Part 2: Monetary Policy
Monetary Policy Report submitted to the Congress on July 13, 2018, pursuant to section 2B of the Federal Reserve Act
The Federal Open Market Committee continued to gradually increase the federal funds target range in the first half of the year...
Since December 2015, the Federal Open Market Committee (FOMC) has been gradually increasing its target range for the federal funds rate as the economy has continued to make progress toward the Committee's congressionally mandated objectives of maximum employment and price stability. In the first half of this year, the Committee continued this gradual process of scaling back monetary policy accommodation, increasing its target range for the federal funds rate 1/4 percentage point at its meetings in both March and June. With these increases, the federal funds rate is currently in the range of 1-3/4 to 2 percent (figure 44).14 The Committee's decisions reflected the continued strengthening of the labor market and the accumulating evidence that, after many years of running below the Committee's 2 percent longer-run objective, inflation had moved close to 2 percent.
...but monetary policy continues to support economic growth
Even after the gradual increases in the federal funds rate over the first half of the year, the Committee judges that the stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation. In particular, the federal funds rate remains somewhat below most FOMC participants' estimates of its longer-run value.
The Committee expects that a gradual approach to increasing the target range for the federal funds rate will be consistent with a sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee's symmetric 2 percent objective over the medium term. Consistent with this outlook, in the most recent Summary of Economic Projections (SEP), which was compiled at the time of the June FOMC meeting, the median of participants' assessments for the appropriate level of the target range for the federal funds rate at year-end rises gradually over the period from 2018 to 2020 and stands somewhat above the median projection for its longer-run level by the end of 2019 and through 2020.15
Future changes in the federal funds rate will depend on the economic outlook as informed by incoming data
The FOMC has continued to emphasize that, in determining the timing and size of future adjustments to the target range for the federal funds rate, it will assess realized and expected economic conditions relative to its maximum-employment objective and its symmetric 2 percent inflation objective. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.
In evaluating the stance of monetary policy, policymakers routinely consult prescriptions from a variety of policy rules, which can serve as useful benchmarks. However, the use and interpretation of such prescriptions require, among other considerations, careful judgments about the choice and measurement of the inputs to these rules such as estimates of the neutral interest rate, which are highly uncertain (see the box "Complexities of Monetary Policy Rules").
Complexities of Monetary Policy Rules
Monetary policy rules are mathematical formulas that relate a policy interest rate, such as the federal funds rate, to a small number of other economic variables--typically including the deviation of inflation from its target value along with an estimate of resource slack in the economy. Policy rules can provide helpful guidance for policymakers. Indeed, since 2004, prescriptions from policy rules have been included in written materials that are routinely sent to the Federal Open Market Committee (FOMC). However, interpretation of the prescriptions of policy rules requires careful judgment about the measurement of the inputs to the rules and the implications of the many considerations that the rules do not take into account.
Policy rules can incorporate key principles of good monetary policy.1 One key principle is that monetary policy should respond in a predictable way to changes in economic conditions. A second key principle is that monetary policy should be accommodative when inflation is below the desired level and employment is below its maximum sustainable level; conversely, monetary policy should be restrictive when the opposite holds. A third key principle is that, to stabilize inflation, the policy rate should be adjusted by more than one-for-one in response to persistent increases or decreases in inflation.
Economists have analyzed many monetary policy rules, including the well-known Taylor (1993) rule. Other rules include the "balanced approach" rule, the "adjusted Taylor (1993)" rule, the "price level" rule, and the "first difference" rule (figure A).2 These policy rules reflect the three key principles of good monetary policy noted earlier. Each rule takes into account estimates of how far the economy is from achieving the Federal Reserve's dual-mandate goals of maximum employment and price stability.
Four of the five rules include the difference between the rate of unemployment that is sustainable in the longer run and the current unemployment rate (the unemployment rate gap); the first-difference rule includes the change in the unemployment gap rather than its level.3 In addition, four of the five rules include the difference between recent inflation and the FOMC's longer-run objective (2 percent as measured by the annual change in the price index for personal consumption expenditures, or PCE), while the price-level rule includes the gap between the level of prices today and the level of prices that would be observed if inflation had been constant at 2 percent from a specified starting year (PLgapt).4 The price-level rule thereby takes account of the deviation of inflation from the long-run objective in earlier periods as well as the current period. Thus, if inflation had been running persistently above 2 percent, the price-level rule would prescribe a higher level for the federal funds rate than rules that use the current inflation gap. Likewise, if inflation had been running persistently below 2 percent, the price-level rule would prescribe setting the policy rate lower than rules that use the current inflation gap.
