Transcripts of the monetary policymaking body of the Federal Reserve from 2002–2008.

  • Good morning, everybody. Why don’t we start with the report from Dave Stockton on the data.

  • We left at your place, and I hope you have found, a GDP advance release for the first quarter. It came in at plus 0.6 percent versus our Greenbook forecast of 0.4. It was really very close to our expectations, both for the total and for the individual components. There were a few small differences. Nonresidential structures, as you can see about halfway down that sheet, are estimated to have been weaker than we were forecasting. I think that additional weakness certainly reinforces the story I was telling yesterday about this being an area in which we are now seeing more convincing signs of softness. Residential investment was not quite as weak as we thought, but I don’t think the difference between a minus 27 and a minus 31 changes the basic tenor of that particular story. Two small areas for which we had some upside surprises were federal spending and inventory investment, but those surprises were really quite small. I don’t see anything in this report, quite frankly, on the real GDP side that would cause us to change our basic outlook. Obviously, when we get the detail, we might make some minor adjustments to the second-quarter forecast. As for prices, the final two lines of that table, total PCE came in right as we had expected. Core PCE was estimated by the BEA to be a tenth higher than we had projected, but that is still ½ percentage point below what we were projecting back in the March Greenbook. So, again, I don’t think that the report that I gave yesterday would be altered by this release.

    We also received the employment cost index. In the release, we get those figures only to one decimal place. To one decimal place, we are right on for total compensation—wages and salaries and benefits; in terms of the 12-month change, it was 3.2 percent, and that was what we were forecasting. Wages were a bit higher than we thought—3.2 versus the 3.1 we projected— but benefits came in a little lower than we were projecting. There again, I think the data just basically confirm the story that we are not really yet seeing any signs of pressure on the labor cost side.

  • Any questions for Dave? All right. If not, yesterday we had an introductory presentation by Bill English on the alternatives. You will be pleased to know that there have been no further changes in the proposed statements. So why don’t we take comments now from the participants. President Plosser.

  • Thank you, Mr. Chairman. What I would like to do—it will probably come as no surprise—is to make the case for why we should stand pat today and make no change. My case is built on a number of points, and I’d like to articulate those as best I can.

    First, as we all know, the economic outlook has weakened since the start of the year, but that deterioration occurred largely between January and March. Since the March meeting, there has been little change in the Greenbook forecast or in my own outlook for the economy. Incoming data over the intermeeting period are consistent with a weak first half but not appreciably weaker than we earlier anticipated. I believe that easing policy is appropriate in a weaker economy, but continuing to cut rates for as long as the economy remains weak is not appropriate. Although it is a difficult task, we must try to calibrate the appropriate level of the fed funds rate with the economic prospects and our policy goals. I will just note that, since last September, we have lowered the funds rate 300 basis points. This year alone, in a period of less than 60 days, we have cut 200 basis points. This is a very aggressive policy of easing. Not enough time has passed, in my view, to see the full effect on the economy of those cuts, and a further 25 basis point cut in the funds rate at this point will do nothing to change the near-term outlook of the economy.

    Second, we are currently running a very accommodative monetary policy, no matter how you look at it. The real funds rate is negative or very negative, depending on which measures of inflation you use to construct it. The nominal funds rate is below the level of most versions of the Taylor rule, even when adjusting for some interest rate and real rate effects, given our objectives. As I noted yesterday, monetary aggregates as measured by M2 and, to some extent, MZM have expanded very rapidly, especially since our rate cuts in late January. Now, although none of these measures of monetary accommodation or monetary ease is perfect—each has its drawbacks—I am concerned that all the measures of monetary accommodation suggest that we are very accommodative at the current time.

    Third, inflation is high, unacceptably high in my view, and has been that way for a sustained period, as I talked about yesterday. Some would argue that the weakened economy will bring the inflation rate down. But theory and experience both say that such will occur only if expectations of inflation remain anchored. But since the end of last year, most measures of expected inflation have moved up. The instability in the measures of expected inflation is a cause for concern. It suggests to me that markets may be less convinced of our willingness to take the necessary actions that are consistent with sustaining a credible commitment to price stability. I certainly understand the difference between a relative price shock and inflation. Clearly, oil prices and other commodity prices are in part a relative price shock. There is no question about that. But it is also true that in the 1970s one of our mistakes was that we accommodated relative price shocks with very accommodative monetary policy, and in so doing helped convert a relative price shock into sustained inflation. I think we should be careful not to fall into the same trap. Besides, I think that in most monetary models today we worry particularly about stabilizing core inflation because it represents the sticky prices in our sticky- price models. So if relative price shocks begin to seep into the core, or into the sticky-price elements, monetary theory would suggest that we need to respond to those. If we are going to achieve something close to optimal monetary policy, we should be concerned about that seepage because it may affect expectations and it is part of what monetary policy should be doing, at least in that class of models.

    Although it is true that we have not seen much in the way of wage inflation to date and that is encouraging, I would also reiterate, as some people noted yesterday, that wage inflation tends to be a lagging, not a leading, indicator of overall inflation. Contrary to the Greenbook forecast, which has us maintaining a negative real funds rate for two years and inflation coming down, I think that, if we continue easing or maintain the real funds rate well below zero for a period of time despite inflation well above our goal, it is reasonable to assume that expectations will not remain anchored. The FOMC’s stated goal of price stability cannot remain credible independent of our actions. If we want expectations to remain well anchored, we have to act in a way that is consistent with that.

    Fourth, I believe that we are in the fortunate position today of being able to pause. Market participants have reacted to the incoming data by appreciably tightening their expectations of future funds rate moves—at least as measured by the futures markets, as we have seen. Participants seem to be getting less comfortable with the idea of very easy monetary policy over a sustained period, given the outlook for inflation. I note that the markets’ reassessment of their policy expectations over the intermeeting period doesn’t appear to have had any significant negative effect on the markets, or the economy more broadly, during this period. I think this reassessment by the markets presents us with an opportunity to reinforce our stated commitment to price stability, not just with words but with action or, in this case, inaction. I think a pause today would send a strong signal of our commitment to price stability, which could further help anchor inflation expectations, which I consider to be very fragile. A pause, it seems to me, balances the risks of the two parts of our mandate. Some might argue that, in the midst of the financial market disruptions that we have seen this year, it is important for the Fed not to add to market turmoil by taking policy actions not anticipated by the markets. The mean expectation for the markets is for 25 basis points of easing today. But market participants are placing odds of somewhere between 25 percent and 30 percent on our pausing, so I don’t think a pause would be very disruptive to the markets. The magnitude of the surprise would be about the same as the surprise we had last time when we cut 75 basis points. That surprise, in my view, did not really cause much turmoil in the marketplace.

    Finally, when I say that cutting 25 basis points won’t help the outlook for the economy very much, others might respond that cutting 25 basis points won’t hurt it very much either, so why not. I disagree. I think a cut today will not be a disaster but will contribute to a further eroding of our credibility in the eyes of the public. At past meetings this Committee has spoken a lot about the need for rapid reversals of our rate cuts that we took out for insurance. I think we should not be overly confident of our ability to implement such rapid reversals. In fact, the lower the rates go, the further we will need to come back when we start taking the accommodation back. I am dubious of our ability because we will be so much further from what might be a more neutral rate.

    In summary, to my mind the gain in credibility from pausing today substantially outweighs any negative effects from slightly disappointing the markets. It doesn’t preclude us from choosing to resume cuts at a later date should economic conditions warrant them. After all, I think this Committee has demonstrated its ability to act aggressively in response to economic conditions, and we can do so again. But that is the future. For today, I think we should take the opportunity that the economy and the markets have afforded us to pause. As the old Latin expression says, “Carpe diem.”

    With regard to language, I am happy with alternative C. Rather than the language in paragraph 4 of alternative C, I would prefer the language of paragraph 4 of alternative B. I would just make that the language for paragraph 4 in alternative C—that is the only change that I think would be necessary. Thank you, Mr. Chairman.

  • Thank you. President Evans.

  • Thank you, Mr. Chairman. I, too, favor maintaining the federal funds rate at 2¼ percent today. The current real interest rate provides accommodative monetary conditions for an economy that is struggling near recession or is in mild recession. Our lending facilities are probably doing as much as can be expected to mitigate the serious and necessary financial adjustments that must be accomplished by the private markets. If the economy takes another serious leg down, our current funds rate setting is well positioned for us to respond promptly, appropriately, and aggressively, if circumstances warrant. A pause today affords us a unique opportunity to wait and see how our recent aggressive actions are influencing the trajectory of real activity. Since markets are putting substantial weight on a 25 basis point easing today, a pause will be a relatively small disappointment. As President Plosser pointed out, that was similar to our March disappointment, which seemed to be all right. I think it is important for us to understand how the economy will respond to a pause in rate-cutting when it does occur. With high food, energy, and commodity prices, the extended positive differential of headline inflation over core measures risks an increase in the public’s inflation expectations. I agree with President Plosser’s discussion of relative prices on that front.

    From a longer-term perspective, which we don’t really talk about very often, I worry about the asymmetric response of policy to high inflation as opposed to when it is low. When headline inflation is above core inflation, we take on board the relative price adjustment, and then we are content, I would guess, to bring inflation down to our perceived inflation targets. But on the downside, when inflation gets low, we become uncomfortable with certain low inflation settings, and so I fear that we would respond more aggressively, as we did in 2003, which really was a positive productivity environment. If you have an asymmetric type of response, you are going to take on board increases in the price level because of that asymmetry. That’s one reason that I am concerned about these types of behaviors. Although I expect emerging resource slack to temper any adverse inflation developments, the risk is simply growing in importance with every additional policy easing, compared with the economic risks, which presumably are abating as we respond to them with such easings.

    Calibrating the current policy stance against these divergent economic and inflation risks is important and challenging, as you pointed out yesterday, Mr. Chairman. I think that comparisons to the rate troughs in the previous cycles of recession policy are instructive. The current real fed funds rate is somewhere in the neighborhood of zero, or it could be lower if you choose a different way to deflate the funds rate by total inflation. I was very impressed with Dave Stockton’s response to my question about what types of factors from financial market stress are embodied in the Greenbook-consistent real interest rate. It seems as though a tremendous amount of care has been taken to introduce some of these special factors in innovative ways, and while they may not capture all facets of that, I thought that they did quite a good job. So I feel a bit more comfortable in making those comparisons, but I do recognize that it is a treacherous period.

    That said, this is about the same place the real funds rate bottomed out during the jobless recovery with financial headwinds in the 1990–91 recession, and with the data we had in hand at the time during the disinflation concerns in 2003. Both periods were unique in suggesting a high degree of accommodation, and the factors that were at work in each of those episodes were unique. Our attempt to incorporate these factors has been quite useful, and so it’s a reasonable, if not definitive, comparison. With our current lending facilities addressing financial stress, I think our current policy accommodation, now at 2¼ percent, is appropriately similar to those episodes.

    My final observation has to do with these end-of-cycle expectations and what they might mean for long-term interest rates. If 25 basis points is viewed as additional insurance against downside risks, I just don’t think this action is significant enough to have much of an effect. We expect to take back some portion of the aggressive cuts, especially the ones that have been an attempt to respond to the financial stress. If the financial stress is mitigated to some extent, we should be expected to take that back. Expectations, as in the fed funds futures market, should limit the effect of those actions on long-term interest rates. After all, by the expectations hypothesis, you are going to be averaging these short-term paths into long-term rates. That is one reason that the Committee injected the language “considerable period” back in 2003, to try to convince people that we would do this for a longer period of time and affect long-term rates. So if there is an expectation of some type of rebound, these last insurance cuts might not have that large an effect. Again, I think our lending facilities are better geared for the financial stress.

    I think we have clearly demonstrated our willingness to provide appropriately accommodative policies in a timely fashion when the economic situation demanded it. For me, the public’s expectation of these actions in that event argues against one further small insurance move. Because we are concerned about inflation risks and have indicated that we must flexibly move toward more-neutral policy stances once the economy and financial markets improve, a pause today is a small down payment on those difficult future actions. In terms of language, if it came to that, I would be comfortable with the language of alternative B with this particular rate action. Thank you, Mr. Chairman.

