when I was teaching big classes in the late 1980s and into the 1990s, the textbooks all discussed three tools for conducting monetary policy: open market operations, changing the reserve requirement, or changing the discount rate.
Somewhat disconcertingly, when my son took AP economics in high school last year, he was still learning this lesson–even though it does not describe what the Fed has actually been doing for more than a decade since the Great Recession. Perhaps even more disconcertingly, when Ihrig and Wolla looked the latest revision of some prominent intro econ textbooks with publication dates 2021, like the widely used texts by Mankiw and by McConnell, Brue and Flynn, and found that they are still emphasizing open market operations as the main tool of Fed monetary policy.
I recommend the whole post. I think this is an important issue.
The way I see it, central bank practices moved away from the textbook story at least 40 years ago. There were three important steps.
1. Intervention via the market for repurchase agreements, commonly called the repo market.
2. The use of risk-based capital requirements (RBC) to steer the banking sector.
3. The expansion of bank reserves and the payment of interest on reserves (IOR).
I will discuss these in turn.
1. The Repo Man
As of the 1980s, the Fed’s main tool was intervention in the repo market. In a repurchase agreement, if I own a Treasury bond, I will sell it to you today and agree to repurchase it tomorrow (or in three days or in a week) at a slightly higher price. In effect, you are lending me funds, with the bond as collateral. The interest rate on repo loans is called the repo rate. It is a very important short-term interest rate in financial markets, closely tied to the “Fed Funds” rate that plays a big role in accounts of the Fed in newspaper stories and textbooks.
Why might I borrow from you for a short period of time in order to fund the bond? If I am a bond dealer, this allows me to hold a lot of bonds in inventory in spite of my having a relatively low capital base. It is like a furniture store using a bank loan to finance a large inventory of sofas.
Or, if you will, think of a consumer using a car as collateral for a loan. If the consumer does not repay the loan, the lender will send the “repo man” to confiscate the car. The difference with financial repo is that the repo man always comes to take the security back. It’s the normal way that repo operates in the bond market.
The Treasury markets its bonds by selling to dealers, like Goldman Sachs, who hold them in inventory until they can sell them. If the Fed were to engage in textbook open market operations, it would purchase Treasury securities from a select group of dealers known as “primary dealers.” In this scenario, the Treasury sells bonds to Goldman Sachs, and the Fed buys the bonds back from Goldman Sachs. The famous video featuring “the Bernank” gets this hilariously right, asking why the Treasury does not just simply sell to the Fed.
But the Fed can influence financial markets by making repo loans to primary dealers. That is, it can lend to dealers to finance their inventory. This pushes down the interest rate on repo loans, and that lower interest rate reverberates through the rest of the market.
What if the Fed wants interest rates to rise? Then it can cut back on its repo lending. Or it can engage in reverse repo, acting as a borrower in the repo market rather than a lender. Tim says that he does not think that one can teach reverse repo to non-experts. I think I just did.
2. Risk-based Capital
Households and businesses want to issue risky, long-term liabilities, like mortgage loans and corporate debt, while holding riskless, short-term assets, like checking accounts. Banks do the reverse. This means that banks are in danger of becoming insolvent (if their risky assets turn bad) or illiquid (if there is a run on their short-term liabilities).
Banks finance some of their activity by raising money in the stock market. Stock in banks is called bank capital. In a purely private financial system, banks would have to raise a lot of capital relative to the risk in their portfolios. Nobody wants to have their money on deposit at a bank that might lose their money.
Since the 1930s, we have operated under the assumption that this desire for banks to raise a lot of capital is a “market failure.” The alleged market failure is that supposedly sound banks can be ruined by bank runs. The solution to this is government-backed deposit insurance, which takes away the incentive to run to the bank to take your money out.
Deposit insurance transfers the responsibility for setting bank capital requirements and determining bank risk strategy from private investors to government regulators. Until the 1980s, bank regulation had a very large subjective component, with regulators auditing banks and evaluating management quality, risk strategy, and so on. The capital requirements were essentially the same at all banks.
