As Scott Burns has recently argued, the Federal Reserve is incapable of fighting the next recession through traditional means. So long as the floor system is in operation, the effect of expanding the monetary base through open market operations will be muted. Instead of lending new money, banks have an incentive to deposit money at the Federal Reserve to collect interest risk-free.
But in the face of a recession, the Federal Reserve does have options available. Jerome Powell, the current chairman of the Federal Reserve, could disassemble the system of paying interest on excess reserves. The Federal Reserve could allow money collecting interest as excess reserves to circulate in the market. It would only need to pay a rate on excess reserves less than would be earned in the market, thus increasing the relative return to private investment.
Influencing the Growth of the Monetary Base
Now that the primary tool for Federal Reserve policy is the rate of interest paid on excess reserves, changes in the quantity of money must be mediated through the interest rate via the adjustment of the rate paid on excess reserves. All else equal, the quantity of base money used in transactions — the effective base — will increase as the rate of economic growth increases relative to the rate paid on excess reserves. This should accompany a relative increase of the risk-free rate of return. Thus, excess reserves will enter circulation if (1) the risk-free rate of return increases, or (2) the rate of interest paid on excess reserves falls. Likewise, excess reserves will be removed from circulation if (1) the risk-free rate of return decreases, or (2) the rate of interest paid on excess reserves rises.
We will use these facts to interpret monetary policy since the interest rate began to rise in early 2016.
Jerome Powell has continued the trend of increasing the federal funds rate target. A few things stand out. Even as interest rates have risen to 2.5 percent, a rise of 100 basis points since the start of Powell’s tenure in February 2018, the rate of growth of the effective monetary base has remained steady. All else equal, we would expect that an increase in the rate paid on excess reserves would remove money from circulation; however, the most recent measure of real GDP growth indicated an annualized rate of growth of just over 3 percent. Annualized real GDP growth a year earlier was 2.34 percent. In fact, the rate of growth of real GDP has increased every quarter since the second quarter of 2016, which was around the time that the Federal Reserve began raising the target federal funds rate. Had the target rate not increased, we would expect that growth of the effective base would have been greater.
Powell has not only continued increasing the rate of interest. He has allowed the total quantity of base money to decrease, not offsetting the fall in the size of the Federal Reserve’s balance sheet. As securities held by the Federal Reserve mature, money flows from borrowers to the Federal Reserve in the form of repayment, shrinking the total quantity of base money. Under Powell, this has had the effect of continually increasing the proportion of the monetary base that is actually circulating. The stability of the growth rate in the effective base implies that banks are withdrawing excess reserves to compensate for base money removed from circulation.
So long as the real rate of economic growth continues to increase, Powell can safely continue to increase the rate of interest paid on excess reserves. Stability in the growth rate of the stock of effective base money suggests that increases in the rate of interest have so far been justified as they have not led to an increase in the quantity of base money collecting interest as excess reserves. Both the proportion of the base and the actual quantity of base money collecting interest as excess reserves have fallen as interest rates have increased under the leadership of Powell.
Withstanding Political Pressure
Many are worried that Powell may be steering the U.S. economy toward recession. In light of recent rate hikes, a concerned President Trump reportedly met to discuss firing Powell. He has since realized that it is not feasible, if even possible, to do so. Given Powell’s unwinding of the Federal Reserve’s balance sheet, it is unlikely that he would respond to an economic downturn by purchasing more securities. If he seeks to maintain a stable rate of growth of the effective monetary base, he would need to lower the federal funds rate target with the onset of a crisis. Otherwise, the interest on excess reserves offered by the Federal Reserve would draw funds out of financial markets, worsening the crisis. Given that about 47 percent of the monetary base is not circulating, marginal downward adjustments of the target rate would be sufficient to mitigate a crisis. Though there is nothing stopping Powell from reviving the Greenspan put, providing temporary liquidity to the market without permanently bloating the Federal Reserve’s balance sheet.
Everyone should calm down about Chairman Powell. His track record so far suggests that he has a grasp on fundamentals and that he is dedicated to reversing a decade of monetary imbalance. The rise in rates appears to be a consequence of, not a hurdle to, economic growth. He refuses to let speculators feast and has not given in to political pressure, even if that means a fall in stock market indices that were likely inflated from a period of low interest rates. Consider that at its recent highs, the S&P had increased by more than a multiple of four since its low in 2009. Powell’s recalibration of monetary policy and, consequently, financial markets may bring temporary pain. But so long as he follows through, it will restore sanity to financial markets in the long run.