  • Thank you. President Lockhart.

  • Thank you, Mr. Chairman. I must say that I am sympathetic to the “hold” advocates and the view that we are already accommodative. I think an apt anecdote is a conversation I had in the past six weeks with a cruise line CEO who doesn’t know how to drive his ships but who has in fact been at the helm a couple of times. He said, “When you turn the wheel and nothing happens for several miles, the temptation to keep turning the wheel is overwhelming.” [Laughter] So I do have some sympathy. That said, I am going to support a reduction in the target rate of ¼ percent, effectively alternative B, as I indicated yesterday. I think it is pretty clear that we have a tradeoff between “a little more help to the economy” and “enough for now” and really some shift in our focus to combating inflation.

    So let me lay out my rationale for not holding. I think there is still substantial downside risk to the general economy, and it may take quite some time for recovery to materialize. A quarter would help slightly to effect a lower cost of borrowing and, therefore, would stimulate activity, although much of that is really beyond our control. It will be dictated by market forces. I think that halting today versus conceivably halting at the next meeting risks some interpretation as a lack of recognition of the real state of weakness in the economy.

    Regarding inflation, I think the core numbers in the first quarter were not overly discouraging, and I have to believe my own forecasts—in many respects, the forecasts I heard— that inflation will soften in the coming months and be consistent with our working view of expectations. I would say, however, that I am concerned that, in the minds of the general public, high prices actually translate into inflation, whether or not the rate of inflation has flattened.

    As I have suggested, I am inclined to pause after this move, provided that the incoming data are not too adverse and too divergent from expectations, but with the caveat that I think a lot of shock risk is still out there and we have to remain flexible to deal with surprises. Holding or signaling a pause may help the housing market a bit by starting to construct a bottom, as borrowers or buyers begin to perceive that they shouldn’t expect any further rate cuts from us.

    Regarding the statement, I think the rationale section in alternative B is appropriate to the situation that we face. Section 3 is a realistic acknowledgement of inflation trends and risk. I gather that, with the changes in section 4, the question was whether or not to signal a pause or an inclination to pause, and I tend to agree with a more cautious, less committal approach of the proposed language—what yesterday was called a “soft” pause. So I am, on balance, quite happy with the language in alternative B. Thank you, Mr. Chairman.

  • Thank you. President Stern.

  • Thank you, Mr. Chairman. Well, I have given serious consideration to both alternatives B and C, and I think a credible case can be made for either one. There are, of course, risks associated with adopting either one as well. On balance, I come out in favor of alternative B, for the following reasons. First, we are certainly not yet out of the economic woods. Although my forecast is for a relatively mild recession, I would not be particularly surprised if it turned out to be both deeper and more prolonged, given, among other things, the persistent overhang of unoccupied, unsold homes and the severity of the financial dislocations of the past nine months. As I have tried to emphasize, I think it could be dangerous to underestimate the effects of the financial headwinds now in train and likely, in my judgment, to get more severe. Second, and closely related to those observations, financial conditions remain quite sensitive. Even if improvement is now under way in some markets, I think it will be some time, as I said yesterday, before credit conditions are fully supportive of economic growth. To amplify a bit, I think we need to be a bit careful about the weight we put on the low level of the real federal funds rate per se for, as Governor Kohn pointed out yesterday, the credit situation is a good deal more complicated than that.

    My principal reservation about supporting alternative B has to do with the inflation outlook. The news here has not been uniformly bad, especially with regard to core inflation, but I am not convinced that inflation will abate in a timely way without policy action. On the other hand, I take some comfort from the fact that apparently financial market participants do not anticipate further reductions in the federal funds rate target beyond this meeting. I think the language associated with alternative B should help to reinforce the view that, at a minimum, a pause in the reductions in the target is not that far off, given what we know today. I think it important that we find opportunities to bolster that view when we can. Thank you.

  • Thank you. President Rosengren.

  • Thank you, Mr. Chairman. There seems to be a groundswell of opinion in financial markets, and perhaps around this table, that given the easing to date we are at or close to a point where we should pause and assess the impact of both fiscal and monetary stimulus already provided. Should we pause at a fed funds rate below 2 percent, at 2 percent, or over 2 percent? The Greenbook forecast assumes that we pause at 1¾ percent. With this degree of stimulus, core and total PCE inflation is at or below 2 percent in 2009, but the unemployment rate remains well above the NAIRU, even at the end of 2010. The Boston forecast generates similar outcomes. The Greenbook and the Boston forecasts suggest that 25 basis points at this meeting may not be enough. Both forecasts imply that a significant degree of slack remains in the economy, even with a 25 basis point reduction at both this and the following meeting. In addition, there are significant downside risks to the outlook. Falling asset prices in other countries have frequently been accompanied by prolonged periods of weakness. Finally, given the rise we have seen in the LIBOR rate, for many borrowers a 25 basis point decrease leaves policy no more accommodative than at our last meeting.

    The consensus seems to be that we should be moving in smaller increments. But if we choose option B, it is not at all clear to me that we should pause after this meeting. In that regard, I was happy to see the revised language in the Bluebook table 1, which does not imply that our easing cycle has definitely ended. While I hope that the economy recovers sufficiently that further easing is not necessary, we need to remain flexible, particularly given that our models indicate that even with further easing we are likely to experience several years of elevated unemployment rates. Thank you.

  • Thank you. Governor Kohn.

  • Thank you, Mr. Chairman. I think I can be brief by just associating myself with the comments of President Stern. This is a difficult decision. You could make a case for either of these. But on balance, I think we should be lowering interest rates 25 basis points, as under alternative B. As President Stern said, I don’t think just subtracting past inflation from the nominal federal funds rate is a good metric for where the stance of policy is today. It would be if financial conditions were consistent with historical relationships, but they’re not. We have very tight credit conditions in many sectors of the market, and a zero or negative federal funds rate means a very different thing today than it did even in the early 1990s, Gary, because then you had the banking system broken but the securities markets working. Now you have the banking system broken and the securities markets not working very well. So I think we have stronger—I guess Greenspan called them “50 mile an hour”—headwinds. I would say they are 60 or 70 today, at least for now.

    We expect the headwinds to abate; and as they abate, policy will look a lot more accommodative. But I don’t think we really have insurance right now against the contingency that the headwinds don’t abate very quickly or even get worse, or against the contingency that the staff is right and we are entering a recessionary period in which consumption and investment fall short of what the fundamentals would suggest. I think that 25 basis points probably won’t buy us much, if any, insurance, but it will get policy calibrated a little better to the situation that we are facing today. I expect a small decrease in the funds rate to be consistent with further increases in the unemployment rate—and everybody does, I think, judging from the central tendencies of the forecast—which will put downward pressure and help to contain inflation. I agree that there is an upside risk from continued increases in commodity prices that feed through, as President Plosser noted, into core inflation.

    I think that this is a very different situation from the 1970s. I looked this morning at the Economic Report of the President, at those tables in the back. The stage for the 1970s was set in the 1960s. Core inflation rose from 1½ percent in the mid-1960s to 6¼ percent in 1969. That’s a situation, obviously, in which inflation expectations can become unanchored, and then these relative price shocks feed through much more into inflation expectations. Looking in the Greenbook, Part 2, page II-32, every measure of core inflation for 2007 was lower than the measure of core inflation for 2006, and half of them—these are Q4-to-Q4 measures of core inflation—are lower than for 2005. So we are not in a situation of a gradual upcreep in core inflation, which I think was what set the stage for the 1970s.

    I don’t expect a small decrease in interest rates to result in higher inflation through this dollar–commodity price–inflation expectations channel either. The decrease in interest rates is already in the markets. If anything, a statement like alternative B might firm rates a bit; and taking out “downside risks” and “act in a timely manner” reinforces the notion that the Federal Reserve is not poised to ease any more. I wouldn’t expect interest rates to go down; therefore, I wouldn’t expect the dollar to go down, and I wouldn’t expect commodity prices to go up from this.

    I think the markets reacted very well over the intermeeting period to incoming data. They saw the tail risk decrease. They raised interest rates. The dollar firmed. They put a U shape in our interest rate path. It seems to me that path is very close to what many of us said we expected and thought was appropriate, give or take ¼ point, for the federal funds rate over the coming couple of years. I don’t see any reason to act in a way that changes those expectations; I think the market expectations are fine. I wouldn’t lower interest rates ¼ point just to confirm market expectations. I think it is the right thing to do, and I don’t see any reason to lean against it to change expectations. I think that expectations are lined up pretty well with our objectives. Thank you, Mr. Chairman.

  • Thank you. President Fisher.

  • Well, Mr. Chairman, I was listening very carefully to Governor Kohn, as I do the rest of my colleagues. I noted your comment that it doesn’t buy us much. I’m worried that it may cost us much. Had I gone first, I would have made arguments similar to those of President Plosser and President Evans. I am in favor of a pause. I think that is pretty clear. I want to stress a couple of things I mentioned yesterday because I think they’re important. I am concerned about our costs regarding what I call a different kind of adverse feedback loop, which is the inflation dynamic whereby reductions in the fed funds rate lead to a weaker dollar and upward pressure on global commodity prices, which feed through to higher U.S. inflation and to cutbacks in consumption by consumers and actions by employers to offset the effects of inflation. I quoted a CEO, whom I consider to be very highly regarded, regarding his company’s behavioral patterns. This is someone, by the way, who was in the business in the 1970s. He said, “We’re learning to run a business, once again, in an inflationary environment.” That quote bothers me because it shows a behavioral response. This goes beyond the issue, but I thought that comment you made yesterday about relative prices, Mr. Chairman, was very interesting. But it shows a behavioral response, and behaviors eventually become habits, and habits become trends, and I’m worried about that.

    There was a period when I felt that we were at risk of a repetition of the 1930s. I think the liquidity measures that we have taken—which I have fully supported, and I applaud you, Mr. Chairman, and the New York group for thinking these through with the staff—have provided the bridge that we spoke of yesterday. Don, you mentioned the 1970s. I am no longer worried about the 1930s, although I think there are tripwires out there that are very, very serious. You pointed to them in your intervention. You are right; under Bill Martin these pressures were put in place. But somebody mentioned yesterday—it may have been Vice Chairman Geithner—that he wasn’t around in the 1970s. I actually sat by President Carter’s side when he got lectures from a left- wing socialist named Helmut Schmidt and by a right winger named Margaret Thatcher. Their points were that you cannot risk appearing to be complacent about inflation. I worry that we risk appearing to be complacent about inflation. I am speaking within the family here, but I sense that we are giving that appearance on the outside. The question really is, Is it worth ¼ point? What is the risk–return tradeoff here? I don’t think it’s worth cutting ¼ point. I think it is worth staying where we are.

    I know that the markets anticipate X or Y. We had a conversation about that yesterday. I made my living in the markets. The markets come and go, and I am happy to hear Governor Kohn say that we are not influenced by the markets. I don’t think we should be. Their reactions are momentary. But I just don’t feel the risk–return tradeoff makes it worthwhile for a ¼ point cut here unless we saw evidence of substantial downside slippage beyond what we are all discounting for housing, which is very negative. I have spoken about a price correction of 35 percent from peak to trough, and we’re not there yet. It would have to be more negative than that to convince me to cut rates further. So, Mr. Chairman, I respectfully submit that we should pause, and that’s how I plan to vote. Thank you, Mr. Chairman.

  • Thank you. President Yellen.

  • Thank you, Mr. Chairman. I favor alternative B with the wording that has been proposed. But I do appreciate that there is a case for alternative C as well, and I understand and appreciate the arguments that have been made in favor of it. On the pure economic merits, I definitely support a 25 basis point cut. As I noted in my comments on the economic situation, it appears that the economy has stalled and may have fallen into a recession. I share the same concerns as Governor Kohn and President Stern. My forecast is close to the Greenbook. I think a further easing in financial conditions is needed to counter the credit crunch, and I believe that a cut in the federal funds rate will be efficacious in easing financial conditions.