The adjusted Taylor (1993) rule recognizes that the federal funds rate cannot be reduced materially below zero, and that following the prescriptions of the standard Taylor (1993) rule after a recession during which interest rates have fallen to their lower bound may, for a time, not provide enough policy accommodation. To make up for the cumulative shortfall in accommodation (Zt), the adjusted rule prescribes only a gradual return of the policy rate to the (positive) levels prescribed by the standard Taylor (1993) rule after the economy begins to recover. The particular price-level rule specified in figure A also recognizes that the federal funds rate cannot be reduced materially below zero. If inflation runs below the 2 percent objective during periods when the rule prescribes setting the federal funds rate well below zero, the price-level rule will, over time, provide accommodation to make up for the past inflation shortfall.
The U.S. economy is complex, and the monetary policy rules shown in figure A do not capture many elements that are relevant to the conduct of monetary policy. Moreover, as shown in figure B, different monetary policy rules often offer quite different prescriptions for the federal funds rate.5 In practice, there is no unique criterion for favoring one rule over another. In recent years, almost all of the policy rules shown have called for rising values of the federal funds rate, but the pace of tightening that the rules prescribe has varied widely.
Uncertainty about the neutral interest rate in the longer run
The Taylor (1993), balanced-approach, adjusted Taylor (1993), and price-level rules provide prescriptions for the level of the federal funds rate; all require an estimate of the neutral real interest rate in the longer run (Rt LR)--that is, the level of the real federal funds rate that is expected to be consistent, in the longer run, with maximum employment and stable inflation.6 The neutral real interest rate in the longer run is determined by structural features of the economy and is not observable. In addition, its value may vary over time because of fluctuations in trend productivity growth, changing demographics, and other shifts in the structure of the economy. As a result, estimates of the neutral real interest rate in the longer run made today may differ substantially from estimates made later.
Academic studies have estimated the longer-run value of the neutral real interest rate using statistical techniques to capture the variations among inflation, interest rates, real gross domestic product, unemployment, and other data series. The range of estimates is wide but suggests that the neutral real rate has declined since the turn of the century (figure C).7 There is substantial statistical uncertainty surrounding each estimate of the longer-run value of the neutral real rate, as evidenced by the width of the 95 percent uncertainty bands for the estimated values in the first quarter of 2018 (figure D).
D. Point estimates and uncertainty bands for neutral real rate in the longer run as of 2018:Q1
|Study||Point estimate||95 percent uncertainty band|
|Del Negro and others (2017)||1.3||(.7, 2.1)|
|Holston and others (2017)||0.6||(-2.5, 3.7)|
|Johannsen and Mertens (2016)||0.7||(-1.3, 2.5)|
|Kiley (2015)||0.4||(-.6, 1.6)|
|Laubach and Williams (2015)||0.1||(-5.4, 5.6)|
|Lewis and Vazquez-Grande (2017)||1.8||(.5, 3.1)|
|Lubik and Matthes (2015)||1||(-2.3, 4.5)|
Source: Federal Reserve Board staff calculations, along with references listed in box note 7.
The longer-run normal level of the federal funds rate under appropriate monetary policy--equal to the sum of the neutral real interest rate in the longer run and the FOMC's 2 percent inflation objective--is one benchmark for evaluating the current stance of monetary policy. Uncertainty about the longer-run value of the neutral real interest rate leads to uncertainty about how far the current federal funds rate is from its longer-run normal level. For the Taylor (1993), balanced-approach, adjusted Taylor (1993), and price-level rules, different estimates of the neutral real interest rate in the longer run translate one-for-one to differences in the prescribed setting of the federal funds rate. As a result, the substantial statistical uncertainty accompanying estimates of the neutral rate in the longer run implies substantial uncertainty surrounding the prescriptions of each policy rule. Following the prescriptions of a policy rule with an incorrect value of the neutral rate could lead to poor economic outcomes.
