Is the Fed Losing Steam in Controlling Interest Rate?

As the final countdown to bring in 2020 begins, new concerns have emerged regarding the Fed’s continuous ability to control the interest rate. Developments in the financial market such as growing U.S. budget deficit, investors’ increased cash hoarding desire, and pressures on the money market rates, such as repo rates, are urging these fears on. The sentiment is that the Fed’s control over the interest rate determines the price of reserves, which in turn eliminates any form of excess supply or excess demand in the market for reserve. In doing so, the Fed maintains its authority to stabilize the money market where the price of short-term funding is determined. The problem is that in modern finance, most financial participants finance their liquidity requirements mainly through selling their security holdings, or using them as collateral, rather than demanding reserves directly. In other words, the availability of market liquidity, which refers to the ability to raise money by selling holdings of financial assets, has higher priority than the supply of reserves. Therefore, as Perry Mehrling argues, and this post highlights, the central bank watchers’ focus should deviate from the Fed’s ability to control the price of reserves, which is the federal funds rate, to its ability to affect market and funding liquidity. This also entails an intellectual migration from a supply and demand framework towards a Flow of Funds accounting perspective.

To understand this point, let’s start by understanding the standard monetary economics view of interest rate. In this framework, the money rate of interest is determined directly by the supply and demand for state money or reserves. The idea is that the Fed can accurately target the federal funds rate to control supply and demand for the money, even though this interbank lending rate is determined in the market. The notion that the reserve balances held at the Fed are the ultimate means of interbank settlement gives the Fed this power. This sentiment of “monetary liquidity” got upheld in postwar economic discussion. The further integration of money supply and demand framework with the “Liquidity preference” framework of Keynes made it an integral part of the standard economist’s toolkit. The issue is that this analytical strategy overlooks the role of borrowing and private credit in the money market by treating the money rate of interest as determined directly by the supply and demand for reserves. In modern finance, however, the dishoarding of money balances is only one way of satisfying the liquidity needs when cash outflow (use of funds) is larger than cash inflow (source of funds).

The other two methods are borrowing or selling financial assets. The former requires access to “funding liquidity,” and the latter involves the availability of “market liquidity.” More importantly, the dealers supply both liquidities. Banks provide funding liquidity by acting as dealers in the money market and earning the spread between overnight rates and term rates. In the process, they set the price of funding liquidity, which is the short-term interest rate. Security dealers, on the other hand, provide market liquidity and determine asset prices by taking on price risk and making the inside spread, which is the difference between the bid and ask prices. In doing so, both dealers take the deficit players’ settlement issues onto their own balance sheets and set short-term and long-term interest rates respectively. To sum up, it is crucial to observe that first, liquidity is a form of credit, not reserve money. Second, the interest rate, or price of liquidity, is determined by the expansion of dealer balance sheets on both sides rather than supply and demand for reserves.

Discussion Questions:

1. What is the main theory behind the supply and demand analysis of interest rates?
2. Why should the Fed watchers shift their focus from the market for reserves to the market for liquidity?