The recent evolution of central banking in the U.S.

Timothy Taylor writes,

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 Fed 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.