If the longer-run value of the neutral real interest rate is currently at the low end of the range of estimates, then monetary policy is more likely to be constrained by the lower bound on nominal interest rates in the future. Historically, the FOMC has cut the federal funds rate by 5 percentage points, on average, during downturns in the economy. Cutting the federal funds rate by this much in response to a future economic downturn may not be feasible if the neutral federal funds rate is as low as most of the estimates suggest. As a result, it may not be feasible to provide the levels of accommodation prescribed by many policy rules, potentially leading to elevated unemployment and inflation averaging below the Committee's 2 percent objective.8 Rules that try to offset the cumulative shortfall of accommodation posed by the lower bound on nominal interest rates, such as the adjusted Taylor (1993) rule, or make up the cumulative shortfall in the level of prices, such as the price-level rule, are intended to mitigate the effects of the lower bound on the economy by providing more accommodation than prescribed by rules that do not have these makeup features.9
In the years following the financial crisis, with the federal funds rate close to zero, the FOMC recognized that it would have limited scope to respond to an unexpected weakening in the economy by lowering short-term interest rates. This risk has, in recent years, provided a sound rationale for following a more gradual path of rate increases than that prescribed by some policy rules. In these circumstances, increasing the policy rate quickly in order to have room to cut rates during an economic downturn could be counterproductive because it might make a downturn more likely to happen.
1. For discussion regarding principles for the conduct of monetary policy and monetary policy rules, see Board of Governors of the Federal Reserve System (2018), "Monetary Policy Principles and Practice," Board of Governors, https://www.federalreserve.gov/monetarypolicy/monetary-policy-principles-and-practice.htm. Return to text
2. The Taylor (1993) rule was suggested in John B. Taylor (1993), "Discretion versus Policy Rules in Practice," Carnegie-Rochester Conference Series on Public Policy, vol. 39 (December), pp. 195-214. The balanced-approach rule was analyzed in John B. Taylor (1999), "A Historical Analysis of Monetary Policy Rules," in John B. Taylor, ed., Monetary Policy Rules (Chicago: University of Chicago Press), pp. 319-41. The adjusted Taylor (1993) rule was studied in David Reifschneider and John C. Williams (2000), "Three Lessons for Monetary Policy in a Low-Inflation Era," Journal of Money, Credit and Banking, vol. 32 (November), pp. 936-66. A price-level rule was discussed in Robert E. Hall (1984), "Monetary Strategy with an Elastic Price Standard," in Price Stability and Public Policy, proceedings of a symposium sponsored by the Federal Reserve Bank of Kansas City, held in Jackson Hole, Wyo., August 2-3 (Kansas City: Federal Reserve Bank of Kansas City), pp. 137-59, https://www.kansascityfed.org/publicat/sympos/1984/s84.pdf. Finally, the first-difference rule was introduced by Athanasios Orphanides (2003), "Historical Monetary Policy Analysis and the Taylor Rule," Journal of Monetary Economics, vol. 50 (July), pp. 983-1022. A comprehensive review of policy rules is in John B. Taylor and John C. Williams (2011), "Simple and Robust Rules for Monetary Policy," in Benjamin M. Friedman and Michael Woodford, eds., Handbook of Monetary Economics, vol.3B (Amsterdam: North-Holland), pp. 829-59. The same volume of the Handbook of Monetary Economics also discusses approaches other than policy rules for deriving policy rate prescriptions. Return to text
3. The Taylor (1993) rule represented slack in resource utilization using an output gap (the difference between the current level of real gross domestic product (GDP) and what GDP would be if the economy was operating at maximum employment). The rules in figure A represent slack in resource utilization using the unemployment gap instead, because that gap better captures the FOMC's statutory goal to promote maximum employment. Movements in these alternative measures of resource utilization are highly correlated. For more information, see the note below figure A. Return to text
4. Calculating the prescriptions of the price-level rule requires selecting a starting year for the price level from which to cumulate the 2percent annual inflation. Figure B uses 1998 as the starting year. Around that time, the underlying trend of inflation and longer-term inflation expectations stabilized at a level consistent with PCE price inflation being close to 2 percent. Return to text
