The lever on which a central bank pushes or pulls in order to keep its target variable (say inflation) on track is commonly referred to as the central bank's policy instrument. The policy instrument is the variable that is under the direct control of a central banker. The classic story is that the pre-2008 Fed conducted monetary policy via its policy instrument of choice—the federal funds rate. By pushing the fed funds lever up or down, the Fed could change the entire spectrum of market interest rates.
I think this is wrong. The fed funds rate was never the Fed's actual policy instrument. Now this isn't a novel claim. Market monetarists tend to say the same thing. According to folks like Nick Rowe, the quantity of money has always been the Fed's true policy instrument. The fed funds rate was little more than a useful shortcut (a communications device) adopted by the Fed to convey to the public what it intended to do.
I'm sympathetic to the market monetarist's position, although I'm not entirely in the same corner. I agree that the Fed's policy instrument was never the fed funds rate. But I'm going to go one further than the market monetarists and say that the Fed's real policy instrument prior to 2008 was always the non-pecuniary return on reserves.
What do I mean by non-pecuniary return? All assets are expected to provide a sufficient return to their holder. This expected return can be decomposed into a pecuniary and a non-pecuniary component. Financial assets, for instance, tend to provide only pecuniary returns. These come in the form of expected interest payments, dividends, and capital appreciation. Non financial assets like couches, books, and cutlery tend to provide only non-pecuniary returns. These non-pecuniary returns come in the form of future consumption (dated consumption claims), protection from uncertainty, status, etc. Complex assets like houses provide both pecuniary and non-pecuniary returns. We expect to enjoy the shelter provided by our house, and we simultaneously expect it to provide a capital gain when we sell it.
Note that another word for non-pecuniary return is convenience yield. I'll use the two interchangeably from here on in.
For the first time ever on Moneyness, an equation to help clear the waters:
Total expected return of an asset = expected non-pecuniary return + expected pecuniary return
In well-functioning markets, all assets provide the same total expected return. If some asset begins to throw off excess returns, people will buy it up till its price has risen to the point that the cost of acquiring that asset offsets its superior return. Vice versa with an asset that begins to throw off deficient returns.
Central bank reserves are like any other asset. They provide an expected return that can be decomposed into pecuniary and non-pecuniary components. Perhaps somewhat oddly for a financial asset, reserves have never provided a pecuniary return, at least not before 2008. This is because reserves failed to pay interest. (In fact, reserves have always provided a slightly negative pecuniary return. They are generally expected to fall in price, burdening holders with a negative capital gain).
Reserves, therefore, are only held because their non-pecuniary return, or convenience yield, is sufficiently large to compensate their owners for a lack of a pecuniary return. [From here on in, it goes without saying that I am talking about the pre-2008 Fed]. What is the nature of this yield? Reserves are the main instrument used for interbank payments and settlement. Should an emergency arise necessitating an immediate payment, a banker can always put his or her inventory of reserves to use. If a banker foregos holding an inventory of reserves, he or she will have to bear the risk of not being able to quickly obtain sufficient reserves for potential unforeseen payments requirements. Reserves are to a banker what a fire alarm is to a household— while neither provides an explicit pecuniary benefit, both assets provide their owners with ongoing protection from the uncertainty of future events. Bankers and households alike expect to "consume" this convenience over the life of the asset, earning the same total return they would on their other assets.
It is the convenience yield on reserves, and not the fed funds rate, that serves as the Fed's policy instrument. By manipulating the convenience yield—the non-pecuniary return provided by reserves—the Fed exercises monetary policy. When the Fed improves the convenience yield on reserves, reserves will provide a superior expected return relative to all other assets in an economy. Rational agents will bid the price of reserves up, and the price level down. When it hurts the convenience yield, reserves will provide an inferior expected return relative to all other assets in an economy. Rational agents will now cry the price of reserves down, and the price level up.
One way to alter the convenience yield on reserves is to change their quantity via open market operations. As the supply of reserves shrinks via open market sales, the marginal reserve provides an ever improving convenience yield. Rational agents will seek to earn an excess return on their portfolios by buying superior-yielding reserves and selling other assets. This causes a fall in the price level until reserves no longer provide superior returns. Conversely, as the supply of reserves is increased via open market purchases, the marginal reserve provides an ever shrinking convenience yield. Rational agents will try to rid themselves of inferior-yielding reserves, causing a decline in the price of reserves, the mirror image of which is a rise in the price level.
There's a second way to change the convenience yield on reserves. Keep the quantity fixed, but make reserves more convenient! Just like an auto manufacturer can improve the expected convenience yield of a car by adding more features—cup holders, AWD, safety air bags, inboard TV, you name it—the Fed can also improve the expected convenience yield on reserves by souping them up. One popular add-on has always been the required reserve stipulation. As a condition of participation in the payments system, a central bank may require member banks to hold a certain quantity of reserves contingent on the number of deposits that each member has issued to the public. Where before central bank reserves were valued primarily for their role in settlement, now reserves can also be held to fulfill the reserve requirement, enabling the bank to continue as a payments system member in good standing. Voilà , reserves are now doubly-convenient since they can perform two roles, not just one. Henceforth, any increase in reserve requirements improves the convenience yield on reserves and any decrease will hurt their convenience yield.