In the 1980s, the Saving and Loan industry, which was a fair chunk of the banking industry, collapsed. There had also been bank crises related to international lending. Regulators and many private economists put some of the blame on the fact that regulatory capital requirements were the same for all banks, regardless of risk. They recommended a new approach, one which could be used worldwide, called risk-based capital. The regulatory bodies assigned “weights” to different classes of assets. The higher the weight, the more capital a bank would hold.
The lowest weights were assigned to sovereign debt. A bank pretty much needed no capital to hold Treasury bonds. Low weights also were assigned to mortgage-backed securities issued by Freddie Mac and Fannie Mae. Then in the early 2000s, low weights were given to other mortgage-backed securities that were blessed with AAA ratings. This worked out very badly by 2008.
Compared with the traditional tools of monetary policy, RBC has much more significance to financial markets in particular and to the economy as a whole. The government uses RBC to steer credit to itself and to mortgage borrowers.
3. Interest on reserves
Before 2008, much of America’s Treasury debt was held by non-bank institutions, including foreign banks. Since that time, a lot of Treasury debt has been purchased by the Fed. The Fed in turn has borrowed from banks. The banks are credited with reserves, a digital asset that might be called Fedcoin. The Fed pays a modest interest rate on these reserves. In effect, the Treasury is borrowing is borrowing less from non-bank institutions and more from banks. The Treasury’s borrowing rate is IOR.
In theory, the Fed can use IOR as a tool to steer the economy. If it raises IOR, then banks will make fewer loans and instead prefer the risk-return characteristics of holding Fedcoin. If the Fed lowers IOR, then banks will be more willing to make loans.
I have some doubts about whether the Fed will be able to execute a tightening policy to the extent that it might be needed. As IOR goes up, the government’s borrowing costs will go up. Because government debt outstanding is at unprecedented levels, higher borrowing costs will be painful. Time will tell.
That’s the clearest explanation of the Fed’s repos that I’ve seen. Thanks.
Agree 100%, I’m going to have to go reread some articles about the repo market interventions back in March 2020 now that I have an idea of what they are and how they work at a high level.
This says a lot more about the state of education than Fed policy. If the one subject you are most familiar with is out of date – how likely is it that all of the other subjects have kept up with the times?
The most important statement in the post: “I have some doubts about whether the Fed will be able to execute a tightening policy to the extent that it might be needed… Because government debt outstanding is at unprecedented levels, higher borrowing costs will be painful. Time will tell.” This is a pretty bland statement of a huge problem. Think of what even a return to historic interest rates of 5% – 5 1/2% on the 10 year would do to the budget, let alone what Volcker era rates would do. So far, inflation seems to be mostly in asset prices rather than consumer prices. If consumer prices take off, creating political pressure, we are likely headed for wage and price controls, and eventual economic severe dislocation.
I have a quibble about your description of capital requirements.
Banks don’t really “hold” capital. Capital requirements are not about the portfolio of banks assets but the structure of the liabilities. They are about bank leverage. They are not like reserve requirements.
Banks were permitted to be more leveraged if they held what was classified as lower risk assets. There was politics in saying what was lower risk.
Sovereign debt is not low risk. Euro crisis told us that, repeated Latin American debt crises told us that, Russia default told us that. Wriston at Citi quipped that countries don’t go broke. The response is he is right, but banks that lend to countries can go broke.
Even US Treasurys. People forget about duration risk even with default-free securities. Holding long bonds is risky if bond yields spike.
There is also liquidity risk for private assets even of good quality. Banks find this out in bank runs. Yes, we need a lender of last resort to provide liquidity.
I would add a credit rationing channel to monetary policy. Often forgotten because it doesn’t fit neatly into a Fischer Black framework. Fed easing or regulatory policy can change the terms of bank lending, not just the lending rate. The housing bubble of 15 years ago may have been driven more by easier credit than lower rates.
I don’t think GSE debt was a problem. (GSE equity was.) The rating agencies gave GSE debt an AAA rating because they said it was guaranteed by the government. They were right. Moreover, the Fed made a market for GSE debt with QE. Effectively, GSE debt is safe and liquid but has duration risk, of course.
The issue about capital requirements was not a risk-weighting for banks holding GSE debt. It was capital requirements for the GSE entities themselves. By having low capital requirements, the government was on the hook, and the equity holders had a free ride for a long time.