5. These prescriptions are calculated using (1) published data for inflation and the unemployment rate and (2) survey-based estimates of the longer-run value of the neutral real interest rate and the longer-run value of the unemployment rate. Return to text
6. The first-difference rule shown in figure A does not require an estimate of the neutral real interest rate in the longer run. However, this rule has its own shortcomings. For example, research suggests that this sort of rule will result in greater volatility in employment and inflation relative to what would be obtained under the Taylor (1993) and balanced-approach rules unless the estimates of the neutral real federal funds rate in the longer run and the rate of unemployment in the longer run that are included in those rules are sufficiently far from their true values. Return to text
7. The range of estimates is computed using published values or values computed using the methodology from the following studies: Marco Del Negro, Domenico Giannone, Marc P. Giannoni, and Andrea Tambalotti (2017), "Safety, Liquidity, and the Natural Rate of Interest," Brookings Papers on Economic Activity,Spring, pp. 235-94, https://www.brookings.edu/wp-content/uploads/2017/08/delnegrotextsp17bpea.pdf; Kathryn Holston, Thomas Laubach, and John C. Williams (2017), "Measuring the Natural Rate of Interest: International Trends and Determinants," Journal of International Economics, supp. 1, vol. 108 (May), pp. S59-75; Benjamin K. Johannsen and Elmar Mertens (2016), "The Expected Real Interest Rate in the Long Run: Time Series Evidence with the Effective Lower Bound," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, February 9), https://www.federalreserve.gov/econresdata/notes/feds-notes/2016/the-expected-real-interest-rate-in-the-long-run-time-series-evidence-with-the-effective-lower-bound-20160209.html; Michael T. Kiley (2015), "What Can the Data Tell Us about the Equilibrium Real Interest Rate?" Finance and Economics Discussion Series 2015-77 (Washington: Board of Governors of the Federal Reserve System, September), http://dx.doi.org/10.17016/FEDS.2015.077; Thomas Laubach and John C. Williams (2015), "Measuring the Natural Rate of Interest Redux," Hutchins Center Working Paper 15 (Washington: Brookings Institution, November), https://www.brookings.edu/wp-content/uploads/2016/07/WP15-Laubach-Williams-natural-interest-rate-redux.pdf; Kurt F. Lewis and Francisco Vazquez-Grande (2017), "Measuring the Natural Rate of Interest: Alternative Specifications," Finance and Economics Discussion Series 2017-059 (Washington: Board of Governors of the Federal Reserve System, June), https://dx.doi.org/10.17016/FEDS.2017.059; Thomas A. Lubik and Christian Matthes (2015), "Calculating the Natural Rate of Interest: A Comparison of Two Alternative Approaches," Economic Brief 15-10 (Richmond, Va.: Federal Reserve Bank of Richmond, October), https://www.richmondfed.org/-/media/richmondfedorg/publications/research/economic_brief/2015/pdf/eb_15-10.pdf. Return to text
8. For further discussion of these issues, see Michael T. Kiley and John M. Roberts (2017), "Monetary Policy in a Low Interest Rate World," Brookings Papers on Economic Activity, Spring, pp. 317-72, https://www.brookings.edu/wp-content/uploads/2017/08/kileytextsp17bpea.pdf. Return to text
9. Economists have found that a "makeup" policy can be the best response in theory when the policy interest rate is constrained at zero. See Ben S. Bernanke (2017), "Monetary Policy in a New Era," paper presented at "Rethinking Macroeconomic Policy," a conference held at the Peterson Institute for International Economics, Washington, October 12-13, https://piie.com/system/files/documents/bernanke20171012paper.pdf; and Michael Woodford (1999), "Commentary: How Should Monetary Policy Be Conducted in an Era of Price Stability?" in New Challenges for Monetary Policy, proceedings of a symposium sponsored by the Federal Reserve Bank of Kansas City (Kansas City, Mo.: Federal Reserve Bank of Kansas City) pp. 277-316, https://www.kansascityfed.org/publications/research/escp/symposiums/escp-1999. Return to textReturn to text
The FOMC has continued to implement its program to gradually reduce the Federal Reserve's balance sheet
The Committee has continued to implement the balance sheet normalization program described in the June 2017 Addendum to the Policy Normalization Principles and Plans.16 This program is gradually and predictably reducing the Federal Reserve's securities holdings by decreasing the reinvestment of the principal payments it receives from securities held in the System Open Market Account. Since the initiation of the balance sheet normalization program in October of last year, such payments have been reinvested to the extent that they exceeded gradually rising caps (figure 45).
