Fed should keep looking forward

The past decade experienced a revolution in how the Federal Reserve conducts monetary policy. While new tools such as quantitative easing have received the most attention, just as significant have been the changes made in how the Federal Open Market Committee sets and controls the level of short-term interest rates.
Before the financial crisis, the Fed controlled short-term rates by engaging in open market operations. Each day, the Federal Reserve Bank of New York would assess whether to add or drain bank reserves from the financial system to balance the supply and demand to achieve the desired short-term interest rate. While straightforward in theory, the process was extremely complex to carry out. Each day the Fed had to forecast all the factors that were affecting the supply of reserves and then act to adjust that supply to equal what banks needed to meet their reserve requirements. In the same vein, banks had to buy and sell reserves to ensure that they had enough to meet their requirements but no excess because reserves earned no interest. To make this more tenable, reserve requirements were calculated over a two-week maintenance period and banks could carry forward small excesses or deficiencies into the subsequent two-week period.
In the fall of 2008, the Fed needed to supply large amounts of liquidity to support the ailing economy and unfreeze gridlocked financial markets. These liquidity provisions blew up the Fed’s balance sheet and the amount of reserves in the financial system. Fortunately, because the legislation for the Troubled Asset Relief Program gave the Fed the immediate authority to pay interest on reserves, the Fed could maintain control of short-term interest rates even with a lot
of excess reserves and an enormous balance sheet.
After the crisis, many FOMC participants favoured going back to the old regime. After all, the crisis was over and the old regime had worked reasonably well for several decades.
The Fed has the ability during times of stress to add liquidity to financial system without needing to worry about how this might compromise its ability to achieve its interest rate objective. This is extremely important because ability of Fed to offer open-ended liquidity backstops can stop contagion from spreading and can help make financial crises less likely.
Regulatory changes made in response to financial crisis caused demand for reserves to be higher than anticipated and this caused some upward pressure on repo rates this fall. But this issue is easily remedied by adding more reserves to banking system. The Fed has been doing this by buying Treasury bills and by engaging in a large number of repo operations with the primary dealer community to supply liquidity and mitigate the upward pressure on repo rates.
The FOMC should create a standing repo facility that is open to a broad set of counterparties confined to Treasury and agency mortgage-backed securities collateral. Such a facility would effectively cap repo rates.
The Fed should exempt bank reserves from assets used to calculate a bank’s leverage ratio. The Fed, not banking industry, determines amount of reserves that banks must hold collectively. Thus, during next downturn, Fed could find itself in uncomfortable position of trying to stimulate economy by buying Treasuries and agency mortgage-backed securities but finding this stimulus offset because the addition of reserves has made the leverage ratio requirement more binding.
—Bloomberg

Bill Dudley is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs