If ever there were an idea intended to confuse rather than enlighten it would be the Fed married to interest rates. Forget about buses in the Alps and hippies driving on the salt flats.
The thing that matters is the supply and demand for the medium of account. And when you start thinking about monetary policy in this way, with the belief that the level of the FF rate reflects something rather than causes something, you’ve helped yourself along to a much better understanding of how monetary policy works. In fact, you might even realize some important facts about what the monetary regime of today implies about monetary policy in the past.
For example, you might notice something a little peculiar about the more recent additions of IoER and reverse repo programs, because adjustments in these are intended to cause frictions in the supply of medium of account. In more recent use, both of these tools have been increased in size with each 25 basis-point rate hike.
If you pull the data on the daily activity for these programs, you might also notice the exponential growth. The reason for that is because the FF rate is market-driven, and on any given day the market rate may settle below the intended range, say 0.75% – 1.00%, to close at 0.65% instead. In such an event, more friction needs to be created to drive the FF rate back up to the range.
The basic nuts bolts of it are that the NY Fed drives the short nominal rate back up to the range by shortening the supply of the medium of account by selling something, mostly in the form of a repo, though I have seen reports lately that MBS have been sold in OMO fashion as well. When these are sold, either in OMO fashion or temporarily as a repo, the liquidity they represent is absorbed, like a giant vacuum sucking up dollar bills.
You might wonder what is so peculiar about this because it looks pretty straight forward. But prior to these recent innovations in monetary policy, the Fed was able to tack the FF rate to the market rate purely by OMOs and adjusting the amount of available reserves, almost never via disjointed programs intended to cause hoarding, with the reason being that hoarding causes bad market mojo in the form of volatility in general, and even worse when it can’t be measured. I could go on to multitudes of opportunities for corruption, but it isn’t required here to illustrate my point.
The clincher here is that the exponential growth in the size of all various market operations combined is rather remarkable considering that the Fed, in order to maintain a neutral policy, really should be tacking the FF market rather than leading it – meaning money is tighter in aggregate and markets are less liquid than necessary on any given day. After weeks and months of this, it adds up to a rather large opportunity cost that we all seem to notice, but can’t quite put a finger on the cause- what might have been done with those dollars that get sucked up into the Fed’s vortex or are encouraged to be hoarded beyond necessity, instead of working for every man, woman, and child in the dollar bloc. And at a more basic and immediate level, I wonder about justice for the people taking unnecessary losses in stealth form. Was that my 401(k) that just took a hit, or my Fidelity fund? Hey, look it was both!
Besides just telling you about the Fed’s giant liquidity wine press and what meaning it has to everyday life, I’ve also just told you something else. If you start thinking about the reasons the Fed is doing all of these things, you just might grasp the seriousness of what both the Bernanke and Yellen Feds have done – the ‘why’ of the ZLB, and how the Fed created and is perpetuating its own interest rate problem and thus our worst nightmare.