A second option to improve the Fed’s control over short-term rates is to drain reserves by offering banks term deposit accounts in which to invest funds for longer terms than overnight. There are two issues that might make this option somewhat less attractive. First, to strengthen monetary policy control significantly through this course, it might be necessary to drain most of the $ trillion of reserves. This could be done of course with effort, but is the effort worth it? Second, the Fed would undoubtedly have to “pay up” to induce banks to hold term deposit accounts relative to keeping their monies in reserves at the excess reserves interest rate. This would likely result in higher Fed interest expenses relative to relying on an overnight RRP facility to set a floor on money market rates. The choices here are important and I expect that considerable testing, analysis and discussion will be necessary to reach firm conclusions about the appropriate course. My goal would be to clarify our intentions later this year, long before we begin to contemplate raising short-term rates. I also think that the choices are about how to conduct monetary policy during the transitional phase, not about the long-term monetary policy framework. Longer term, the issue will be whether to return to the type of corridor system that was in place prior to the crisis or to instead to stay with the type of floor system that will likely be the type of regime that is in place as the balance sheet gradually normalizes.
To the extent that the overnight RRP rate were set very close or equal to the interest rate on excess reserves (IOER) without caps, then this might result in a large amount of disintermediation out of banks through money market funds and other financial intermediaries into the facility. This could encourage further development of the shadow banking system. If this were deemed undesirable, this would argue for a wider spread between the overnight RRP and the IOER in order to reduce the volume of flows into the facility. The second issue is the facility’s potential impact on financial stability. In particular, would such a facility make financial instability less likely? And, when financial stress did occur, would such a facility amplify or dampen financial strains? On the first point, it seems that such a facility would tend to make financial instability less likely. The overnight RRP facility allows us to make a short-term safe asset more widely available to a broad range of financial market participants. The provision of short-term safe assets by the official sector might crowd out the private creation of runnable money-like liquid assets. This might enhance financial stability by reducing the likelihood of a financial crisis. However, if a financial crisis were to occur, the existence of a full allotment, overnight, RRP facility might exacerbate instability by encouraging runs out of more risky assets into the facility. That is because the supply of a full allotment facility would be completely elastic at the given fixed rate.