    Although the real federal funds rate is accommodative by any usual measure of it, I completely agree with Governor Kohn’s discussion of this topic. This is a situation in which spreads have increased so much and credit availability has diminished so much that looking at the real federal funds rate is just a very misleading way of assessing the overall tightness of financial conditions. I consider them, on balance, to be notably tighter than they were in the beginning of August. I don’t agree that further cuts in the federal funds rate will be ineffective in helping us achieve our employment goal or counterproductive to the attainment of price stability over the medium term. Given that a 25 basis point cut is what the markets are now anticipating—it is built in—I would not expect this action, coupled with the language in alternative B, to touch off further declines in the dollar or to exacerbate inflationary expectations.

    That said, I did see arguments in favor of alternative C as well. I can see some advantage in doing a little less today than markets are expecting as long as we reaffirm that we do retain the flexibility to respond quickly to further negative news with additional cuts. A case that could be made for pausing is that we will soon get information relating to GDP in the second quarter and get a better read on just how serious the downturn is. With respect to market and inflationary psychology, I also can see a case for doing less than markets expect. It is true that some measures of inflation expectations have edged up a bit, and I would agree with President Fisher that perhaps a pause would counter any impression that we have become more tolerant of inflation in the long run. But I don’t think we have become more tolerant of inflation in the long run, and I did see today’s reading on the employment cost index as further confirmation that at this point nothing is built into labor markets that suggests that we are developing a wage–price spiral of the type that was of such concern and really propelling the problems in the 1970s. On the other hand, I agree with President Plosser, too. Wages aren’t a leading indicator. We have to watch inflationary expectations. So I don’t think that is definitive. Nevertheless, I do find it quite reassuring that nothing is going on there at this point.

    I think doing nothing today might mitigate the risk of a flight from dollar assets, which could exacerbate financial turmoil. So there are arguments in favor of alternative C, and I recognize them. But, on balance, I believe that the stronger case is for B.

  • Thank you. President Bullard.

  • Thank you, Mr. Chairman. The FOMC is badly in need of a stopping rule on the federal funds rate. Continued reaction to bad economic news—and there is likely to be bad news in the coming months—is going to set up serious future problems for this Committee. The fragile credibility of the Committee is being eroded as we speak, and we will do well to take steps to reassert inflation-fighting resolve at this meeting.

    The intuition in dealing with the current crisis is that we can use new lending facilities to help return financial markets to more normal operation and that interest rate policy is not that likely to help on this dimension. But exceptionally low rates can create new problems. Since lower rates are not really helping directly with the smooth operation of financial markets, I suggest that we put that on hold for the time being and let our past, stunningly aggressive, interest rate moves have an effect through the summer and into the second half of the year. This would be consistent with alternative C in the policy alternatives.

    Many participants have emphasized that there will be a long unwinding process. The Chairman described us as being in the third inning on this, similar to the late 1980s and early 1990s. During that episode, the Fed went on hold at 3 percent, considered an exceptionally low rate at the time. That gave financial markets a chance to heal following the S&L problems without creating other problems for the mid to late 1990s. In retrospect, this policy worked quite well during that era, and it seems to me that something similar could be done today at the current level of the federal funds rate. Thank you.

  • Thank you. President Hoenig.

  • Mr. Chairman, I’m glad that reasonable people can differ. I do continue to hold the view that easing policy today is a mistake. If I were voting on it, I would vote to hold where we are. With the fed funds rate at the level it currently is, I think that continuing to ease policy in an environment of rising inflationary pressures gives serious erosion to our long-run credibility. We are seeing increasing signs that inflation expectations are rising. I see it constantly, as the public’s inflation psychology is changing as well. This change reflects the large, sustained now, increases in food, energy, and other commodities and accelerating import prices. I am concerned that maintaining at this highly accommodative policy level for an extended period, while it may bring some short-run stimulus into the economy, increases inflationary risk to an unacceptable level, which will, over the not-too-distant future, begin to distort long-run investment decisions and continue to increase the risk of financial instability and imbalances in the longer-run. Finally, on the psychology of the markets, holding rates constant, although it might disappoint some on Wall Street, will please many, many on Main Street. I judge that it will confirm to the world that we are turning our attention to these longer-run issues, and I’m disappointed that we’re not seizing the opportunity to make that statement. Thank you

  • Thank you. President Pianalto.

  • Thank you, Mr. Chairman. My concerns about the real economy are similar to those that I had in March. I continue to believe that residential real estate markets could deteriorate even further than what I have in my baseline projection and could exert even greater downward pressure on business activity. Financial markets in my view are still fragile, and larger or more-widespread liquidity pressures could quickly present us with an even weaker set of economic fundamentals. At the same time, I can’t easily dismiss the ongoing escalation of energy and commodity prices. Although many of us, as we talked about yesterday, have expected these price pressures to abate for some time, they have not; and as I indicated yesterday, I do believe there is a risk that core inflation will not follow the downward path that I submitted as my projection for this meeting. So like others, I can see a case being made for alternative C. However, I think a modest reduction to our policy rate today as a precaution against further slippage in the real economy is prudent. But I also strongly support the language that indicates we’re very close to, if not at, a pausing point in our easing cycle. So I support the policy recommendation and the language in alternative B. Thank you.

  • Thank you. President Lacker.

  • Thank you, Mr. Chairman. I find myself agreeing with my colleagues who have advocated alternative C. One way to think about our approach to the policy decision today is to look ahead and think about the probabilities associated with two bad outcomes. Will the economy go into a substantially deeper recession than we expect? Or coming out of this recession, will the trailing inflation rate be higher than it was when we went in? Although I hope neither of these occurs, my sense right now is that the chance of an increase in trend inflation is more likely than a much deeper recession, and I think we should alter our policy path accordingly.

    The incoming data since the beginning of the year have resulted in a more adverse outlook, and that change in the outlook is already, in my view, reflected in the current stance of policy. I noted yesterday that the real federal funds rate using the Greenbook’s inflation forecast rather than four-quarter lagged core inflation is now between minus ½ and minus ¾ percent. I think it makes sense to take advantage of information about foreseeable gaps between overall inflation and core, and the stance of policy strikes me as very stimulative, certainly plenty for the recession we now expect, when we look at back historical recessions. As I noted yesterday, at the retail level for firms and consumers, spreads aren’t out of line with where they’ve been in past recessions. It is true that jumbo mortgage rates and some other rates have not come down as much as they’ve come down in past recessions, but I just remind people of the secular technology shift. There’s a sort of level shift in intermediation technology that we’re going through right now that really constitutes a change in the relative prices of different financial assets.

    Now, I can’t think clearly about the stance of policy without talking first about the risk-free rate and then thinking about various spreads as really having to do with the relative prices of different financial claims. So in looking at and through retail rates, that’s informative. But the risk- free rate is the risk-free rate, and an array of factors affects how those relative financial prices evolve. The securitization channel that seemed to work very well for a while is now exposed as more costly and less efficacious than once was thought. Some of these securitization vehicles didn’t exist in past recessions or expansions, and only a couple of decades ago these spreads were as high as or higher than they are now. So I stick to thinking about the stance of monetary policy in terms of the real risk-free rate.

    I think our experience between the January and the March meetings with inflation expectations is pretty good evidence of their fragility in the current environment without our having articulated what our long-run objective is for inflation. I don’t think that the level of inflation expectations is aligned with our objectives; I think it is too high relative to our objectives. Market participants see a good chance of our dropping the rate ¼ point today and reversing field later in this year and raising rates again. I suspect they don’t fully grasp how difficult it’s going to be to reverse course while we negotiate the murky waters of the recovering economy later this year. Indeed, I think that the fiscal stimulus that we’re going to get will make those waters even murkier. It will be even harder to divine the underlying, ex-fiscal-policy strength of the economy.

    So for these reasons, I believe that we should leave the fed funds rate alone today. The upward surprise at our last meeting did not appear to affect financial markets adversely. Coupled with that statement’s emphasis on inflation risks, it did seem to have the beneficial effect of reversing the run-up in inflation expectations. I would expect that leaving the funds rate alone today would have a similar beneficial effect in stabilizing inflation expectations. So I favor alternative C, Mr. Chairman.

  • Thank you. Governor Warsh.

  • Thank you, Mr. Chairman. I can support alternative B, but I must admit I can’t do it with the conviction that I would prefer to have. I think market participants will look at our decision today and at the data over the next few weeks and try to measure whether we can hold up to the pause language that accompanies alternative B. Taking action with a 25 basis point move today, we have to then be prepared to stomach the continued weakness in the real economy that is in many of our projections. Speaking for myself, I’d say we also have to be prepared when we next meet to hold the line even if we see a retracing of some of the improvements in financial markets. So in my own base case, the judgment when we next meet will be a harder one. The economy might look weak; financial markets might look weaker than they are; and trying to signal to the markets in alternative B that we are serious about holding the line at what would then be 2 percent is putting a pretty hard task on us. I think we’re capable of holding the line there, but we have to hold ourselves to that standard.

    The 25 basis point move, in and of itself, doesn’t strike me as that consequential. What strikes me as consequential is the symbolism. Given the uncertainties that Dave and the team have spoken about, it strikes me that the 25 basis points is not nearly as consequential in effect as what might well happen to the transmission mechanism and the efficacy of this change in federal funds rates on the real economy. Put differently, if the financial markets can get back to business, they will be helping the real economy, in effect lowering the cost of capital far more than our actions would today.

    As I said, I think the symbolism here does matter. By moving 25 basis points today, we’re taking some risks with the dollar. I think that the dollar improvement we have seen over the past several days and weeks has occurred because there’s an expectation that we are closer to a pause and that this Committee is going to have a tougher decision about whether or not to move than they had anticipated some weeks ago. Even though the language in alternative B is useful in trying to lay the factual predicate for a pause when we next meet, there will be a lot of folks who will be wondering about our convictions there, and when they do, I think we are assuming some dollar risks. We are also assuming incremental risks on the inflation front. Continued easing could well encourage the perception that the FOMC has a greater tolerance for inflation than is prudent, with potential adverse effects on inflation expectations, a further run-up in commodity prices, and a continued decline in the foreign exchange value of the dollar.

    So this is a tough judgment that we’re making, with significant uncertainty. I take comfort in believing that the language in the minutes and the remarks that we all offer between now and the next time we meet will suggest not that this is a cut with a dovish pause but that this is a cut with an expectation of holding after our actions today. We are not barring all events because we can certainly imagine the world turning yet again and we can certainly imagine another let-down, particularly in the global economy. But this is a statement that we want to hold after our action today and that we are prepared to stomach some additional bad news with respect both to the economy and to financial markets. Thank you, Mr. Chairman.

  • Thank you. Governor Kroszner.

  • Thank you, Mr. Chairman. As many speakers before me have said, this is a pretty close call, and reasonable cases can be made for both alternative B and alternative C. If you look at financial market conditions, you can see your favorite indicator and say whether things have eased or not eased. One indicator that I look at when thinking about the transmission of monetary policy is the LIBOR–OIS spread, which has gone up very significantly. A lot of short- term borrowing is priced off of that. If we wanted just to keep policy where it was six weeks ago, we would actually have to cut more—not that I’m suggesting that we should. But if you use that spread as the relevant indicator, it would suggest that, if one were to keep the same stance, or potentially the same stance, of monetary policy, you’d have to cut a lot. It doesn’t seem as though our liquidity facilities have been effective on this particular dimension. We had been hopeful that they would be, but they don’t seem to be. Even with some of the things that we voted on yesterday, we’re still going to see very elevated spreads in some of these markets, still making borrowing costs relatively high and so disrupting the traditional monetary transmission mechanism. So that’s where I would argue for alternative B.

    Another argument for alternative B is the potentially protracted slowdown. I agree very much with President Stern. As I’ve talked about a lot before, this sort of slow burn is related to the housing market. The repair and recovery of those markets is going to take a long time. The spreads are still quite elevated in a number of these markets. So providing more cushion against the downside risk there for those markets and then thinking about how that risk affects the potential for broader downside risks, in which the housing market seems to be a potential trigger point for negative nonlinear dynamics, again suggests that moving down 25 basis points now is prudent.

