FOMC Excerpt: Advantages of Operating Floor Framework>

     WASHINGTON (MNI) - The following is an excerpt from the Federal 

Open Market Committee minutes of the November 7 - 8 meeting, published 

Thursday: 

     "Committee participants resumed their discussion of potential 

longrun frameworks for monetary policy implementation, a topic last 

discussed at the November 2016 FOMC meeting. The staff provided 

briefings that described changes in recent years in banks uses of 

reserves, outlined tradeoffs associated with potential choices of 

operating regimes to implement monetary policy and control short-term 

interest rates, reviewed potential choices of the policy target rate, 

and summarized developments in the policy implementation frameworks of 

other central banks.

     The staff noted that banks liquidity management practices had 

changed markedly since the financial crisis, with large banks now 

maintaining substantial buffers of reserves, among other high quality 

liquid assets, to meet potential outflows and to comply with regulatory 

requirements. Information from bank contacts as well as a survey of 

banks indicated that, in an environment in which money market interest 

rates were very close to the interest rate paid on excess reserve 

balances, banks would likely be comfortable operating with much lower 

levels of reserve balances than at present but would wish to maintain 

substantially higher levels of balances than before the crisis. On 

average, survey responses suggested that banks might reduce their 

reserve holdings only modestly from those lowest comfortable levels if 

money market interest rates were somewhat above the interest on excess 

reserves (IOER) rate. Across banks, however, individual survey responses 

on this issue varied substantially. 

     The staff highlighted how changes in the determinants of reserve 

demand since the crisis could affect the tradeoffs between two types of 

operating regimes: (1) one in which aggregate excess reserves are 

sufficiently limited that money market interest rates are sensitive to 

small changes in the supply of reserves and (2) one in which aggregate 

excess reserves are sufficiently abundant that money market interest 

rates are not sensitive to small changes in reserve supply. In the 

former type of regime, the Federal Reserve actively adjusts reserve 

supply in order to keep its policy rate close to target. This technique 

worked well before the financial crisis, when reserve demand was fairly 

stable in the aggregate and largely influenced by payment needs and 

reserve requirements. However, with the increased use of reserves for 

precautionary liquidity purposes following the crisis, there was some 

uncertainty about whether banks demand for reserves would now be 

sufficiently predictable for the Federal Reserve to be able to 

precisely target an interest rate in this way. In the latter type of 

regime, money market interest rates are not sensitive to small 

fluctuations in the demand for and supply of reserves, and the stance of 

monetary policy is instead transmitted from the Federal Reserves 

administered rates to market ratesan approach that has been effective 

in controlling short-term interest rates in the United States since the 

financial crisis, as well as in other countries where central banks 

have used this approach. 

     The staff briefings also examined the tradeoffs between alternative 

policy rates that the Committee could choose in each of the regimes. In 

a regime of limited excess reserves, the Federal Reserves policy tools 

most directly affect overnight unsecured rates paid by banks, such as 

the effective federal funds rate (EFFR) and the overnight bank funding 

rate (OBFR). These rates could also be targeted with abundant excess 

reserves, as could interest rates on secured funding or a mixture of 

secured and unsecured rates. 

     Participants commented on the advantages of a regime of policy 

implementation with abundant excess reserves. Based on experience over 

recent years, such a regime was seen as providing good control of 

short-term money market rates in a variety of market conditions and 

effective transmission of those rates to broader financial conditions. 

Participants commented that, by contrast, interest rate control might 

be difficult to achieve in an operating regime of limited excess 

reserves in view of the potentially greater unpredictability of reserve 

demand resulting from liquidity regulations or changes in risk 

appetite, or the increased variability of factors affecting reserve 

supply. Participants also observed that regimes with abundant excess 

reserves could provide effective control of short-term rates even if 

large amounts of liquidity needed to be added to address liquidity 

strains or if large-scale asset purchases needed to be undertaken to 

provide macroeconomic stimulus in situations where short-term rates are 

at their effective lower bound. Monetary policy operations in this 

regime would also not require active management of reserve supply. In 

addition, the provision of sizable quantities of reserves could enhance 

financial stability and reduce operational risks in the payment system 

by maintaining a high level of liquidity in the banking system.    

     A number of participants commented that the attractive features of 

a regime of abundant excess reserves should be weighed against the 

potential drawbacks of such a regime as well as the potential benefits 

of returning to a regime similar to that employed before the financial 

crisis. Potential drawbacks of an abundant reserves regime included 

challenges in precisely determining the quantity of reserves necessary 

in such systems, the need to maintain relatively sizable quantities of 

reserves and holdings of securities, and relatively large ongoing 

interest expenses associated with the remuneration of reserves. Some 

noted that returning to a regime of limited excess reserves could 

demonstrate the Federal Reserves ability to fully unwind the policies 

used to respond to the crisis and might thereby increase public 

acceptance or effectiveness of such policies in the future. 

Participants noted that the level of reserve balances required to remain 

in a regime where rate control does not entail active management of the 

supply of reserves was quite uncertain, but they thought that reserve 

supply could be reduced substantially below its current level while 

remaining in such a regime. They expected to learn more about the 

demand for reserves as the balance sheet continued to shrink in a 

gradual and predictable manner. They also observed that it might be 

possible to adopt strategies that provide incentives for banks to reduce 

their demand for reserves. Participants judged that if the level of 

reserves needed for a regime with abundant excess reserves turned out 

to be considerably higher than anticipated, the possibility of 

returning to a regime in which excess reserves were limited and 

adjustments in reserve supply were used to influence money market rates 

would warrant further consideration". 

     ** MNI Washington Bureau: (202)371-2121 ** 

[TOPICS: MMUFE$,M$U$$$,MT$$$$]