When the FOMC wanted to adjust its federal funds rate target – that is, the interest rate banks earn or pay when lending or borrowing overnight reserves with another bank – it directed the System Open Market Account (the Desk) manager in New York to alter the supply of reserves within the banking system (up or down) as needed to match the estimated demand for reserves in order to keep the federal funds rate very close to the FOMC’s target.2 In this setup, the amount of banking reserves in the system – required and excess – was very small and the Desk typically conducted open market operations that added or drained no more than a few billion dollars of reserves from the banking system to ensure that the federal funds rate traded around the FOMC’s target. In October 2008, after passage of the TARP legislation, the Federal Reserve was authorized to implement a new tool, the ability to pay interest on required and excess reserves.3 This tool was significant because it meant that the FOMC would be able to control interest rate policy even with a much larger balance sheet and a much larger amount of excess reserves in the banking system. This was important because it gave us more scope to expand the Federal Reserve’s balance sheet to help address the financial crisis and to provide support for the economic recovery, knowing that later, when the recovery took hold, we could raise interest rates even with an enlarged balance sheet.
As we noted in the December FOMC statement, we anticipate that we will continue reinvestment “until normalization of the federal funds rate is well underway.” I think this policy makes sense not only because the decision to end reinvestment will represent a further tightening of monetary policy, but also because it is difficult to assess ahead of time the impact of such a decision on financial market conditions given the lack of historical experience. I also believe that continuing reinvestment until the federal funds rate reaches a higher level makes sense. We want to ensure that we have the ability to respond to adverse shocks by easing monetary policy by lowering the policy rate. Having more “dry powder” in the form of higher short-term interest rates seems more desirable than less dry powder and a smaller balance sheet. Now the words “well underway” in the FOMC statement are vague – what does that mean in terms of the level of the federal funds rate? Reiterating the disclaimer that I am speaking for myself, my view is that we should not set a numerical tripwire for ending reinvestment. If the economy were growing very quickly and the risks of an early return to the zero lower bound for the federal funds rate were deemed to be low, then I could see ending reinvestment at a relatively low federal funds rate.