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Thursday, January 10, 2019

Oh, the Horror of a Corridor!

The December 2018 FOMC minutes are out and reveal members continue to discuss the potential long-run frameworks for monetary policy implementation. Their discussion as to whether they should keep their current floor operating system or move to a corridor operating system can be illustrated using the figure below:


The FOMC likes the floor system since it separates the size of the Fed's balance sheet from the setting of its target interest rate. This added flexibility is possible because the reserve supply schedule is on the horizontal part of the reserve demand curve as seen above. Here, banks will take all the reserves sent their way--killing off interbank lending--as their demand for reserves is perfectly elastic. The corridor system puts the reserve schedule back on the downward slopping part of the reserve demand curve. That creates an opportunity costs for reserves and resurrects interbank lending. 

Recall that the floor system is a byproduct of the crisis. It was part of the unconventional monetary policy actions taken during that time. Consequently, the Fed is now discussing how to normalize its operating system. As I have argued in a recent paper and in various blog posts, I prefer the Fed leave the floor system and move to a symmetric corridor system. In my view, the political an economic costs exceed any benefits of a floor system. 

I do not want to rehash these arguments, but I do want to respond to a claim made by the FOMC members as reported in the December 2018 minutes. Specifically, the FOMC claims there will be much greater interest rate volatility under a corridor system. Here is the relevant part (my stress):
Reducing reserves close to the lowest level that still corresponded to the flat portion of the reserve demand curve would be one approach consistent with the Committee's previously stated intention, in the Policy Normalization Principles and Plans that it issued in 2014, to "hold no more securities than necessary to implement monetary policy efficiently and effectively." However, reducing reserves to a point very close to the level at which the reserve demand curve begins to slope upward could lead to a significant increase in the volatility in short-term interest rates and require frequent sizable open market operations or new ceiling facilities to maintain effective interest rate control. These considerations suggested that it might be appropriate to instead provide a buffer of reserves sufficient to ensure that the Federal Reserve operates consistently on the flat portion of the reserve demand curve.
Well, if there were any doubts as to where the FOMC is leaning in this debate over operating systems this paragraph should put the doubts to rest. FOMC members apparently love their flat reserve demand curves. So much so, they cannot handle the imagined horrors of interest rate volatility under a corridor system.

Yes, the horrors of interest rate volatility in a corridor system. I mean, how can central banks like the Bank of Canada (BoC) impose such a cruel system on their financial system? How dare the BoC leave the peaceful sanctuary of a floor system and move to the interest rate jungle of a corridor system! Just look at the all the interest rate volatility they are imposing on the Canadian financial system.



Oh wait, the BoC corridor system actually looks okay. Yes, there is some interest rate volatility for the overnight repo rate relative to the BoC's interest rate target, but the repo rate stays well within the corridor bounds.

Maybe the FOMC means interest rate volatility in a corridor system compared to a floor system, like the one it runs. After all, the FOMC is a true believer in its own operating system. The FOMC did say in the minutes that the "efficient and effective implementation of monetary policy" most likely requires providing "a buffer of reserves sufficient to ensure that the Federal Reserve operates consistently on the flat portion of the reserve demand curve."

With such confidence in their own floor system, it must be that the FOMC members are indeed thinking of the interest rate stability in their system. Right?


Oops, maybe not. Overnight U.S. repo rates do not look so stable compared to Canada. Maybe the scales of the above figure overstate the volatility of repo rates in the United States? How about comparing the actual spread between the overnight repo rate and target rate for the two countries and their different operating systems?


Okay, maybe the corridor system is not so bad. Maybe the FOMC is thinking of a return to an asymmetric corridor system like the one that existed pre-2008. There might be more interest rate volatility in returning to that system, but most advocates of a move to corridor system--like George Selgin, Stephen Williamson, Bill Nelson, Peter Ireland, and myself--are not advocating such a move. Instead, we want a move to symmetric corridor system where the IOER pins down the lower bound and the discount rate anchors the upper bound. 

Such a system can easily collapse into a floor system during a crisis, so the Fed could still have its desired flexibility if needed in a bind. Moreover, many other countries use some form of a symmetric corridor system. George Kahn of the Kansas City Fed has a great review of these experiences and the workings of these operating systems. 

I am glad the FOMC is debating the future of its operating system. My hope is that Fed does not get blinded by its own experience with an asymmetric corridor system and instead looks elsewhere in the world for understanding how a symmetric corridor system can work.