up the relative yield on T-bills, which is what we're seeing. The magnitude of this equilibrium change in price will be inversely related to the elasticity of demand for reserves vs. T-bills as a function of the spread.
DeleteIn the post, David seems to be implying that this elasticity of demand is high - banks will try to avoid holding excess reserves now that there's no longer any yield advantage. My point is that if this elasticity is high, then the market-clearing change in spread should be small (which it evidently has not been)! In the worst case, if banks *are* really reluctant to hold excess reserves when there's no longer any reward - but they haven't fully acted out on this reluctance yet - then we'll see it in the form of lower yields on other money market assets, as banks try to exchange reserves for those assets.
You seem to be worried that when this time comes, "along with" the fall in yields, we'd see some kind of explosion in lending or something (in your post you refer to a "hot potato"). Sure, if securities yields are lower, then at the margin banks are more willing to lend - but this increased willingness is precisely captured by the change in spread. There's no immaculate transmission from excess reserves to economic outcomes that isn't accompanied by changes in yields and asset prices. The fact that many old monetarists seemed to believe in such immaculate transmission was a major cause of their epic predictive failure in thinking that the rise in base money would cause a large rise in inflation (e.g. Allan Meltzer).
Well, we are not so very far apart.Being a good Wicksellian (or a Wicksellian at any rate), I reject both what you call the "immaculate transmission" alternative of some monetarists and the interests rates do it all view of...well, way too many people. Of course as banks try to rid themselves of reserves yields, having risen, fall again to "accommodate" the increased quantity of funds supplied. But as that not-so-immaculate increase makes its way through various markets, the rise in demand pushes rates up again, while growth in liabilities raises banks' required reserve needs. You can think of the story as a standard Wicksell one, were the policy rate is below the natural rate. Except while in Wicksell's version you have either hyperinflation or a policy rate that's raised to equate the higher natural rate, in the IOER case the fixed IOER rate can mean that the cumulative process continues until there are no longer any excess reserves.
DeleteAnon 1,
DeleteYou note that if the higher yield on repos attracts banks attention, this increased demand for repos will lower the repo yield until it equals IOER rate. That is a fair point, but it assumes banks are price makers in the overnight market. It is not clear to me that they are. In fact, if I take the banks 'ffr and repo' measure seen in the post above and divide it by repo market as outlined in this NY Fed report (with the expansion factor updated based on an exchange with one of the authors), I get the banks share of the repo market to be about 10% for the period spanning the Fed's floor system. It is hard for me to see how your arbitrage story actually plays out with banks being a relatively small part the repo market. It seems they are more a price taker than price maker in this market.
With that said, I should have been more careful with my statement on inflation. For even if my scenario unfolds, I am sure the Fed would raise the IOER (even if it meant pushing it above its natural rate level).
Anon 1, okay, I am having some doubts. See my second update above.
DeleteThat would bring the end of the Fed's floor system and rise in the inflation rate.
ReplyDelete--David Beckworth
Fascinating blogging.
The above sentence seems a little cut and dried. Perhaps bank lending into real economic activity will increase. But then we may also see increases in productivity. We are seeing a rise in the value of the dollar which is lowering import prices.
Or perhaps there is still slack in the economy that modern measures do not capture.
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