    The key, of course, that people have been talking about is inflation pressures going forward—inflation expectations. Here a case can be made on either side with some cogency. One challenge we have right now is that we have a lot of differences in the way to read inflation expectations. Looking at the five-year-ahead versus the five-to-ten-year-ahead, we’ve seen them spread apart quite a bit and now start to come back together, with the next five years starting to move up but the five-to-ten-year-ahead moving down. We have a number of other measures of expectations, some of which have moved up quite significantly but maybe primarily because of some relative price movements rather than underlying inflation trends.

    One thing that is comforting for me on the alternative B side is that during the last year to 18 months, when we have had very low—below 5 percent—unemployment rates, we have seen very little evidence of high wage pressure. I find it unlikely that it is going to increase as the unemployment rate goes above 5 percent, and I think, as many people around the table do, that unemployment may sustain itself above 5 percent for quite some time. We also haven’t seen some of the real shocks to energy and commodity prices feed through to core. Now, that still could be coming. But we’ve seen very elevated prices in these areas for quite some time—six to nine months—and the most recent readings from the PCE index suggest that they haven’t fed through. Maybe that is still to come, and I think to be worried about that is reasonable. It is also reasonable to be worried about implications for the dollar if we were to go for alternative B rather than alternative C.

    But the language in alternative B can provide some comfort to the markets that we are unlikely to be pushing much further, given what we see and what we expect, but that we are open to that possibility. We certainly have a very long time between this meeting and the next meeting. We’re going to be getting two employment reports, GDP, and a lot of other information, so we may need to revisit some of these issues. But at this point I would come down for alternative B with the language that we have. I think it gives us the appropriate flexibility, and I don’t see sufficient evidence of an unhinging of inflation expectations or actual inflationary pressures, at least with respect to core, to say that we need to take a pause now. Thank you, Mr. Chairman.

  • Thank you. Governor Mishkin.

  • Thank you, Mr. Chairman. Well, I’m in a very uncomfortable position here because I usually like to be very decisive, and I think in all past cases I’ve had a strong view before going into the meeting in terms of what is the appropriate alternative that the Committee should take, at least that I should take. I’m in a very uncomfortable position because I’m actually sitting exactly on the fence between alternative B and alternative C. As you know, sitting on the fence and having a fence right in that anatomically uncomfortable position is not a good place to be. [Laughter] So let me go through the current situation and argue why I’m in this uncomfortable position.

    The first point to make is that inflation expectations are actually reasonably well contained. It is true that I have a concern that high headline inflation could make containing inflation expectations and preserving the nominal anchor more difficult. But it is important to note that we have been in a situation in which we’ve had very high headline inflation and, in fact, core inflation and inflation expectations have behaved very well. So it’s very important to emphasize that this is not the 1970s, and I really get disturbed when people point to that as a problem. We do have to worry about inflation expectations possibly going up, but it’s not a situation that, if we make a mistake, they go up a whole lot. They could go up, and it might be costly to get them down, but it would not be a disaster.

    The second issue is that, although we may have turned the corner, we are still in a situation of very fragile financial markets, and we have been disappointed before. I am getting more optimistic. I’m hopeful and think it’s very possible that we’ll look back at the middle of March and say that was the worst of it. But there is a possibility, and it’s not a small possibility, that things could go south again, and that would argue for the need for aggressive cuts in the future.

    The third thing that I point out about the situation is that the modal forecast given by the Greenbook—and consistent with my modal forecast and with the modal forecasts of most of the participants—suggests that we may have to cut a bit further in the future. So the problem is that, given the conditions that we face, we need a lot of flexibility to deal with potential downside risks. I think the downside risks have diminished, but they could go back up again. So there could be a situation in which we need to ease aggressively in the future. Of course, we’ve convinced the markets that we are non-gradualists, but so far we’ve been non-gradualists in only one direction, which is to ease. In fact, we’d like to be in a situation where we could aggressively ease in the future if we had to but not risk having inflation expectations go up. That’s a very serious problem that many participants have pointed out.

    So how would I like the markets to perceive us? Well, I’d like the markets to perceive us as being willing to be very aggressive in terms of easing, if necessary; but I’d also like them to perceive us as having the Volcker characteristics of being six feet, six inches, tall and having a big baseball bat and, if inflation and inflation expectations are starting to unhinge, being willing to take out the baseball bat and do whatever is necessary. You really would like to position yourself to have those characteristics.

    So let me first talk about the case for alternative C of not changing and then go to the case for alternative B. In the case for C, the advantage of pausing at this point is that it would actually indicate to the markets by our actions that we’re serious about keeping inflation under control and that it’s more likely that we would bring out the baseball bat. In that sense, it could enhance credibility, and a very important, positive element of that is that it would be easier for us to be flexibly aggressive if we needed to be so in the future. That is one reason that I think there is a strong case for alternative C. But I also think there is a strong case for B. First, the evidence that inflation expectations are unhinged or are likely to get unhinged is not very strong. I do not put a lot of stock in consumer surveys. But I tend to look at financial markets as being the canary in the coal mine. Though being a New Yorker, I actually have been in a coal mine [laughter] – at the Museum of Science and Industry in Chicago. It’s really cool. All of you should go there someday when you go visit Charlie.

  • But he has never seen a canary. [Laughter]

  • I have seen a canary. But the key is that the canary has not keeled over. In fact, if you look at what’s going on in the financial markets, the concerns in terms of inflation compensation have dissipated somewhat. I think the fact that they were moving up is an indication of greater inflation risk. They’ve come back down again. I don’t think that should make us complacent, but I do think it tells us that we haven’t seen anything really bad happen at this stage.

    So the question is why we should cut now and go with alternative B rather than C. Well, first, I think the modal forecast suggested that a cut is in line with optimal monetary policy, and I think that’s an important argument. It is particularly so because there is a very strong likelihood that, even though I’m a little more confident that the recession that we’re probably in now will be very mild, if it’s even a recession at all—I think it is likely that we’re in a recession but a mild one—the recovery actually is going to have a lot of the characteristics of the recovery that we had in the 1990s because it’s just going to take a long time to clean up this mess. That again argues for a cut. The other issue that I think is important is that there is a very long period between now and the next FOMC meeting. Given that the modal forecasts indicate that things are likely to get worse in the economy in this quarter, there is an issue that, if we get bad news, then we might regret not having cut now, and I’m not a big fan of intermeeting cuts. That would be another argument for cutting now.

    I guess the bottom line is that I’m just in a very uncomfortable position in that I dislike being not very decisive here. One thing that has helped me a lot in being comfortable with alternative B is that the language has changed quite significantly from the initial wording. I was not happy with the idea that, if we suggest that there will be a pause in the future, it would be time dependent. It should be clearly data-dependent. If it were time-dependent, we would get into exactly the problem that Charlie Evans talked about: We want the flexibility of saying that what we’re doing is dependent on data, not time, because if people know that you’re going to reverse things later on, it doesn’t have the impact. I think that is an important change here. So I’m quite comfortable with the language of alternative B. I’m willing to support B. It looks as though that is the consensus, and my view today is that I’m going to go with whatever the consensus is. Thank you very much.

  • Thank you, Mr. Chairman. The transcript says, “Mishkin says canary wheezing but hasn’t keeled over.” [Laughter] I support alternative B. I think you could frame this as a modest recalibration of policy with a hawkish soft pause.

  • And a wheezing canary. [Laughter]

  • I don’t think the canary is wheezing. Look, I think there are lots of good arguments on both sides of this. I think all the good ones have been made. The markets have been giving us a pretty good test against the concern, which I think we all share, that if we move today we risk some significant erosion of our inflation credibility or inflation expectations feeding through the dollar into a commodity price spiral. We have had a pretty good test of it. Over the past several weeks, there has been a very substantial shift in expectations for the path of the fed funds rate, which embody substantial expectations around a near-term cut and very little beyond that and some modest retracing as we go forward. Expectations have come down despite what has happened to oil prices. Inflation has come down. The dollar is stronger on net over that period. This is pretty good validation that the path that is represented in alternative B does not come with excessive risk that we will be eroding our credibility. We can’t know for sure. It’s good to be worried about that risk, but the protection against that risk is fairly good.

    What strikes me about this discussion is the extent of the gap in this Committee in how we think about the way to measure the stance of monetary policy. What we could do is use a seminar and a bit of history on this. It would be nice to run monetary policy back over the past four decades to see, if it had been set with a basic policy regime in which we looked only at the real fed funds rate deflated by headline inflation today, what the outcomes would have been for the economy at that time. That’s essentially what you guys are saying. It seems to me that you are basically saying that equilibrium doesn’t vary and that deflating the nominal fed funds rate with some mix of headline and core today is the best way to judge the stance of policy. But I think it’s worth having a little exercise in it. It is hard to look back.

  • Excuse me. Make sure that you say you’re speaking for yourself, not for me, in terms of how I think about policy.

  • Okay, but it is a surprising gap. So I think it would be worth some time to think through that. Obviously we also disagree about how inflation works in the United States, how relative price shocks take effect, and what we should respond to in that sense. That would be worth a little time, too. Again, it is a surprise to me. We sit here to make monetary policy, and we haven’t talked much about this basic core question: How should we judge the stance of policy? It would be worth some attention.

    I just want to end by saying something about the dollar. My basic sense about the dollar— and I’m very worried about this dynamic now—is that it has been trading more on concern about tail risk in the economy and in the financial system than anything else. As I said yesterday, if you look back to when there has been an increase in perceived tail risk, however you want to measure it—credit default swaps on financials or something like that—and the two-year has fallen sharply or we have had a big flight to quality, those have been the periods that have been most adverse to the dollar. Now, it is not a consistent pattern, but I think it’s basically right; and I think it gives an important illustration that what goes into a judgment about whether people hold dollars and U.S. financial assets has to do with a lot of things. It has a lot to do with confidence that this Committee will reduce the tail risk in the financial system and the economy to tolerable levels. It also has a lot to do with confidence in our willingness to keep inflation stable over a long period, but it’s not only that. Again, we have had a pretty good experiment in that proposition over the past year or so.

    My sense is that the biggest risk to the dollar, since I’m pretty confident that this Committee is going to make good judgments about inflation going forward, is in the monetary policy of other countries. The real problem for us now is that we have a large part of the world economy—in non- China, non-Japan Asia and the major energy exporters—still running a monetary policy that is based on the dollar as nominal anchor. That has left them with remarkably easy monetary policy and a pretty significant rise in asset-price inflation. The transition ahead for them as they try to get more independence for monetary policy and soften the link to the dollar is going to carry a lot of risk for us because the market is going to infer from that a big shift in preferences for the currencies that both governments and private actors in those countries hold. As that evolution takes place in their exchange rate and monetary policy regimes the risk for us is that the market expects a destabilizing shift in portfolio preferences, which people might infer is also a loss of confidence in U.S. financial assets. I think that’s a big problem for us. It’s not clear to me that it means that we should run a tighter monetary policy against that risk than would otherwise be appropriate because I don’t think it buys much protection against that risk. I just want to associate myself with all the concerns said about the dollar in this context. The judgment that goes into confidence and people’s willingness to hold U.S. financial assets is deeply textured and complex, and it has a lot to do with confidence in this Committee’s capacity to navigate the perilous path between getting and keeping down that tail risk and preserving the confidence that inflation expectations over time will stay stable. So I support alternative B and its language.

  • Thank you all. The discussion was very good as usual, and let me just assure you that I listened very, very carefully. So I’m certainly hearing what you’re saying, and I understand the concerns that people have expressed. I play Jekyll and Hyde quite a bit and argue with myself in the shower and other places. [Laughter] Let me first say that I think we ought to at least modestly congratulate ourselves that we have made some progress. Our policy actions, including both rate cuts and the liquidity measures, have seemed to have had some benefit. I think the fear has moderated. The markets have improved somewhat. As I said yesterday, I am cautious about this. There’s a good chance that we will see further problems and further relapses, but we have made progress in reducing some of the uncertainties in the current environment.

    I also think that there’s a lot of agreement around the table—and I certainly agree—that we have reached the point where further aggressive rate-cutting is not going to be productive and that we should now be signaling a willingness to sit, watch, and listen for a time, for two reasons. First, risks are now more balanced. That is, there is more attention to inflation risks and dollar risks, and although our output risks remain quite significant, the balance is closer than it has been for some time. Second, given that we have done a lot in a short time and moved aggressively and that we’re seeing fiscal actions coming in and perhaps other policy effects as well—lagged effects of our own actions— it seems to be a reasonable time for us to pause, to watch carefully, and to presume that we’re not going to move unless conditions strongly warrant it. So I think that, at least in that broad respect, there’s a lot of agreement around the table.