In the first quarter, the Open Market Desk at the Federal Reserve Bank of New York, as directed by the Committee, reinvested principal payments from the Federal Reserve's holdings of Treasury securities maturing during each calendar month in excess of $12 billion. The Desk also reinvested in agency mortgage-backed securities (MBS) the amount of principal payments from the Federal Reserve's holdings of agency debt and agency MBS received during each calendar month in excess of $8 billion. Over the second quarter, payments of principal from maturing Treasury securities and from the Federal Reserve's holdings of agency debt and agency MBS were reinvested to the extent that they exceeded $18 billion and $12 billion, respectively. At its meeting in June, the FOMC increased the cap for Treasury securities to $24 billion and the cap for agency debt and agency MBS to $16 billion, both effective in July. The Committee has indicated that the caps for Treasury securities and for agency securities will increase to $30 billion and $20 billion per month, respectively, in October. These terminal caps will remain in place until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.
The implementation of the program has proceeded smoothly without causing disruptive price movements in Treasury and MBS markets. As the caps have increased gradually and predictably, the Federal Reserve's total assets have started to decrease, from about $4.4 trillion last October to about $4.3 trillion at present, with holdings of Treasury securities at approximately $2.4 trillion and holdings of agency and agency MBS at approximately $1.7 trillion (figure 46).
The Federal Reserve's implementation of monetary policy has continued smoothly
To implement the FOMC's decisions to raise the target range for the federal funds rate in March and June of 2018, the Federal Reserve increased the rate of interest on excess reserves (IOER) along with the interest rate offered on overnight reverse repurchase agreements (ON RRPs). Specifically, the Federal Reserve increased the IOER rate to 1-3/4 percent and the ON RRP offering rate to 1-1/2 percent in March. In June, the Federal Reserve increased the IOER rate to 1.95 percent--5 basis points below the top of the target range--and the ON RRP offering rate to 1-3/4 percent. In addition, the Board of Governors approved a 1/4 percentage point increase in the discount rate (the primary credit rate) in both March and June. Yields on a broad set of money market instruments moved higher, roughly in line with the federal funds rate, in response to the FOMC's policy decisions in March and June. Usage of the ON RRP facility has declined, on net, since the turn of the year, reflecting relatively attractive yields on alternative investments.
The effective federal funds rate moved up toward the IOER rate in the months before the June FOMC meeting and, therefore, was trading near the top of the target range. At its June meeting, the Committee made a small technical adjustment in its approach to implementing monetary policy by setting the IOER rate modestly below the top of the target range for the federal funds rate. This adjustment resulted in the effective federal funds rate running closer to the middle of the target range since mid-June. In an environment of large reserve balances, the IOER rate has been an essential policy tool for keeping the federal funds rate within the target range set by the FOMC (see the box "Interest on Reserves and Its Importance for Monetary Policy").
Interest on Reserves and Its Importance for Monetary Policy
The financial crisis that began in 2007 triggered the deepest recession in the United States since the Great Depression. In response, the Federal Open Market Committee (FOMC) cut its target for the federal funds rate to nearly zero by late 2008. Other short-term interest rates declined roughly in line with the federal funds rate. Additional monetary stimulus was necessary to address the significant economic downturn and the associated downward pressure on inflation. The FOMC undertook other monetary policy actions to put downward pressure on longer-term interest rates, including large-scale purchases of longer-term Treasury securities and agency-guaranteed mortgage-backed securities.
These policy actions made financial conditions more accommodative and helped spur an economic recovery that has become a long-lasting economic expansion. The unemployment rate has declined from 10 percent to less than 4 percent over the course of the recovery and expansion, and inflation has been low and fairly stable. The FOMC's actions were critical to fostering progress toward maximum employment and stable prices--the statutory goals for the conduct of monetary policy established by the Congress.
The Federal Reserve's large-scale asset purchases had the side effect of generating a sizable increase in the supply of reserve balances, which are the balances that banks maintain in their accounts at the Federal Reserve.1 From the onset of the financial crisis in August 2007 until October 2014, when the FOMC ended the last of its asset purchase programs, the supply of reserve balances rose from about $15 billion to about $2-1/2 trillion.2 Reserve balances rose well above the level necessary to meet reserve requirements, thus swelling the quantity of excess reserves held by the banking system.