If the Fed's monetary policy instrument has always been the convenience yield on reserves and not short term interest rates, as is commonly supposed, why all the hoopla about the federal funds rate? Why do central banks talk so much about manipulating overnight interest rates?
The problem with doing monetary policy in terms of convenience yields is that convenience yields are not directly visible. We know that they exist, but we can't really see them. This leaves the Fed in a conundrum, because if it tries to communicate about monetary policy, it can only talk about raising or lowering the hidden convenience yield on reserves, but it can't go into any numeric depth on the issue.
But wait! There are indirect ways to measure convenience yields. One way is to ask people how much money they expect to earn if they forgo the convenience of some asset for a duration of time. The rent they expect to earn in compensation should "shadow" the convenience yield. The more convenient an asset becomes, the higher the rent the asset holder expects to be compensated with if they are to do without that asset for a period of time. The less convenient, the lower the rent.
The federal funds market is the rental market for reserves. Banks can either hold reserves and enjoy their convenience, or they can rent their reserves out to other banks, foregoing the convenience of reserves for a period of time but earning compensatory payments. These payments are the rental value of reserves, or the fed funds rate. The fed funds rate is driven by the convenience yield on reserves. So when reserves are made more convenient by the Fed, banks will expect to earn a higher fed funds rate as compensation from borrowers. When the fed funds rate falls, that means that reserves have been made less convenient.
So the fed funds market provides a numeric manifestation of the unobservable convenience yield on reserves. The Fed can use this manifestation as a stand-in for communicating with the public, describing monetary policy as-if it was directly manipulating the fed funds rate whereas in actuality the convenience yield is the Fed's true policy instrument. In the 1990s and 2000s, when the Fed announced changes in the fed funds rate target, it was doing nothing more than describing to the public how a change in the underlying convenience yield would appear to the superficial observer. As Nick Rowe says, interest rate targeting is not reality, its a way of framing reality.
The fed funds rate also serves the Fed's Open Market Committee as a useful sign post, or indicator, that provides information on the way to hitting its final price target. For each modification it makes in the convenience yield, the FOMC can measure how successful it has been by referring to how far the fed funds rate has moved in response. Alternatively, the FOMC can use the fed funds rate as a guide for stabilizing what would otherwise be an invisible and difficult to manage convenience yield. In general, the Fed has tried to keep the convenience yield on reserves flat for extended periods of time between meetings. Whenever the fed funds market blips up or down in the interim, the Fed can use these blips as indicators that it is not keeping the underlying convenience yield steady. Action, either OMOs or reserve requirement changes, will be used to bring the convenience yield on reserves back into its holding pattern.
But the key point here is that the federal funds rate is NOT doing the heavy lifting in monetary policy. The federal funds rate only responds passively to changes in the Fed's true policy instrument—the convenience yield on reserves. Fed-induced changes in the convenience yield create an instantaneous and simultaneous reaction in all markets, including the fed funds market, bond markets, stock markets, labour markets, goods markets, and commodity markets. The fed funds rate isn't the first price to react, nor is it the pivot around which the full network of other market rates move. That we use the fed funds market to measure the reaction of the economy to a change in the policy instrument rather than using, say, commodity markets, is merely for the sake of ease. The funds rate just happens to be the one that provides the most noise-free signal for how much the convenience yield has been manipulated.
...but not a perfect noise-free signal. The fed funds rate's ability to act at a good reflection of the underlying convenience yield comes to an end when it gets too low. Even as the Fed continues to reduce the convenience yield, the fed funds rate falls to 0% from where it refuses to budge, conveying the impression—an improper one—that the Fed's policy instrument is powerless. But further reductions in the convenience yield, and a higher price level, ARE still possible.
My point here is very similar to the one that Nick Rowe makes when he says that interest rates "go mute" at zero. This is an important point I never grasped intuitively till I began to think of Fed policy as the manipulation of convenience yields. The main difference between the two of us is that Nick takes the "money" view, which looks at absolute quantities of money, while I take a "moneyness view", which means I'm interested in monetary convenience yields [on money vs. moneyness]. We arrive at the same final destination, though, albeit by different roads.
Plenty of things changed after October 2008. I suppose I could go into this in more detail, but this post is already too long. Suffice it to say that reserves ceased offering a present non-pecuniary return and began offering a pecuniary return. The latter is IOR (interest-on-reserves). The non-pecuniary return has shrunk because there is currently such a glut of reserves in the system that the marginal reserve no longer offers its owner a present convenience yield. All of these changes complicate the picture.
There's plenty more to say on all this stuff, but this post is heavy enough. Just keep in mind that thinking in terms of convenience yields and not the federal funds rate opens up a whole new world. The idea that the funds rate was ever the policy instrument should be confined to the trash bin. More later.
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