The New Normal

Also included in Federal Reserve Chair Ben Bernanke’s statement to Congress last week were some guidelines for what we might expect Federal Reserve decisions and communications to look like as we make the gradual adjustment to more normal conditions.

In recent years, the Fed had gotten very good at communicating its intentions to the market. FOMC statements came down to a routine in which the Fed announced at each FOMC meeting a target for the fed funds rate that Fed watchers had usually figured out well before the meeting. But the fed funds rate has become an essentially irrelevant number for the last year, and given the Fed’s apparent intention to keep a huge volume of reserves outstanding, will likely remain irrelevant for some time to come. Hence one purpose of Bernanke’s statement was to communicate what we should be looking for in the way of a new format for policy decisions and announcements from the Fed:

As a result of the very large volume of reserves in the banking system, the level of activity and liquidity in the federal funds market has declined considerably, raising the possibility that the federal funds rate could for a time become a less reliable indicator than usual of conditions in short-term money markets. Accordingly, the Federal Reserve is considering the utility, during the transition to a more normal policy configuration, of communicating the stance of policy in terms of another operating target, such as an alternative short-term interest rate. In particular, it is possible that the Federal Reserve could for a time use the interest rate paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance, while simultaneously monitoring a range of market rates. No decision has been made on this issue; we will be guided in part by the evolution of the federal funds market as policy accommodation is withdrawn. The Federal Reserve anticipates that it will eventually return to an operating framework with much lower reserve balances than at present and with the federal funds rate as the operating target for policy.

In other words, instead of watching for an announcement by the Fed of a target for the fed funds rate, we may be anticipating announcements about the interest rate that the Fed chooses to pay on reserves. Bernanke noted that the value chosen for interest on reserves might come to move other interest rates around in the same way that the fed funds rate used to:

By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates, as banks will not supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at the Federal Reserve Banks. Actual and prospective increases in short-term interest rates will be reflected in turn in longer-term interest rates and in financial conditions more generally.

So perhaps instead of a fed funds futures contract on the Chicago Board of Trade, we’ll need an interest-on-reserves futures contract to tell the rest of us what the savviest Fed-watchers have figured out.

Bernanke signaled that the Fed may also dip its toes further with operations on reverse repos and the Term Deposit Facility, though I think he was cautioning us not to read too much into any initial steps in these programs, as the Fed may want to simply try using these facilities on a larger scale to see how they’re going to work out before making any real policy changes:

The sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments. One possible sequence would involve the Federal Reserve continuing to test its tools for draining reserves on a limited basis, in order to further ensure preparedness and to give market participants a period of time to become familiar with their operation. As the time for the removal of policy accommodation draws near, those operations could be scaled up to drain more significant volumes of reserve balances to provide tighter control over short-term interest rates. The actual firming of policy would then be implemented through an increase in the interest rate paid on reserves. If economic and financial developments were to require a more rapid exit from the current highly accommodative policy, however, the Federal Reserve could increase the interest rate paid on reserves at about the same time it commences significant draining operations.

Still, the Fed is seeing all of this as potentially still far in the future, with Bernanke’s statement repeating a phrase that has become boilerplate for recent FOMC statements:

economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

The New Normal

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About James D. Hamilton 244 Articles

James D. Hamilton is Professor of Economics at the University of California, San Diego.

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