Fed Can't Return to Old Money Market Ways Even If It Wants to

(Bloomberg) -- You can't go home again.

That's the message a high-ranking Federal Reserve official had for a chorus of critics of the central bank's $4.4 trillion balance sheet and its current monetary operating regime at a Hoover Institution conference last week.

Lorie Logan, a senior vice president at the New York Fed, said that she saw “virtually no chance of going back to the pre-crisis balance sheet size of $800 billion,'' no matter what framework the central bank adopts in the future to guide short-term interest rates.

Even if the Fed returns to using a so-called corridor system to that end, that framework is likely to look a lot different from what was in place before the financial breakdown of a decade ago, because of fundamental changes in the money market since then.

“A reinstated corridor system may be less familiar than some expect,'' Logan told the gathering in Palo Alto, California, on May 4. “Such a framework would involve uncertainties about reserve demand and greater variability in factors affecting reserve supply, and would likely require operations that are larger, more variable, or even very different from those used before the crisis.''

Under the old technique, the reserves that commercial banks held at the Fed were kept in scarce supply. The central bank sought to achieve its target for the federal funds rate -- the rate the banks charge each other for overnight loans -- by adjusting the supply of reserves through frequent, minor interventions in the money market.

Political Risk

Critics at the conference argued that the so-called floor system the central bank now uses requires a big balance sheet and a large Fed presence in the financial markets. That in turn leaves the central bank exposed politically, with the risk that lawmakers raid the proceeds from its bond holdings to finance their pet projects -- something that's happened already.

“The Fed should steer monetary policy clear of fiscal policy -- and the most effective way of doing so is to shrink its balance sheet,'' Mickey Levy, chief economist for the Americas and Asia at Berenberg Capital Markets LLC in New York, told the conference.

Under the current system, the Fed's main tool for controlling short-term rates is the interest it pays on the abundant reserves that commercial banks deposit with it. The rate paid to the banks effectively acts as a floor for other money market rates, including fed funds. The central bank reinforces that floor via a separate borrowing facility available to other financial institutions.

Logan said that growth in the central bank's liabilities means that it will end up having a balance sheet considerably larger than before, even under a corridor system. Currency in circulation, for instance, has more than doubled since the crisis to $1.6 trillion, and is projected to keep on growing in line with the economy.

Variable Demand

She also contended that running a corridor system would be a lot harder now than in the past, although it could be done. Rules and supervisory practices put in place after the financial crisis could lead to higher and more variable commercial bank demand for reserves at the Fed. The central bank's other liabilities, which include accounts held by the Treasury and other central banks, are also bigger and potentially more changeable than in the past.

The result, according to Logan: the Fed routinely might need to carry out overnight operations in the money market of about $25 billion to hit its interest rate target -- five times its average in the years before the crisis. Interventions might occasionally have to go as high as $100 billion.

In contrast, the floor system that the Fed now operates has worked well as the central bank has raised interest rates, she said.

Efficient and Effective

That echoes an assessment made by Federal Open Market Committee members in November 2016. At that time, they found the floor framework to be efficient and effective, according to the minutes of that gathering. Then Fed Governor -- and now Fed Chairman -- Jerome Powell subsequently said in July 2017 that he shared that view.

“It's hard to see the balance sheet getting below a range of $2.5 trillion to $3 trillion,” Powell told the Economic Club of New York back then.

Some officials, though, retain a fondness for the old system.

“While it may simply be a case of nostalgia on my part, I found our minimalist pre-crisis
operating framework to have a number of features that served us well,'' Kansas City Fed President Esther George said at the Palo Alto conference. Those attributes include a much reduced balance sheet and a smaller Fed footprint in the financial markets, she said.

In any event, a decision by the Fed on which system to use in the long run is probably a ways off. That's because the central bank is reducing its balance sheet so slowly that it'll take time before it reaches a low enough level to make returning to a corridor system feasible.

This issue “will not need to be decided for some time.,‘' Fed Vice Chairman for Supervision Randal Quarles told the conference.

--With assistance from Michael McKee

To contact the reporter on this story: Rich Miller in Washington at rmiller28@bloomberg.net.

To contact the editors responsible for this story: Brendan Murray at brmurray@bloomberg.net, Alister Bull, Ros Krasny

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