As Marvin Goodfriend will discuss, part of this was due to appropriate market pricing of credit risk, but other aspects reflected segmentation in the money markets that was exacerbated by a pronounced lack of dollar liquidity. Some of this decline in money market functioning was not reflected in the effective fed funds rate as it was measured at that time. 7 The situation today is very different for a number of reasons. The Federal Reserve has the authority to pay interest on reserves. Many countries that run a “corridor” system of monetary policy implementation have had this authority for a long time and could transition from reserves scarcity to a state of more plentiful supply of liquidity while maintaining adequate control of their interest rate, as I noted was the experience for the European Central Bank. In addition, the Desk has augmented an old tool, reverse repurchase agreements, or RRPs for short, that allow an expanded set of counterparties to invest with the Federal Reserve either at a fixed interest rate or up to certain quantity. 8 With the advent of interest on reserves, RRP, and the Term Deposit Facility mentioned previously, policymakers have more tools for influencing market interest rates, and sterilization is no longer necessary to control rates with large amounts of excess reserves. Perhaps the most important development is the successful liftoff of the federal funds rate in December.
Although we don’t know yet whether the interest rate control exhibited to date with the new tools will continue at different settings of the target range, so far, things have gone as well as could have been expected. While other countries have operated a “floor” system before, no country with as complex a financial system as the United States, with its wide variety of bank and nonbank institutions, had ever attempted to raise interest rates with such a large supply of excess reserves. The success of the new tools so far has been important for instilling confidence that policymakers can control overnight interest rates at levels appropriate to meet their goals. It also means that, in future, the Federal Reserve will not have to face the same technical constraint that leads to a conflict between easing strains in broad money markets and controlling the policy rate whether it uses a floor or corridor system. This could make the Federal Reserve System more agile and better able in future circumstances to provide the elastic currency that has  6  The Term Deposit Facility was established to facilitate the conduct of monetary policy by providing a tool with which the Federal Reserve can manage the aggregate quantity of reserve balances held by depository institutions. An increase in term deposits outstanding drains reserve balances because funds to pay for them are removed from the accounts of participating institutions for the life of the term deposit.