    The two alternatives that have been discussed by most people are B, which is to move 25 basis points today but to send a fairly strong signal of a preference to pause after this meeting, and C, which is not to move but to keep some elements of the downside risk alive in our risk assessment. Like a number of people, I think both are plausible. Both have appeal. Alternative C, in particular, has the appeal of pushing back against some critics on the inflation side who have criticized us for not being sufficiently attentive to the dollar, to commodity prices, and so on. As I said yesterday, I think that inflation is an important problem. It’s a tremendous complication, given what is happening now in the other parts of the economy. In no way do I disagree with the points made by many participants that inflation is a critical issue for us and that we have to pay very close attention to it. As I said yesterday, I do think that some of the criticism that we are getting is just simply misinformed. I don’t think there’s any plausible interest rate policy that we can follow that would eliminate the bulk of the changes in commodity prices that we’re seeing. I think they are due mostly to global supply-and-demand conditions. A small piece of evidence for that is that yesterday the ECB was mentioned favorably as having the appropriate inflation attitudes compared with our attitudes. I would just note that headline inflation in the euro zone is about the same as it is here, despite their stronger currency, because they are being driven by the same global commodity prices that we are.

    I would also say that, although the inflation situation is a very important concern, I don’t see any particular deterioration in the near term. Since the last meeting, oil prices have gone up, which is very high profile, but gold, for example, has dropped about 12 or 13 percent. Other precious metals are down. Some other commodities are down. The dollar is stronger. TIPS breakevens have moved in the right direction. Wages, as we saw this morning, are stable, and I would urge you to compare wage behavior over the past five years with wage behavior during the 1970s. Wage growth then was not only high but also very unstable and responsive to short-term movements in headline inflation. So I think the canary is still getting decent breath here. [Laughter] I want us to be careful not to overpromise. We cannot do anything about the relative price of gasoline, and I don’t think that we’re on the edge of an abyss of the 1970s type. I do think it’s an important issue, and I do think that there is benefit to pushing against the perceptions. In this business, perceptions have an element of reality to them, and we understand that. That’s an important part of central banking, and I fully appreciate that point. So again, I see a lot of merit in the alternative C approach.

    As I think you can conjecture, I’m going to recommend alternative B—25 basis points but with a stronger indication of a pause. Let me discuss why in the end I come down on that side. First is the substance, the fundamentals. I don’t think that 25 basis points is irrelevant. For example, one-month LIBOR is up about 35 basis points since our last meeting. These short-run financing costs do matter, particularly in a situation of financial fragility. So it is not just an issue, as President Evans mentioned, of long-term interest rate expectations. Overnight and short-term financing costs do matter for the financial markets, and a lower rate will help the markets to heal. It will affect other rates. To take an obvious example, it affects the adjustable rate that mortgages move to in the economy. So I think there’s a case to be made on the substance. I will not add much to the discussion about how we define “accommodative.” But one way to do it, I guess, is to look at the Greenbook’s very thorough analysis, which rather than using rules of thumb attempts to look at a broad forecast conditional on what the staff can ascertain about the financial drags that we’re seeing. Their analysis suggests that something around where we are or a little lower is consistent with slow economic growth but also price stability within a relatively short time. That is one way of trying to calibrate. Obviously, there are other ways as well.

    The second point I’d make, besides just the substance, is the consistency with our own projections. Virtually everybody around the table still thinks that the downside risks to growth are significant, and we’ve mentioned the same factors—financial conditions, housing, and a few other things. Those remain very serious downside risks. I don’t think anybody thinks they are under control at this point. Yes, we also see an increased number of people with upside risks to inflation. But again, in terms of the numbers we’ll publish, I think the downside risks are still held by more people than the inflation assessment. That, by the way, suggests why we can’t really do what President Plosser suggests—hold and move to the alternative B, paragraph 4, language. Not to move and to say that the risks are balanced would, I think, be clearly inconsistent with the risk assessments that are in the projections.

    The other issues have to do with communications. We are at an important transition point in our communication strategy. One of the risks that we took when we made the very rapid cuts in interest rates earlier this year was the problem of coming to this exact point, when we would have to communicate to the markets that we were done, that we were going to flatten out, and that we were going to a mode of waiting. It was always difficult to figure out how that was going to work in a smooth way. Whether through luck or design, market expectations have set up perfectly. I mean, basically they’re now assuming a flat path going forward, with some increase later; and that appears to be consistent, as Vice Chairman Geithner noted, in the last few days with significant dollar appreciation, declines in commodity prices, and declines in inflation expectations—all the things that we want to see. It appears that we’re in a position that had seemed really problematic some time ago, so we are now able to make the transition in a way that will be relatively clear and, I hope, not too disruptive.

    Now, I want to come back to the issue of disappointing markets. I agree with President Fisher and many others that disappointing markets can be a good thing. It is certainly not always a bad thing, by any means. I think the issue is a little more subtle than that. The issue here is the clarity of what we’re trying to say and the way our message is going to be read. Let me make two points about that. If we were to do alternative C, I think there would be essentially two issues. One is that, although we would not be moving, which would be a surprise, we would also not be declaring a pause because of downside risk, which would be another surprise. We’d have a surprise both in the action and in the statement. The risk there is that we confuse the markets about what our intentions are and what would cause us to respond. For example, the Greenbook’s projections of Friday’s employment numbers are somewhat more pessimistic than those being held in the market. If we took action C today and Friday’s numbers were consistent with the Greenbook forecast and with our own projections but worse, significantly worse, than the market expectation, would statement C then lead to the building in of additional ease? I think there would be a lot of confusion there—a lot of uncertainty about what exactly we are saying about when we’d be willing to respond.

    The other communication issue that I have with alternative C—and this, again, is something President Fisher said yesterday—is that if we don’t move and we put C out there, the stock market could go up because it might be read as saying that the Fed has increased confidence, is seeing things looking better, and is feeling stronger about the economy. I’m not sure that really is the assessment we have, and if we then have bad data on the labor markets and the financial markets weaken somewhat, will we be seen as having made a wrong call, as being blindsided by circumstances? This is more discussion than it’s worth, but what I’m trying to convey is that it’s not just a question of disappointing or not disappointing markets. It’s a question of whether or not we’re sending a clear message. I think alternative B, while it’s consistent with our risk assessments, is also a pretty strong statement. Let me, just for what it is worth, assure you now that data that come in within the general, broad ranges of what we’re expecting, even though they will be weak, should not cause us to ease further, given this statement. I believe that this statement will provide us with plenty of cover. No matter what the markets expect, we have said that we have come to a point at which we need to take a pause, we need to see what’s happening, and we are going to be watchful and waiting.

    With respect to the language, I just want to point out how much the language in alternative B has moved from March. It really is a very significant change. First of all, we are acknowledging explicitly how much we have already done—the substantial easing of monetary policy to date plus the measures to foster market liquidity—and expressing a general confidence implicit in that first sentence that we have done a lot; that it is likely to help; and therefore, that we should wait and see what happens. Second, we removed any reference to downside risk to growth, which has been in there for a long time. That’s a very strong statement. That says a lot about our inclinations going further. Third, we’ve added the phrase “continue to monitor,” which to me suggests very much a watchful waiting rather than an active approach to developments in the economy. Finally, we have made it clear that we are going to be data dependent and, in particular, though we have done a lot, we are expecting continued weakness, and we’ll act as needed. But we have taken out the “timely manner,” so the presumption that we’ll be responding in a very rapid and aggressive way, I think, has been moderated.

    I think of alternative B as being a compromise in the sense that it takes a step that is consistent with the fundamentals in terms of the underlying tightness of the financial system and the risks that most of us see to economic growth as well as inflation. At the same time, I think it is a rather strong step in expressing a shift in our strategy—that we are moving from the phase of rapid declines and aggressiveness to a phase of waiting and observing how this economy is going to evolve. Again, with full respect to everyone’s comments, I understand. Unlike Governor Mishkin, I wasn’t sitting on the fence; I thought that was a little uncomfortable. But I understand the concerns and the arguments. The communication issues did concern me, and largely on that basis, I would advocate B today. Are there any comments? If not, could you please take a roll call?

  • This vote encompasses the language of alternative B in the table that was handed out as part of Bill’s briefing yesterday, as well as the directive from the Bluebook.

    “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with reducing the federal funds rate to an average of around 2 percent.”

    Chairman Bernanke Yes
    Vice Chairman Geithner Yes President Fisher No
    Governor Kohn Yes
    Governor Kroszner Yes
    Governor Mishkin Yes
    President Pianalto Yes
    President Plosser No
    President Stern Yes
    Governor Warsh Yes

  • Thank you. I will ask the Governors to join me in the office for the discount rate decision. Everyone else, why don’t you take a 20-minute coffee break.

  • [Coffee break]

  • Okay. Why don’t we recommence. The meeting that we are about to begin is a joint meeting of the FOMC and the Board, so I need a motion to close the meeting.

  • Without objection. The discussion is about interest on reserves. Let me turn to Brian.

  • Thank you, Mr. Chairman. We will be referring to the package of material labeled “Implications of Interest on Reserves for Monetary Policy Implementation.” Today, the staff will report on work prompted by two changes the Congress made to the Federal Reserve Act in October 2006 and will seek your guidance on further work. Both changes become effective in October 2011. As shown on page 2, the first change allows the Board to authorize the Reserve Banks to pay interest on balances maintained by depository institutions at an interest rate or rates not to exceed the general level of short-term interest rates. The second allows the Board to set required reserve ratios on transaction deposits within a range of 0 to 14 percent rather than the currently mandated range of 8 to 14 percent, permitting the Fed effectively to eliminate reserve requirements if it chooses. These two changes will allow the Federal Reserve to make significant improvements in its approach to monetary policy implementation. They give us an opportunity to reduce distortions and deadweight losses resulting from our current complex system of reserve requirements. They also give us an opportunity to improve the effectiveness of monetary policy implementation in routine circumstances as well as in conditions of financial stress.

    While the Congress made important changes in the law, it also left some key statutory constraints in place. As discussed on page 3, if the Board chooses to retain reserve requirements, the law continues to allow them to be imposed only on transaction deposits, nonpersonal time deposits, and Eurodollar liabilities and only on depository institutions. In effect, the law continues to enshrine a system of reserve requirements that was designed to facilitate control of M1—an objective that has had little relevance to the conduct of U.S. monetary policy for a quarter-century. Second, the prohibition against paying interest on demand deposits remains in force and is a significant continuing distortion in the U.S financial system. We continue to work with congressional committees and staff to seek opportunities for the repeal of this prohibition. Third, the law retains significant constraints on the assets that the Federal Reserve can purchase in the open market. Fourth, interest on reserves has potential implications for priced services and for Reserve Bank operations more generally. Finally, the Federal Reserve remains unable to pay explicit interest on balances held at the Federal Reserve by the Treasury and by foreign central banks.

    Page 4 summarizes the steps we have taken to date in our work on interest on reserves. Shortly after the legislation was passed, the Chairman asked the staff to begin background work. Last year, a System workgroup undertook a preliminary study of a range of options for implementing monetary policy given the new authorities. I’d like to recognize the participants in that workgroup, who made remarkable progress during a period in which some of these individuals were experiencing considerable pressures relating to the implementation of monetary policy that day, not just in five years. These individuals included Jim Clouse, Seth Carpenter, John Driscoll, Sherry Edwards, David Mills, and Travis Nesmith from the Board; Spence Hilton, Leo Bartolini, Chris Burke, Todd Keister, Antoine Martin, and Jamie McAndrews from the New York Fed; Ron Feldman from Minneapolis; Steve Meyer from the Philadelphia Fed; and Huberto Ennis and John Weinberg from Richmond. Separately, a System workgroup co-headed by Don Hammond here at the Board and Ron Mitchell at the Boston Fed has begun work on the implications for priced services of paying explicit interest on balances. In February, the Board hosted a workshop on monetary policy implementation; five foreign central banks and the Federal Reserve participated.