As the economic expansion continued and unemployment declined--and with labor market conditions projected to continue improving--the FOMC decided that it would scale back policy support by increasing the level of short-term interest rates and by reducing the Federal Reserve's securities holdings. To that end, the Committee began gradually raising its target range for the federal funds rate in December 2015. Later, in October 2017, it began gradually reducing holdings of Treasury and agency securities; this gradual reduction results in a decline in the supply of reserve balances. The FOMC judged that removing monetary policy stimulus through this mix of first raising the federal funds rate and then beginning to shrink the balance sheet would best contribute to achieving and maintaining maximum employment and price stability without causing dislocations in financial markets or institutions that could put the economic expansion at risk.
Interest on reserves--the payment of interest on balances held by banks in their accounts at the Federal Reserve--has been an essential policy tool that has permitted the FOMC to achieve a gradual increase in the federal funds rate in combination with a gradual reduction in the Fed's securities holdings and in the supply of reserve balances.3 Interest on reserves is a monetary policy tool used by all of the world's major central banks.
Interest on reserves is the principal tool the FOMC uses to anchor the federal funds rate in the target range. The federal funds rate, in turn, establishes an important benchmark for the borrowing and lending decisions in the banking sector (figure A). When the Federal Reserve increases the target range for the federal funds rate and the interest rate it pays on reserve balances, banks bid up the rates in short-term funding markets to levels consistent with those increases; rates in other short-term funding markets--such as commercial paper rates, Treasury bill rates, and rates on repurchase agreements--all tend to move higher as well (figure B). This increase in the general level of short-term rates, together with the expected future path of short-term rates, then influences the level of other financial asset prices and overall financial conditions in the economy. Thus, changing the interest rate on reserves has proven to be an effective tool for transmitting changes in the FOMC's target range for the federal funds rate to other interest rates in the economy.
The rate of interest the Federal Reserve pays on banks' reserve balances is far lower than the rate that banks can earn on alternative safe assets, including most U.S. government or agency securities, municipal securities, and loans to businesses and consumers.4 Indeed, the bank prime rate--the base rate that banks use for loans to many of their customers--is currently around 300 basis points above the level of interest on reserves. Banks continue to find lending attractive, and bank lending has been expanding at a solid pace since 2012. Households have begun to see interest rates on retail deposits rising as well. Moreover, the configuration of interest rates implies that the return the Federal Reserve earns on its holdings of securities is higher than the interest it pays on reserve balances. Each year, the Federal Reserve remits its earnings--that is, its income net of expenses--to the Treasury Department; in 2017, remittances totaled more than $80 billion.
Had the Federal Reserve not been able to pay interest on reserve balances at the same time that excess reserves in the banking system were large, it would not have been able to gradually raise the federal funds rate and other short-term interest rates while reserve balances were abundant; the FOMC would have had to take a different approach to scaling back monetary policy accommodation. This approach likely would have involved a rapid and sizable reduction in the Federal Reserve's securities holdings in order to put sufficient upward pressure on interest rates. Getting the pace of asset sales just right for achieving the Federal Reserve's objectives would have been extremely challenging. Such an approach to removing accommodation would have run the risk of disrupting financial markets, with adverse effects on the economy.
Indeed, as observed during the early summer of 2013, market reactions to changes in the outlook for the Federal Reserve's holdings of long-term securities can have outsized effects in bond markets. At that time, FOMC communications that pointed to the eventual cessation of asset purchases seemed to alarm investors and reportedly contributed to a rise in longer-term rates of 150 basis points over just a few months. That rise in rates quickly pushed up the cost of mortgage credit and rates on other forms of borrowing for households and businesses.
Thus, Federal Reserve policymakers judged that the best strategy for adjusting the stance of monetary policy would be gradual increases in the target range for the federal funds rate, supplemented later on by gradual reductions in the Federal Reserve's securities holdings. The ongoing, gradual reduction in the Federal Reserve's securities holdings that the FOMC set in motion in 2017 will bring the level of reserve balances down substantially over the next few years. The size of reserves that banks eventually want to hold will reflect balances held to meet reserve requirements and payments needs as well as balances held to address regulatory and structural changes in the banking system since the financial crisis.5 Although the level of reserve balances that banks will eventually want to hold is not yet known, that level is likely to be much lower than it is today, though appreciably higher than it was before the crisis.6 In addition, the amount of U.S. currency--Federal Reserve notes--that people in the United States and elsewhere want to hold has increased substantially since the crisis. If banks want to hold more reserve balances and the public wants to hold more U.S. currency than before the crisis, the Federal Reserve will need to supply the reserves and currency, so the Federal Reserve's securities holdings also will have to be larger than before the financial crisis.7
Interest on reserves will remain an important policy tool for keeping the federal funds rate within the target range set by the FOMC and thus managing the level of short-term interest rates, even as the ongoing reduction in the Federal Reserve's securities holdings generates a gradual decline in the amount of reserve balances on which the Federal Reserve pays interest. In June 2018, the Federal Reserve made a small technical adjustment to de-link the rate of interest on reserves from the top of the Committee's target range for the federal funds rate. At the June 2018 FOMC meeting, the Committee increased the federal funds target range by 25 basis points, while the rate of interest on reserve balances was increased by 20 basis points. This change is intended to ensure that the federal funds rate continues to trade well within the Committee's target range. The spread between the effective federal funds rate and the rate of interest on reserves could continue to narrow over time as the Federal Reserve's securities holdings and the supply of reserve balances gradually decline.
