Share

Share on facebook
Share on twitter
Share on linkedin
Share on email

Corridors and Floors: A Primer on How the Fed Implements Monetary Policy

Investors are right to keep a close eye on what the Federal Reserve is doing.  As the central bank of the United States, it is charged with the responsibility of implementing monetary policy. Monetary policy has a powerful impact on the economy and capital markets.

The Dual Mandate

The objectives of monetary policy are given by Congress (the “dual mandate”) to:

“maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” [1]

The Fed attempts to meet these objectives (and implements monetary policy) by changing interest rates.  For example, they raise rates when inflation is too high or lower rates when the economy is operating below its potential.  The relative level of interest rates in the economy influence business and consumer borrowing, which impacts economic output and financial asset valuations.  Interest rates are an essential link between the capital markets and the real economy.

The Corridor System

To actually implement monetary policy, the Fed focuses on only one interest rate: the Federal Funds rate. The Fed Funds rate indirectly influences all other short-term interest rates in the market.  It only exists because all banks and other depository institutions must keep funds on deposit at the Fed equal to a certain percentage of their deposits (called required reserves).  Banks can keep more than the required amount at the Fed (called excess reserves) and they actively borrow or lend these reserves among themselves at the Fed Funds rate, a rate set by supply and demand.  The Fed would historically change the Fed Funds rate by adding or subtracting reserves to the banking system by buying or selling treasury securities in the open market.  This way of changing the Fed Funds rate is called the corridor system.

Quantitative Easing (and its critics)

But the Fed also has many unconventional tools in its toolbox to influence the economy in times of extreme distress in the markets.  In response to the Global Financial Crisis of 2007-09 (GFC), the Fed implemented Quantitative Easing (QE) in three stages from 2008 to 2013, by buying trillions of dollars worth of Government bonds to add liquidity to the financial system and to attempt to lower longer term interest rates.  It paid for these securities with “thin air” credit by writing checks drawn on itself, which significantly increased the banking system’s excess reserve balances with the Fed.

Today, the Fed still owns a little over $4 trillion in Government securities.  These assets are offset on the liability side of the balance sheet by those green backs (a.k.a. Federal Reserve Notes) in your wallet or purse ($1.7 trillion) and those reserve deposits by banks and other depository institutions ($1.8 trillion) [2] [3].

Ever since QE was implemented, it has been the subject of criticism from many sides, beginning with those fearing hyperinflation (remember those full-page ads back then touting the need to buy gold?).  This was because banking system reserves are the stuff money and credit in an economy are made from, and a fast growing money supply can create high inflation.  That fear was ultimately unfounded, since the banks never lent those excess reserves out, which is required for the money supply to expand.

Another criticism centered on what would happen to the markets and economy when the Fed decides to unwind QE and reduce its holdings of government securities? Wouldn’t that be disruptive to the capital markets and push interest rates way up?  Also, politically, using the Fed’s balance sheet in this way is very unpopular, and the Fed’s Board of Governors is well aware of this. The Fed has therefore been very slowly reducing the balance sheet by $50 billion per month, from a high of $4.5 trillion on 12/31/2014.

The Floor System

This is where things get interesting.  With QE, the Fed realized that flooding the banking system with huge amounts of excess reserves would interfere with the corridor system of implementing monetary policy.  They therefor decided to start paying interest on those reserve balances, which it never did before.  The Fed then sets the deposit rate just above the market rate of interest, which, in turn, creates a floor for the Fed Funds rate. This is because banks will not lend excess reserves to other banks at a rate less than they can earn (risk-free) by just leaving their reserves sitting on the books of the Fed.  Thus, the Fed discovered a new way to change the Fed Funds rate by simply changing the deposit rate for reserves.  This way of implementing monetary policy is called the floor method.

You may be wondering by now if there is a point to this tutorial on Money & Banking?  The point is this:  the Fed is now actively debating whether to go back to the corridor system or keep the current floor system.  If they keep the floor method, they will not have to reduce the size of the balance sheet any further, plus it is administratively much simpler to administer.

Our guess is that the floor method will be permanently adopted as the method for implementing monetary policy.  This means that they will eventually stop reducing the $50 billion monthly runoff of asset.

Here is how the Fed’s balance sheet might look [4]:

Adopting the floor system and reducing the balance sheet to around $3.5 trillion will mitigate one large source of uncertainty: the fear of what a complete unwind of QE would do the markets.  While this decision will undoubtedly raise another chorus of criticism, we believe it is a prudent course of action right now, especially given the Fed’s current commitment to keep raising interest rates.  The Fed is frequently blamed for causing recessions by raising rates too high.  We hope that they have the wisdom to know when to stop this time.

John Finley


John serves as Chief Investment Officer for Coyle Financial Counsel and is responsible for overseeing the investment process. John’s prior experience includes managing institutional fixed-income portfolios for corporations, pension funds, non-profit organizations and foundations at several large, global asset managers. With more than 20 years of institutional investment experience, he is energized by helping individuals understand the role investing plays in meeting their long-term financial goals.

 

www.coylefinancial.com
800-480-7913 | coyle@coylefinancial.com

We value your comments and opinions, but due to regulatory restrictions, we cannot accept comments directly onto our blog.  We welcome your comments via e-mail and look forward to hearing from you.

All information is from sources deemed reliable, but no warranty is made to its accuracy or completeness.   This material is being provided for informational or educational purposes only, and does not take into account the investment objectives or financial situation of any client or prospective client.  The information is not intended as investment advice, and is not a recommendation to buy, sell, or invest in any particular investment or market segment.  Those seeking information regarding their particular investment needs should contact a financial professional.  Coyle, our employees, or our clients, may or may not be invested in any individual securities or market segments discussed in this material.  The opinions expressed were current as of the date of posting, but are subject to change without notice due to market, political, or economic conditions.

[1] https://www.chicagofed.org/research/dual-mandate/dual-mandate

Accessed 12/14/18.

[2] https://www.federalreserve.gov/releases/h41/current/

Accessed 12/13/18

[3] For non-accountants, a balance sheet, in order to balance, assets must equal liabilities plus owner’s equity or capital.  In this case, the Fed only has capital equal to 1% of its assets.  (Talk about leverage!).

[4] Goldman Sachs Economic Research, “What’s Next for the Fed’s Implementation Framework and Balance Sheet Normalization?” 11/29/18

Share

Share on facebook
Share on twitter
Share on linkedin
Share on email
book img2

A Comprehensive Guide To Safeguarding Your Financial and Family Wealth.

Subscribe to our blog

Looking for Something?

Coyle Financial
Counsel Events

Recommended Reading

book img3
Download Free Chapter on
Lifelong Learning

Watch More Videos