October 30, 2018 Reading Time: 2 minutes

Monetary policy has changed significantly in the last decade. Traditionally, the Federal Reserve conducted open market operations to hit its federal funds rate target. Today, it maintains a bloated balance sheet and pays interest on reserves (IOR). How should the Fed move forward?

There are essentially three paths the Fed might take:

  1. Remain in a floor system, where the supply of reserves and federal funds rate can be adjusted independently.
  2. Bypass the primary-dealers market (and, hence, the IOR wall) by injecting new money directly into the market.
  3. Reduce the size of the balance sheet until the traditional corridor system is restored.

Let’s start with option 1. Fed economists have listed several benefits of paying banks interest on required and excess reserves. However, realizing those benefits, to the extent that they exceed the corresponding costs, would not require paying an above-market rate. (The Fed is legally prevented from paying interest in excess of “the general level of short-term interest rates.” But it has chosen rates of greater risk and duration — specifically, “rates on obligations with maturities of no more than one year, such as the primary credit rate and rates on term federal funds, term repurchase agreements, commercial paper, term Eurodollar deposits, and other similar instruments” — to serve as a benchmark.) And it is an above-market rate that permits such a large balance sheet.

Although being able to adjust the supply of reserves and federal funds rate independently is often cited as a benefit, it really isn’t. As George Selgin notes, it is akin to putting a car in neutral. You can step on the gas and turn the steering wheel as you please without careening off a cliff. But you don’t go anywhere. Likewise, you can adjust the supply of reserves and the federal funds rate independently so long as you are paying an above-market rate on reserves. But there is no effect on nominal spending.

There is at least one good reason for Fed officials to maintain a large balance sheet (a good reason for Fed officials, that is). It results in larger revenues. Larger revenues enable Fed officials to pad their budgets without reducing (and, indeed, even increasing) remittances to the Treasury.  

How about option 2? One way to bypass the financial sector and inject money directly into the market would be to channel the new money through a Treasury spending program. However, such a spending program would risk politicization, as the new money might be directed at specific projects rather than spread evenly throughout the whole economy. Alternatively, the Fed could deposit new money into consumer bank accounts. Such an approach would resemble Milton Friedman’s theoretical helicopter drop. But, contrary to received wisdom, helicopter drops “are likely to be significantly more distortive than open market operations.”

That leaves us with option 3: return to normalcy. Conventional monetary policy has its problems, to be sure. But they are familiar problems. Returning to a corridor system means Fed officials can draw on past experiences. And, if we are lucky, those experiences will enable them to do a better job in the future.

William J. Luther

William J. Luther

William J. Luther is the Director of AIER’s Sound Money Project and an Associate Professor of Economics at Florida Atlantic University. His research focuses primarily on questions of currency acceptance. He has published articles in leading scholarly journals, including Journal of Economic Behavior & Organization, Economic Inquiry, Journal of Institutional Economics, Public Choice, and Quarterly Review of Economics and Finance. His popular writings have appeared in The Economist, Forbes, and U.S. News & World Report. His work has been featured by major media outlets, including NPR, Wall Street Journal, The Guardian, TIME Magazine, National Review, Fox Nation, and VICE News. Luther earned his M.A. and Ph.D. in Economics at George Mason University and his B.A. in Economics at Capital University. He was an AIER Summer Fellowship Program participant in 2010 and 2011.

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Nicolás Cachanosky

Dr. Cachanosky is Associate Professor of Economics and Director of the Center for Free Enterprise at The University of Texas at El Paso Woody L. Hunt College of Business. He is also Fellow of the UCEMA Friedman-Hayek Center for the Study of a Free Society. He served as President of the Association of Private Enterprise Education (APEE, 2021-2022) and in the Board of Directors at the Mont Pelerin Society (MPS, 2018-2022).

He earned a Licentiate in Economics from the Pontificia Universidad Católica Argentina, a M.A. in Economics and Political Sciences from the Escuela Superior de Economía y Administración de Empresas (ESEADE), and his Ph.D. in Economics from Suffolk University, Boston, MA.

Dr. Cachanosky is author of Reflexiones Sobre la Economía Argentina (Instituto Acton Argentina, 2017), Monetary Equilibrium and Nominal Income Targeting (Routledge, 2019), and co-author of Austrian Capital Theory: A Modern Survey of the Essentials (Cambridge University Press, 2019), Capital and Finance: Theory and History (Routledge, 2020), and Dolarización: Una Solución para la Argentina (Editorial Claridad, 2022).

Dr. Cachanosky’s research has been published in outlets such as Journal of Economic Behavior & Organization, Public Choice, Journal of Institutional Economics, Quarterly Review of Economics and Finance, and Journal of the History of Economic Thought among other outlets.

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