    As shown on page 5, our briefing today is in four parts. After this introduction, Steve Meyer will present a summary of the Federal Reserve’s current approach to implementing monetary policy. Next, Jim Clouse and Spence Hilton will discuss five options for implementing the new legislative authorities. Finally, Bill Dudley will make a number of concluding comments and present our recommendations.

    As shown on page 6, we will be seeking your comments on the criteria that we have tentatively adopted for evaluating the options; on the options themselves; and on the process and timeline that we are tentatively proposing for this project. One of the key issues is whether you would be prepared to see reserve requirements reduced to zero. Steve will now continue our presentation.

  • As Brian noted, I will summarize our current approach. As indicated on page 7, I will discuss depository institutions’ demand for central bank balances, how the Desk manages the supply of balances, and outcomes in the federal funds market. There are three components of demand. Some depository institutions (DIs) hold balances to satisfy the reserve requirements shown on page 8. Many more hold contractual clearing balances, and some routinely hold excess reserves.

    Page 9 notes that DIs can meet their reserve requirements by holding currency, by holding balances at a Reserve Bank, and by holding deposits at a correspondent that holds an equal amount at a Reserve Bank. These assets earn no interest, so DIs have an incentive to reduce their required reserves to the level of vault cash and reserve balances they would choose to hold if there were no requirements. In practice, DIs cut required reserves by using sweep programs that shift deposits out of transaction accounts into linked nonreservable accounts. This stratagem works because the Fed applies reserve requirements to end-of-day, post-sweep, deposits. About half of the DIs have no reserve requirement. A large majority of the remainder meet their requirements entirely with vault cash. Only 1,500 DIs hold balances to meet reserve requirements, so last year required reserve balances averaged less than $7 billion, an amount equal to 0.1 percent of total deposits in the U.S. banking system. Economists claim that central banks impose reserve requirements to ensure a sizable demand for central bank balances. Imposing a high required reserve ratio on a narrow deposit base and then allowing DIs to run sweep programs and use vault cash to meet reserve requirements does not achieve that goal.

    More than 7,000 DIs have accounts at Reserve Banks. On an average day, they use their accounts to make and receive more than 0.5 million interbank payments with a value of roughly $2.5 trillion. As noted on page 10, many of those DIs need a larger balance to avoid frequent overnight overdrafts than to satisfy reserve requirements. About 5,700 choose to hold a contractual clearing balance. The incentive to maintain a contractual balance is that such balances earn implicit interest that offsets the fees a DI incurs when it uses our priced services. But these “earnings credits” cannot be paid in cash, so DIs that do not use our services have no incentive to hold a contractual balance. Page 11 shows that DIs hold a bit less than $7 billion of contractual clearing balances. The rough equality with required reserve balances is coincidence.

    Required and contractual balances, though small, facilitate the implementation of U.S. monetary policy in two ways, as indicated on page 12. First, required and contractual balances are set before the start of each reserve maintenance period, so they establish a predictable lower bound on the period-average demand for balances. Second, DIs are allowed to meet reserve requirements and contractual balance commitments on average over multi-day reserve maintenance periods. This averaging feature helps make the demand for balances interest elastic. DIs reduce the opportunity cost of meeting requirements by holding smaller balances on days when the fed funds rate is above target and larger balances on days when the funds rate is below target. Carryover provisions and clearing bands, which give DIs some flexibility to hold too many or too few balances in one maintenance period and the opposite in the next period, also help make the demand for balances interest elastic.

    Page 13 summarizes the third component of demand for balances: desired excess reserves. Large DIs usually aim to hold zero excess reserves on average. Small DIs as a group generally hold positive excess reserves. The left half of the graph on page 14 illustrates that the daily sum of required, contractual, and excess reserve balances averaged about $15 billion from January through July of last year but varied between $10 billion and $25 billion. The day-to-day variation largely reflects big banks’ behavior: Big banks want much larger balances on days when an unusually large volume of payments flows through their Federal Reserve accounts than on other days. This strategy lowers their risk of incurring overnight overdrafts on high-payment- flow days while reducing their opportunity cost of holding non-interest-bearing balances on other days. The right half of the graph shows that demand for balances has oscillated even more widely since August. Even at $25 billion or more, DIs’ balances are not big enough to clear $2.5 trillion of Fedwire payments per day without incurring overdrafts. Indeed, DIs make heavy use of daylight credit. At least in theory, ready availability of inexpensive daylight credit reduces DIs’ demand for central bank balances. A proposed reduction in the cost of collateralized daylight credit—the proposal is now out for public comment—may further reduce demand for balances.

    We turn next to the supply of balances, beginning on page 16. You’ve told the Desk to keep the federal funds rate close to target on average. The Desk does so by trying to make each day’s supply of balances equal to the quantity that DIs would demand that day if the funds rate were at target. The Desk’s strategy is to use outright purchases or sales of Treasury securities, plus 14-day and 28-day repurchase agreements, to supply a level of balances somewhat lower than the minimum amount the banking system is likely to demand going forward. The Desk then uses one- to seven-day repo to supply the remainder. The Desk structures its operations so that maturing repo almost always leave the supply of balances short of the quantity demanded and then undertakes a new repo to fill in the gap. But as indicated on page 17, the Desk does not completely control the supply. Unanticipated changes in autonomous factors can make the supply of balances larger or smaller than projected. The staffs at the Board and in New York do a very good job, but not a perfect job, of predicting changes in these factors.

    Variations in borrowing from the primary dealer credit facility also affect the supply of balances. For example, Citigroup Global Markets borrowed on 20 of the first 25 business days that the PDCF was in operation, in amounts that varied from $0.5 billion to $2.7 billion. Barclays Capital borrowed on 21 days, in amounts that ranged from $1 billion to $7 billion. Four other primary dealers were frequent borrowers; another six borrowed less often. Changes in PDCF credit are not always captured in the staff’s daily projections, so they can, and do, cause the supply of balances to deviate from the intended level. In any case, if the day’s projected supply is not close to the forecast of quantity demanded, the Desk conducts an open market operation to make the two roughly equal. As noted on page 18, the Desk was in the market almost every business day—indeed, all but six business days—from January 2006 through July 2007, replacing maturing repo with larger or smaller repo as projections showed a need to add or to drain balances.

    How well does this approach to implementing monetary policy work? If the key criterion is keeping the funds rate close to target, our current approach works well in normal times and not so well when interbank markets are under stress. But our current approach imposes substantial and unnecessary burdens. As the graph on page 20 indicates, the effective fed funds rate is almost always within a few basis points of target during normal times, as it was from January through July of last year. But there have been many larger-than-usual deviations from target since last August, for two primary reasons. First, daily variations in demand for balances have become larger and more difficult to forecast. Second, demand apparently has become less responsive to temporary deviations of the funds rate from target—that is, demand has become less elastic. Even so, the average of daily deviations from target has been close to zero since mid-September. Pages 21 and 22 summarize equilibrium in the federal funds market and the reasons for large deviations from target. Fed funds typically trade near the target early in the morning because buyers and sellers usually expect the Desk to supply enough balances to get the funds rate to target in the afternoon. But the funds rate sometimes is firm or soft in early trading, signaling a likely shortage or surplus of balances and leading the Desk to aim for a somewhat larger or smaller supply than otherwise.

    After the Desk conducts the day’s operation, three things happen concurrently: The supply of balances responds to changes in autonomous factors and PDCF credit; the demand for balances is realized as DIs make and receive payments; and DIs trade federal funds, determining the day’s average or “effective” funds rate. If the supply of balances is close to the actual quantity demanded and if the payment system and the federal funds market work normally, the funds rate will be close to target. Any excess demand or supply generally does not become apparent until late in the day, when the Desk is unable to adjust the supply of balances because primary dealers no longer have uncommitted collateral. DIs that end up with larger balances than they want late in the afternoon seek to sell fed funds. When the banking system as a whole has sizable excess balances, DIs that try to sell fed funds late in the day find few buyers. Because balances earn no interest, the funds rate can fall to zero in that situation. On the other hand, an excess demand for balances makes the funds rate rise relative to target. If the funds rate climbs sufficiently above the primary credit rate, some DIs overcome their reluctance to borrow, raising the supply of balances and helping limit the increase in the funds rate.

    Last August provides an interesting case study. The demand for balances rose as DIs sought greater liquidity. The Desk increased the supply. Even so, the funds rate traded firm relative to target almost every morning as European banks bid aggressively for fed funds to lock in dollar funding before the end of their business day in Europe. The firm morning rate suggested a shortage of balances. But late in the day in New York, the funds rate often fell well below target as domestic banks that held larger-than-normal balances during the day tried to sell fed funds rather than hold big non-interest-bearing balances overnight.

    While our current regime keeps the funds rate close to target on average, it imposes sizable and unnecessary burdens. As noted on page 23, DIs use real resources to run sweep programs and to carefully manage each day’s balance in their Federal Reserve accounts. While those efforts generate private gains, they are a waste from a social perspective. Even with sweep programs, the opportunity cost of holding unremunerated reserve balances averaged about $360 million per year during the past two years. In addition, the banking system and the Federal Reserve spend many millions of dollars each year to ensure and monitor compliance with complex reserve requirement rules.

    As indicated on page 24, our current approach to implementing monetary policy has strengths: It usually keeps the funds rate close to target, and it supports an active interbank market. But our current approach also has shortcomings: It allows occasional large deviations of the funds rate from target even in normal times and more-frequent large deviations when interbank markets are disrupted. Our approach is less than transparent; even well-informed market participants sometimes are surprised by the Desk’s daily operations, and there was widespread misunderstanding of the Desk’s actions last August. Finally, our current approach imposes burdens that simply are not necessary to enable the Desk to keep the funds rate close to target. Theory and foreign experience suggest that it is possible to reduce the shortcomings of the current U.S. approach to implementing monetary policy without sacrificing its strengths. Jim Clouse and Spence Hilton will now discuss a range of options for improving the U.S. approach.

  • Thanks, Steve. As noted on page 25, the Interest on Reserves Workgroup developed a set of options for monetary policy implementation in the United States based on alternative settings for a small set of core structural elements. The first core element—so-called balance targets—is a central feature of many systems. In the United States, Japan, Switzerland, and the euro area, balance targets are established through mandatory reserve requirements. In the United Kingdom, balance targets are established through voluntary contractual arrangements. Other countries, such as Canada and Australia, operate with no formal balance targets. Target bands are a second structural element incorporated in many systems to afford banks some flexibility in meeting their targets. The carryover provisions for required reserves and the clearing band for required clearing balances play this role in the United States. The structure of the maintenance period is another core structural element. As Steve noted, the U.S. system operates with a mixture of one-week and two-week maintenance periods. The United Kingdom and the euro area operate with maintenance periods that correspond to the interval between monetary policy meetings. Central banks like the Bank of Canada and Reserve Bank of Australia that operate without balance targets implicitly operate with a one-day maintenance period. Finally, most systems involve some form of interest rate corridor with the upper bound of the corridor established by a standing lending facility and the lower bound set by the rate of remuneration on excess reserves or a redeposit facility.

    As noted on page 26, market developments may, at times, impair the efficacy of one or more of these core structural elements. For example, the standing lending facility should, in theory, establish a cap on interbank rates. However, the presence of stigma in using the standing lending facility can impair the effectiveness of the cap. That certainly seems to have been the case in the United States over recent months. We have observed depository institutions regularly bidding for funds in the market at rates above the primary credit rate. The table at the bottom reports some evidence on this score culled from data on Fedwire transactions. Over recent weeks, many of the largest banks in the country have executed numerous trades for sizable amounts at rates well above the primary credit rate. It may be possible to redesign the discount window to mitigate stigma to some extent, but it appears likely that stigma will continue to be an issue for the discount window, especially during periods of financial distress. As a result, systems that rely heavily on a standing lending facility to establish an upper bound on the federal funds rate implicitly disadvantage those institutions that are most wary about using the discount window. As you can see in the table, that set of institutions in the United States includes many that are critical providers of liquidity across a range of markets. It is noteworthy in this regard that Citibank in the past has been willing to provide liquidity in the funds market by borrowing primary credit and relending the proceeds in the funds market. However, in recent weeks, Citi has seemed reluctant to pursue this strategy and has, in fact, executed more than 100 trades from late March through last week in sizable amounts at rates above the primary credit rate. Indeed, the three largest banks in the country— shown in the first three rows—all appear to be quite wary about using the discount window.

