“What few will appreciate, however, is that only five of the 17 dots really matter.”, Benn Steil, The Wall Street Journal
“Who cares whether its five or 17 dots!!! This small group of economic and monetary experts don’t know what the uncertain future holds. They can’t even forecast a year out, with any accuracy. Let free and fair markets set interest rates!!! Why, especially in America, the Land of the Free and Home of the Brave, do we allow our money and rates (half of every transaction for goods and services) to be centrally planned???”, Mike Perry, former Chairman and CEO, IndyMac Bank
Misreading the Fed on a Rate Increase
Ignore the Federal Open Market Committee. The smaller, more dovish Board of Governors will decide.
Photo: Getty Images
By Benn Steil
On June 17 the Federal Reserve will release its new “Dot Plot,” which will show, anonymously, what each Federal Reserve Bank president and member of the Board of Governors thinks short-term interest rates should be in coming years. Fed watchers will be studying the chart for signs that policy makers are lowering their expectations for rate increases based on recent economic weakness. What few will appreciate, however, is that only five of the 17 dots really matter.
The reason involves a change in how the Fed conducts monetary policy that effectively shifts control over rate increases from the voting members of the Federal Open Market Committee (currently 10) to the much smaller Board of Governors (currently five).
Before the financial crisis, the FOMC set a target for the federal-funds rate, the interest rate at which depository institutions lend balances to one another overnight. The New York Fed would then conduct open-market operations—buying and selling securities—to nudge that rate toward the target. It did this by affecting the supply of banks’ reserve balances at the Fed, which go up when banks sell securities to the Fed and down when they buy them.
The Fed kept the level of reserves in the system low enough that some banks needed to borrow from others to meet their reserve requirements. This ensured that the federal-funds rate was important. The cost of borrowing through other means tended to move up and down with the federal-funds rate, thus giving the Fed power over the cost of short-term credit in the economy broadly.
During the crisis, the Fed’s quantitative-easing programs—large-scale purchases of assets from the banks—drove up the volume of excess reserves to unprecedented levels, and so now many institutions can fulfill their reserve requirements without borrowing. Competition for reserves is low, and small changes in supply no longer induce the same changes in the cost of borrowing.
Open-market operations, in short, are no longer sufficient to drive the cost of borrowing in the federal-funds market to the FOMC’s target. In 2008, as the size of the Fed’s balance sheet rose, the federal-funds rate became volatile and started to deviate markedly from the FOMC’s target.
This is where recent legislation has become important in changing the way monetary policy is conducted. The Financial Services Regulatory Relief Act of 2006 amended the 1913 Federal Reserve Act to give the Fed the authority to pay interest on reserves beginning Oct. 1, 2011. The 2008 Economic Stabilization Act brought this forward to Oct. 1, 2008. Paying interest on reserves helps set a floor under short-term rates because banks that can earn interest at the Fed won’t lend to others below the rate the Fed is paying. This allows the Fed to achieve its target for the federal-funds rate even with high levels of excess reserves.
The FOMC has said that the Fed intends to rely on adjustments in the rate of interest on excess reserves to achieve its federal-funds target rate as it begins to tighten monetary policy. The market anticipates this will come later in the year. However, authority for setting the rate of interest on excess reserves, according to the 2006 act, belongs to the board— Janet Yellen, Stanley Fischer, Daniel Tarullo, Jerome Powell and Lael Brainard—and not to the FOMC. This could be consequential going forward.
The Federal Reserve Act stipulates that the interest rate on reserves should not “exceed the general level of short-term interest rates,” but it does not prevent the board from setting it well below the general level of short-term interest rates. This means that the FOMC could decide that short-term rates should rise to, say, 4%, while the board, thinking this excessive, could decide only to raise the rate on reserves to 3%.
Because the quantity of excess reserves is so enormous, it would be virtually impossible for the trading desk at the New York Fed to conduct open market operations sufficient to achieve the 4% target set by the FOMC. Overnight rates would therefore trade closer to the board-determined 3% rate on reserves.
Sen. Richard Shelby (R., Ala.) has released a draft Financial Regulatory Improvement Act that would transfer the authority to set the interest rate on bank reserves to the FOMC. This would restore the committee’s ability to control short-term rates. But unless such legislation is passed, or the volume of excess reserves declines significantly, the Board of Governors, not the FOMC, will control how quickly rates rise.
This is important because the average board member is considerably more dovish than the average non-board FOMC member. Using Reuters’s 1-5 dove-hawk scale for Fed policy makers, the average board member is a 2.2, considerably lower than the 2.8 average for non-board FOMC members.
Fed watchers may be overestimating the pace of rate increases because they’re focusing on the views of the wrong committee. For now, at least, it is the more dovish board, and not the FOMC, that wields the real power over rate increases.
Mr. Steil is director of international economics at the Council on Foreign Relations and author of “The Battle of Bretton Woods” (Princeton University, 2013).