1. All depository institutions (commercial banks, savings banks, thrift institutions, credit unions, and most U.S. branches and agencies of foreign banks) that maintain reserve balances are eligible to earn interest on those balances. We refer to these institutions as "banks." Return to text
2. For a detailed discussion of how the changes in Federal Reserve securities holdings affect the Federal Reserve's balance sheet and sectors of the U.S. economy, see Jane Ihrig, Lawrence Mize, and Gretchen C. Weinbach (2017), "How Does the Fed Adjust Its Securities Holdings and Who Is Affected?" Finance and Economics Discussion Series 2017-099 (Washington: Board of Governors of the Federal Reserve System, September), https://www.federalreserve.gov/econres/feds/files/2017099pap.pdf. Return to text
3. The Financial Services Regulatory Relief Act of 2006 authorized the Federal Reserve Banks to pay interest on balances held by or on behalf of depository institutions at Federal Reserve Banks, subject to regulations of the Board of Governors, effective October 1, 2011. The effective date of this authority was changed to October 1, 2008, by the Emergency Economic Stabilization Act of 2008. The Congress authorized the payment of interest on reserves to help minimize the incentives for costly reserve avoidance schemes and to provide the Federal Reserve with a policy tool that could be useful for monetary policy implementation more broadly. Return to text
4. The Congress's authorization allows the Federal Reserve to pay interest on deposits maintained by depository institutions at a rate not to exceed the "general level of short-term interest rates." The Federal Reserve Board's Regulation D defines short-term interest rates for the purposes of this authority as "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." The rate of interest on reserves has been well within a range of short-term interest rates as defined in Board regulations. For current rates on a number of short-term money market instruments, see Board of Governors of the Federal Reserve System, Statistical Release H.15, "Selected Interest Rates," www.federalreserve.gov/releases/h15/current. Return to text
5. For a discussion of the changes in the banking system since the financial crisis and their potential effects on the demand for reserve balances, see Randal K. Quarles (2018), "Liquidity Regulation and the Size of the Fed's Balance Sheet," speech delivered at "Currencies, Capital, and Central Bank Balances: A Policy Conference," Hoover Institution, Stanford University, Stanford, Calif., May 4, https://www.federalreserve.gov/newsevents/speech/quarles20180504a.htm. Return to text
6. Uncertainty about the eventual level of reserve balances is another reason that the FOMC has been reducing the Federal Reserve's holdings of securities, and the supply of reserve balances, gradually. Return to text
7. Currency grows roughly in line with nominal gross domestic product. In December 2008, currency in circulation was around $850 billion, compared with $1.6 trillion at the end of June 2018. Return to textReturn to text
14. See Board of Governors of the Federal Reserve System (2018), "Federal Reserve Issues FOMC Statement," press release, March 21, https://www.federalreserve.gov/newsevents/pressreleases/monetary20180321a.htm; and Board of Governors of the Federal Reserve System (2018), "Federal Reserve Issues FOMC Statement," press release, June 13, https://www.federalreserve.gov/newsevents/pressreleases/monetary20180613a.htm. Return to text
15. See the June SEP, which appeared as an addendum to the minutes of the June 12-13, 2018, meeting of the FOMC and is presented in Part 3 of this report. Return to text
16. The addendum, adopted on June 13, 2017, is available at https://www.federalreserve.gov/monetarypolicy/files/FOMC_PolicyNormalization.20170613.pdf. Return to text