    As noted on page 27, it is helpful, broadly speaking, to think about the five options discussed in the paper as falling into two basic categories—systems that incorporate a multiple-day maintenance period and systems in which depositories manage their reserves to meet a daily reserve objective. The multiple-day systems— options 1 and 2 in the paper—rely on arbitrage across days of a maintenance period as an important factor contributing to day-to-day funds rate stability. Single-day systems tend to rely more heavily on standing facilities and the structure of remuneration rate(s) on reserves to stabilize the funds rate. The next few slides focus on multiple-day systems.

    Option 1. As noted on page 28, option 1 considers a straightforward modification of our current system of monetary policy implementation. Required reserve balances would be remunerated at a rate close to the target funds rate. The primary credit facility, in theory anyway, would establish the upper bound of an interest rate corridor. The lower bound of the corridor would be established by paying interest on excess reserves at a rate appreciably below the target funds rate. The solid line in the picture displays what the demand for reserves might look like on the last day of the reserve maintenance period. The curve would be downward sloping and might entail some precautionary demand for excess reserves. The reserve demand curve on previous days in the maintenance period—the dotted line—would be much flatter at the target rate over a wide range, reflecting the ability of banks to substitute balances across days of the maintenance period in meeting reserve requirements. Eventually, though, at very low levels of balances, the increased risk of an overnight overdraft would push the intraperiod demand curve up to the primary credit rate. At high levels of balances, the intraperiod demand curve would eventually fall to the remuneration rate on excess reserves as banks recognized that they held excess balances that could not be worked off by the end of the maintenance period. The width of the “flat portion” of the intraperiod demand curve tends to narrow over the maintenance period as the scope for substitution diminishes across the remaining days of the period. In this structure, the Desk would operate much as it does today, supplying an aggregate quantity of reserve balances each day to address both daily demands and maintenance-period average needs.

    Option 2. As noted on page 29, option 2 in the paper is a multiple-day system based on voluntary balance targets rather than mandatory reserve requirements. This system would share many of the key structural elements of the system for monetary policy implementation employed in the United Kingdom. Depository institutions would establish a voluntary balance target that they would agree to meet, on average, over a maintenance period. The maintenance period could be set equal to the interval between FOMC meetings. The system could include a target balance “band” to afford banks some flexibility in meeting their voluntary target balance. As shown on the right, the demand for reserves on the last day of the period would again be downward sloping, and the Desk would supply an aggregate quantity of reserves equal to the quantity demanded at the target funds rate. Reserve management and the funds market under this option probably would be similar to that for option 1. The longer maintenance period might allow depository institutions more scope for substitution of balances across days of the maintenance period. That could imply less need for daily fine-tuning of balances and greater funds rate stability. A key issue, however, is whether the aggregate quantity of voluntary balance targets would be large enough to provide adequate leeway for effective arbitrage across days of the maintenance period. Many banks might choose not to establish a voluntary balance target in this system, and those that do may not choose to establish a large balance target. In this case, the funds rate could be fairly volatile within the interest rate corridor.

    Option 3. As noted on page 30, option 3 in the paper—the simple corridor—is similar to the systems employed by the Bank of Canada and the Reserve Bank of Australia. Banks would not need to establish a balance target of any sort and would simply manage their accounts each day to balance the opportunity cost of holding reserves against the risk of overnight overdrafts. The system would involve a fairly narrow symmetric funds rate corridor. As noted in the figure, the Desk would supply reserves each day equal to the quantity demanded along the downward sloping portion of the demand curve. Because the demand curve is likely to be fairly steep, shocks to reserve supply are likely to result in significant volatility in the funds rate within the corridor. As noted earlier, the heavy reliance on the primary credit facility to establish an upper bound on the funds rate may be suspect, especially during periods of financial distress.

    Option 4. As noted on page 31, option 4 in the paper is a system similar in many respects to that employed by the Reserve Bank of New Zealand. Key structural features of this system include an asymmetric interest rate corridor and a relatively high level of balances to ensure that the funds rate trades near the floor of the interest rate corridor. As in option 3, depositories would not need to establish a balance target of any sort. The reserve demand curve for this system might look like that shown to the right. At low levels of balances, the demand curve would be downward sloping reflecting precautionary demands for balances to avoid overnight overdrafts. But at sufficiently high levels of balances, the risk of overnight overdrafts should become very low, and the demand curve would asymptote near the floor of the funds rate corridor. It is difficult to estimate the level of balances that would be necessary to reach this point, but an aggregate level of balances on the order of $50 billion would probably be sufficient in most cases. In principle, fluctuations in various factors affecting reserves would not have much effect on the funds rate, and the generally high level of balances could reduce daylight overdrafts. Partly because of the experience in New Zealand, there are questions about incentives for strategic behavior in this structure.

    Option 5. As noted on page 32, option 5 is a hybrid single-day system that would involve a voluntary daily balance target and a relatively wide target band. Depositories would receive full remuneration on balances maintained up to the upper bound of the target band and would be penalized for any shortfall in balances below the lower bound of the target band. With these structural elements, the reserve demand curve should be fairly flat at the target rate over a wide range, but the curve would be downward sloping near the upper and lower bounds of the target balance band. The Desk would presumably operate by targeting a quantity of balances each day near the middle of the target band. As with option 2, a significant issue with option 5 would be whether depositories would choose a high enough level of voluntary balance targets to allow the target band to play the desired role in stabilizing the federal funds rate.

    As noted on page 33, the paper also identifies a number of general issues that cut across all the options. First, depository institutions will still be subject to statutory limitations on their ability to pay interest on demand deposits. As a result, the Federal Reserve’s initiative to pay interest on reserves may be seen by correspondent banks as unfair competition. There are also technical issues associated with the setting of the remuneration rates on reserve balances that appropriately account for the essentially risk-free nature of balances held with the central bank. The Federal Reserve would need to work through governance issues associated with all the options. In particular, the Board is responsible for setting all remuneration rates on balances, and this would need to be closely coordinated with the FOMC’s determination of the target federal funds rate. Finally, many if not all the options discussed would likely require some transition period that would need to be carefully managed. Spence will now discuss some of the pros and cons of each option in more detail and how they stack up relative to key objectives.

  • Thank you, Jim. We have identified four critical objectives for a new operating framework, which are listed on page 34 of your handout. These are (1) to reduce burdens and deadweight loss associated with the current regime, (2) to enhance monetary policy implementation, (3) to promote efficient and resilient money markets, and (4) to promote an efficient payment system. For each of the five options that Jim has just presented, I am going to describe what we see as the major advantages and disadvantages of each vis à vis these objectives. I will also highlight some important sources of uncertainty that we have about how some of these options might function in practice. Then I will close with a broad assessment of how the five options measure up against each of these four objectives.

    The key advantages and disadvantages of option 1—remunerate required and excess reserve balances—are listed on page 35. This option would have the advantage of being relatively easy to implement given that it would build largely on elements of the current operating framework and would simply pay interest on reserve requirements and, at a lower rate, on excess reserves. The basic framework, which consists of an interest rate corridor with reserve requirements and maintenance periods, is widely used by other central banks, and we’re pretty certain how it would function in practice. For central banks that have adopted this basic framework, it has proven to be reasonably effective for controlling short-term interbank rates under a variety of circumstances. However, this option would do little to reduce the administrative burdens associated with our current regime. This framework is also somewhat rigid, particularly in the flexibility it would provide to us and to banks themselves to adjust the level of requirements in ways that would facilitate monetary policy implementation. A particular shortcoming is that many depositories active in the interbank market have a very small base of deposits against which requirements of any level could be assessed. An important source of uncertainty with this option is whether it would lead to a significant increase in total required operating balances, which would be helpful for damping interest rate fluctuations that can arise when requirements are very low. However, the Fed would have some power to influence the aggregate level of requirements by raising requirement ratios.

    Option 2—voluntary balance targets—(shown on page 36) would lead to some reduction of administrative costs and burdens compared with the current framework (option 1), as relative simplicity would be one of the principal design objectives for a new system of voluntary reserve targets. The basic framework is similar to that of option 1. It consists of an interest rate corridor with maintenance periods but substitutes voluntary targets for reserve requirements. As already noted, this basic framework has proven to be reasonably effective for controlling overnight interbank rates where it has been adopted. Furthermore, a new system of voluntary targets could provide all DIs with considerable flexibility for setting their own level of targets and for adjusting the size of these targets, a feature that banks might find useful during periods of heightened uncertainty or stress. With this option, there would also be the opportunity to review and totally revamp the length and mechanics of the maintenance period to make them more supportive of monetary policy implementation. However, almost any system of voluntary targets for reserves is bound to impose some administrative costs on both depositories and the Fed, and there may be some tradeoff between administrative simplicity and design flexibility. An important source of uncertainty with this option is that we have yet to identify with precision a system of voluntary reserve targets that would be workable, in the sense of being easy to administer across a large number of DIs with disparate structures, and that would be effective in yielding a total level and distribution of voluntary targets across DIs that would enhance our ability to achieve our operating objectives. Unfortunately, experiences of other central banks offer little guidance in how to design voluntary targets. A particular risk that concerned the Bank of England when it designed its voluntary target scheme was the potential for market manipulation that a new system might offer individual banks if they were entirely free to choose their level.

    Option 3—simple corridor—(on page 37) would go about as far as possible toward eliminating administrative burdens by doing away with all requirements and maintenance period accounting rules. This option should also keep the overnight interbank rate within a narrower range than the other options, assuming that we adopt a narrower spread between the discount rate and the interest rate paid on excess reserves. Experiences of other central banks that have adopted this kind of operating system support that belief. However, there is also reason to believe that, with removal of the ability of banks to average reserve holdings over a maintenance period, interest rate volatility within the interest rate corridor could be high. We could respond to high volatility within a corridor by further narrowing that corridor. But there is the risk that, at some point as you go in that direction, market participants could use our discount window or interest on excess reserves as a first recourse rather than as a last resort and thus affect the Fed’s role as intermediary and impair normal market functioning. There are some important questions about how effectively a simple corridor system would function in our particular environment. All the options we are considering propose to use the primary credit facility to limit upward movements in market rates. To the extent that this facility might not serve as an effective brake on upward rate movements, the consequences would be greatest for this option because there are no other mechanisms for smoothing interest rates. Some central banks that have a simple corridor framework have also developed arrangements to adjust reserve levels late in the day to prevent exogenous reserve shocks from pushing market rates to either the upper or the lower end of the corridor.

    Option 4—floor with high balances—is shown on page 38. It would also do away with all requirements and maintenance period accounting rules and, like option 3, would go a long way toward eliminating administrative burdens. Moreover, because the rate effects of even a large aggregate reserve shock or a payment shock at an individual DI are likely to be relatively small, the need for depositories or for the Desk to manage daily reserve positions intensively is likely to be reduced, which should translate to further resource savings. Better insulation of market rates from exogeneous reserve shocks is a design objective, and it is a particularly distinctive feature of this framework. However, completely severing the link between daily reserve levels and interest rate movements can be a double-edged sword. While we may wish to better insulate market rates from reserve shocks, we may also wish to preserve some ability to influence market rates by manipulating reserve supply when other factors are distorting rates. One risk associated with this option is that it would represent a radical departure from the basic elements of our own current framework and from those of almost every other central bank, preventing us from learning from the experiences of other central banks. A particular unknown with this option is the possible implication for the functioning of the interbank market. Offering to compensate DIs for all the reserves they might choose to hold at a rate that is in line with market rates could have profound effects on their willingness to lend in the market, under both normal circumstances and during periods of market stress. The Reserve Bank of New Zealand, one central bank that has experimented with a system similar to option 4, did run into some difficulties with the hoarding of reserves by individual banks to the detriment of the interbank market. As a result, they adjusted their framework to cap holdings of excess reserves by individual banks.

