The Hitchhiker’s Guide to the Federal Reserve’s Monetary Policy Toolkit.
Sean Corrigan has never been one to mince his words. As the extraordinary monetary policy of the last few years has unfolded, he’s again and again talked in numerous columns and in his Macro newsletters (both Midweek Macro Musings and Money, Macro and Markets) about the policy and the Macroeconomic implications.
Just last week he was on CNBC talking about the Stimulus effect – then he appeared on plenty of other programs about the same but slightly different sectors within the larger economy.
Now, enough is enough. With Yellen’s Jackson Hole speech Sean has put pen to paper (or whatever the modern equivalent is – fingers to keys) to school The Fed on what they have in their toolkit and why they might want to deploy it a bit better.
The Pre-Crisis Toolkit
Prior to the financial crisis, the Federal Reserve’s monetary policy toolkit was simple but effective in the circumstances that then prevailed. Our main tool consisted of open market operations to manage the amount of reserve balances available to the banking sector. These operations, in turn, influenced the interest rate in the federal funds market, where banks experiencing reserve shortfalls could borrow from banks with excess reserves.
Before the onset of the crisis, the volume of reserves was generally small – only about $45 billion or so. Thus, even small open market operations could have a significant effect on the federal funds rate. Changes in the federal funds rate would then be transmitted to other short-term interest rates, affecting longer-term interest rates and overall financial conditions and hence inflation and economic activity. This simple, light-touch system allowed the Federal Reserve to operate with a relatively small balance sheet – less than $1 trillion before the crisis – the size of which was largely determined by the need to supply enough U.S. currency to meet demand.
‘More question begging. Why were banks able to support $7.7 trillion’s worth of M2 liabilities and $11.1 trillion in total assets on such a scanty reserve basis on the eve of the crisis? Because the Fed had spent much of the previous decade-and-a-half degrading the role of reserves, largely in order to assuage the cupidity of the very banks over whom it was supposed to be exerting control.
This was not so much a ‘light-touch’ system as a ‘light the blue touch-paper’ one.’