Sovereign debt from 1st world countries is certainly “low risk” compared to other possible debt instruments. The Euro crises showed that. For all the hardship, was there any actual default? Nope. Not a single Euro wasn’t repaid to creditors. A tiny amount (compared to totals outstanding) was paid back a couple weeks late to the IMF, an institution that basically goes out of its way to be a doormat.
It’s so low risk that the financial system literally bends over backwards to avoid it.
Technically, the GSE’s had only a $4 billion line of credit, which was not enough to cover the debt. In the summer of 2008, Freddie and Fannie were about to go bankrupt, because they couldn’t borrow at low rates. They could not borrow at low rates because investors were not sure that the government would back all their debt. In the end, the government bailed out all of the debtholders, not just a $4 billion line of credit, but in the process they took over Freddie and Fannie (“conservatorship”).
I agree that GSE capital requirements were too low, but given their low capital base, and assuming that the only backing for GSE debt was the line of credit, the risk weight on GSE debt at banks was too low.
Thanks SO much for the video – I was working too much in 2010 to see it. It’s so hilarious, true, and sad.
Republicans, perhaps especially Rand Paul, should be pushing the Fed to buy Treasuries from the Treasury.
Banks are using the Fed to obfuscate their financialization of the economy. This is similar to some rich folk using off-shore companies to obfuscate their ownership control of other companies. When was the last Fed audit? (Never?? calling Paul again? – but he’s a doctor!! so was his father Ron.)
Unasked Q: What is the problem with printing money?
A: inflation, and increasing inflation, and the fear of uncontrollable hyper inflation.
Q: why has so much money been printed with so little consumer product inflation?
A: because so much of it has gone to the super rich who mostly invest in financial assets like stocks – and those assets ARE going up by inflation, even hyperinflation.
Nobody knows what the endgame/ crisis looks like with hyper asset inflation – it’s never happened to the “world’s primary currency” before. When Apple broke a Trillion $ market cap, and no problem … it seems like why can’t any company break the Trillion limit? (5 have now) Why not 2 trillion? 20 trillion?
Why not “hyper inflation”? Grey’s hyperinflation law – No Hyperinflation without Food Shortages. Keep the market economy/ consumer production going so that there’s enough food producers so competition keeps prices low, and there’s very little “limit” on how much money can be printed without big consumer price rises. Milk at <2% annual avg increases means low inflation for decades.
Rich investors need an alternate, better ROI investment to divert their savings glut investment cash, to keep getting richer faster, before they abandon USD. It doesn't now look like Commie Renminbi/ Yuan. Nor bitcoin/ crypto. It might become crypto in the future.
I'm now supporting a small wealth tax on financial instruments for those who own more than 100 years of avg median income (~60k so $6,000,000) of stocks & bonds.
We, our society, need a way to slow down the increasing gap of rich getting richer faster than working folk.
Small typo "is borrowing" 2x:
" In effect, the Treasury is borrowing is borrowing less from non-bank institutions and more from banks. The Treasury’s borrowing rate is IOR."
Why might I borrow from you for a short period of time in order to fund the bond? If I am a bond dealer, this allows me to hold a lot of bonds in inventory in spite of my having a relatively low capital base. It is like a furniture store using a bank loan to finance a large inventory of sofas.
I don’t understand this. If I buy a bond to sell it back to you tomorrow morning at a profit, am I borrowing the bond, or am I lending the money? What does “borrow for a short period of time to fund the bond” mean? Am I increasing my inventory of bonds so I have more for sale? Or is the other party raising money to buy more bonds? And doesn’t this all unravel by 8am, so what’s the point?
Maybe, I’m missing something. But repo lending seems a lot like open market operations. What is the key difference I’m not seeing?
Never mind, I realized what I was missing.
Repo lending does have the same effect. But in textbook open market operations, the Fed buys the bond and keeps it. And the reserves that the bank gets in exchange for the bond are then lent out to the public.
With repo lending, the Fed buys the bond and then sells it back very shortly thereafter. The Fed is lending money to a dealer, not creating reserves at a bank.
Since 2008, the story is different. The Fed is now buying bonds and keeping them, but it paying interest on reserves in order to discourage banks from lending them out.
Thanks