    Option 5—voluntary daily target with clearing band—is on page 39. It has many of the same advantages and disadvantages as option 2, stemming from the fact that both feature voluntary reserve targets. Because simplicity would be one of the design principles, it should reduce current administrative burdens. It would also provide DIs with the same kind of flexibility that option 2 does for setting and adjusting their own reserve targets. On the other hand, a system of voluntary targets for reserves would still leave some administrative costs, and we have yet to specify a system of voluntary reserve targets that would be workable and effective. An additional advantage of this option is that it could allow the Fed to adjust the width of the daily clearing band around the reserve target. The final choice of clearing band width could be made after some experimentation based on what works best. Moreover, being able to make temporary adjustments to the width of this daily clearing band could be a powerful tool for dealing with exigent circumstances. Experiences of other central banks provide little guidance about how this flexibility might be best employed. But the Bank of England did widen its maintenance period clearing band during the recent financial market turmoil, and they have been happy with the results. Interestingly, the ECB, quite independently, has been examining the possibility of a new system centered on a one-day clearing band rather than a multi-day maintenance period.

    Let me sum up by outlining how these five options stack up against the four objectives that we have established for a new operating framework, which are summarized on pages 40 and 41. First, all the options would eliminate most of the current “reserve tax” associated with the nonpayment of interest on reserves, and perhaps with the exception of option 1, they would reduce the administrative burdens associated with our current framework. Option 3 (simple corridor) and option 4 (floor with high balances) would do the most to eliminate these administrative costs.

    Second, all the options would improve monetary policy implementation by helping set a floor on the fed funds rate. Most have additional features that could help control rate volatility, although these differ from one another in terms of their mechanics. But some of the options offer greater potential to adjust parameters in ways that could be helpful amid changing circumstances—say, during periods of market stress or heightened uncertainty about developments that could affect our balance sheet. An adjustable clearing band in option 5 could offer considerable flexibility. Adjustable reserve targets, a feature of both options 2 and 5, are another possibility.

    Third, all the options would rely on efficient money markets for distributing reserves between DIs. There is more uncertainty, however, about how some of the options might influence the incentive structure for trading and the allocation of liquidity in short-term financing markets and the role of the central bank in that process. This is the case with option 3 (simple corridor), should that corridor be too narrow, and with option 4 (floor with high balances), where the choices of lending excess liquidity in the market versus holding excess reserves would be nearly equivalent.

    Fourth, all the options are compatible with the proposed changes in payment system policies. However, there are differences among the options in the levels of reserves that would likely be in place and that could serve as a substitute for the provision of central bank daylight credit. Option 4 (floor with high balances) would provide the most reserves in the system, and option 3 (simple corridor) would provide the fewest, perhaps even lower than current levels. A system of voluntary reserve targets, a feature of both options 2 and 5, could be deliberately designed to encourage a relatively high level of reserves.

  • Building on the earlier presentations, I am going to focus briefly on four areas. First, I’d like to put the interest on reserves project in the broader context of monetary policy implementation. Second, I will discuss briefly the implications of our experience during the recent market turmoil in terms of how it might influence our choices in this project. Third, I’ll suggest some next steps and a potential timeline. Fourth, I’ll focus on the criteria for evaluating the different options and those areas where your guidance will likely be particularly important.

    Turning to page 42 of the handout, the issue of paying interest on reserves should be placed in a broader context. In particular, this project should be considered as part of the process of improving the overall monetary policy framework. Put bluntly, although the current system works very well during normal times, we have found it recently to be less robust during times of stress. As a result, we should use this opportunity to strengthen the robustness of the framework.

    So what are the weaknesses of the current monetary policy framework? As shown on page 43 of the handout, four come immediately to mind. (1) In times of stress, the federal funds rate can be very volatile—both day-to-day and intraday. (2) On the upside, the primary credit facility rate is not a binding ceiling on rates. (3) When there is a large reserve adding miss, the Desk can temporarily lose control of the federal funds rate target to the downside. (4) Stability in the federal funds rate may not limit upward pressure in term funding rates. Today I’ll focus on the volatility issue and the failure of the PCF rate to be a binding cap. Two issues are worth noting regarding volatility. First, the federal funds rate has become more volatile on a day-to-day basis since last August. This can be seen on page 44. Second, the federal funds rate has become very volatile intraday. The exhibit on page 45 shows how wide the range of federal funds rate trading has been recently. The vertical dashed lines indicate the daily range. Note that the primary credit facility rate has not acted as a firm cap on the upper end of the daily range.

    As shown on page 46, these shortcomings suggest that paying interest on reserves should be considered in tandem with other changes to the overall monetary policy framework. We should be willing to make significant adjustments to our monetary policy framework so that it is more robust during times of stress. In this context, although option 1 (paying interest on required and excess reserves) and option 2 (eliminating reserve requirements) are attractive because both would eliminate the reserve tax distortion, they do not do much in terms of making the monetary policy framework more robust. That said, option 2 has a number of favorable features. It is voluntary and would lessen the regulatory burden. We have considerable experience with this type of framework, so the risks of unintended consequences might be lower than for some of the other options. The Bank of England has been using this framework successfully, and it has proven to be reasonably robust through this period of market turmoil. Nevertheless, we may wish to be more ambitious.

    Turning to page 47, option 5 (voluntary daily target with clearing band) is potentially more robust than option 3 or option 4. In part, this is because it is very flexible. This proposal has a number of parameters that can be adjusted—for example, the width of the corridor and the size of the voluntary reserve band. Thus, this option has the advantage that it could be modified relatively easily in light of experience or in response to changing market conditions. The biggest shortcoming of option 5 is that no other central bank has adopted such a model. Thus, experience and empirical evidence are lacking compared with the other proposals.

    So what is our recommendation in terms of pushing this forward (see page 48)? As Jim noted in his presentation, the five options can be broken down into two classes. Options 1 and 2 operate in a framework of a multiple-day reserve maintenance period. Options 3, 4, and 5 are single-day systems. Reserve maintenance periods have both advantages and disadvantages. Reserve maintenance periods reduce volatility by averaging—which can be a good thing. But there is a cost. The shocks can persist. In contrast, in single-day systems, each day is a new start, so one avoids the problem of a large shock contaminating an entire reserve maintenance period. This suggests that a reasonable next step might be to develop the best proposal within each of these two broad classes. We recommend focusing on option 2 as the best proposal within a reserve maintenance framework and option 5 as the best proposal in a single-day system.

    What would be the next steps (see page 49)? First, we would need to identify workable systems of voluntary targets for reserves needed for either option 2 or option 5. This would include setting clear objectives for the aggregate size and the distribution across depository institutions and how such a system would be applied to a heterogeneous banking system. Second, we would need to critically assess the relative merits of maintenance periods versus daily clearing bands. In this context, we would need to determine the optimal length of a reserve maintenance period and the width of a clearing band. Third, we would have to define the optimal width of a rate corridor under both options. Here we would have to understand the implications for rate dynamics and the functioning of the market during normal conditions and during times of stress. Finally, we would need to assess whether the options were compatible or could be made compatible with other changes that we might implement, such as changes in our counterparties or in the types of collateral we accept as part of our central bank operations.

    So what would be a possible timeline between now and implementation in October 2011? The timeline that I will discuss should be viewed as tentative and subject to revision in light of your comments and further discussion within the Federal Reserve System. Turning to page 50, we would propose that most of the remainder of 2008 be used for an extensive study of the options. In May 2008, the staff would publish a white paper on possible approaches for public comment. In December, the staff would propose a specific approach to the Board and to the FOMC. Continuing on page 51, the first half of 2009 would be spent filling in the details, with the final proposal published for public comment in August 2009. The rules implementing the proposal would be published by the Board in October 2009. The final two years would be spent preparing for October 2011 implementation.

    On the last page, we outline areas in which we particularly seek your guidance. These include the following questions. Do you agree with our metrics for evaluation of the policy options? In particular, what are the appropriate weights to place on the reduction in burden and distortions versus the other criteria? Which options should be studied further? Are you comfortable with our proposed timeline? Finally, how do you view the interaction of the interest on reserves project with other issues—for example, collateralized daylight overdrafts? We would now like to open the floor for questions and comments.

  • Well, let me first congratulate and compliment the staff for a really thorough piece of work, both the presenters and all the other people whom Brian mentioned. It is excellent work, particularly under very trying circumstances. I mentioned that in February a workshop was held here at the Board on monetary policy implementation, which brought together people from major central banks around the world. So there has been a very, very serious attempt to evaluate others’ experience. Thank you very much for all of that. Why don’t we take some questions first, if there are any. Then anyone who would like to make comments can do so. Any questions? President Hoenig, do you have a question, sir?

  • Yes. Option 1 doesn’t seem to be one of your recommendations, and yet it is something that basically people know how to do. The idea is to eliminate the pack so that you have the system already in place. It’s simple; you can learn from it. Why wouldn’t that be one of the options you’d pursue? I don’t have any real opposition to option 2, but I was just curious because the transition seemed so simple with option 1. That is the question.

  • President Hoenig, I would say that we believe we already have a fairly good sense as to how paying interest on the required reserve balances and on excess reserves would work, at least qualitatively. We do think it would be an acceptable means of implementing monetary policy. As Jim noted, it probably wouldn’t be all that different in terms of monetary policy effectiveness from the way things work now. Of course, as we also emphasized, the current system of reserve requirements has a lot of problems. Admittedly, paying interest on required reserve balances in some sense solves the first-order problem, but there are lots of costs associated with the system of reserve requirements that we’ve discussed, and we think that those may warrant serious consideration of eliminating reserve requirements. But to be clear, we’re not suggesting that we rule out option 1 at this stage. We could certainly view it as a fallback position, for instance.

  • I’d like to understand this issue in terms of the voluntary targets. How are they deciding on these? Clearly a big part of the issue is whether or not they choose you. I was just completely confused about what their considerations in choosing these numbers would be and what implications that would have. Now, there is experience for that one case. I’m sure you have views on this, but it’s sort of the black box in this proposal, and it’s a really important part of it.

    The second question regards the corridor approach. I do not think it is a good model for us because the countries that use it have very few banks. The issue of using the central bank as a financial intermediary is less of a problem for them because there are fewer guys that they have to look at, and we have to look at a zillion people. But is it true that they have high volatility? I’m not sure. I just would like to know the facts, but as I say, I don’t think it’s critical. I don’t think the experience there, even if it worked well, really does tell us that we should do something here.

  • Maybe I could just take the second question, and Spence or Jim may want to take the first. On the corridor approach, for other countries that are using it—I’m thinking of the Bank of Canada in particular here—their institutional set-up allows them extremely precise control over the supply of reserves. Also the demand for reserves—I’m talking about reserve balances—is considerably less uncertain than in the United States. Part of it comes from the fact that they have only a handful of large banks.

  • It is five or six banks, right.

  • So the communication with banks regarding their reserve management is extremely simple compared with what we could expect here in the United States.

  • The determination of voluntary targets, as Spence mentioned, is a really big issue that we’d have to study much further. At least in the context of the simple models, banks will face some probability of an overdraft charge if they are operating with very low balances, so they might have an incentive to set up a voluntary requirement on which they receive remuneration. On the other hand, they may not view even fully remunerated balances as an especially attractive asset, so there might be some balancing between the desire to hold large enough requirements to stay away from overdrafts and the idea of having balances or assets booked that aren’t particularly high earning. But this is a major uncertainty for these types of models.

  • The Bank of England has used a procedure like this. What has been their experience? Again, it may not be completely comparable.

  • Well, for the Bank of England, the way the voluntary target rules are set is really very simple. The bank chooses its own voluntary target. It can’t be below zero, of course, but they have a cap. It can’t be any higher than a certain amount, and I think it’s 2 percent of some measure of their liabilities on their balance sheet. They were extremely worried. They had no idea what they were going to get. Their experience was encouraging in that they got an aggregate level and a distribution that have brilliantly facilitated their control over their interbank market. But it is sort of taking a leap to go into that system, although we have some experience with our clearing balance program. We do see how banks adjust their participation with reserve-management objectives in mind. In our case, because there are practical limits—ceilings on the size of a clearing balance that makes sense for any bank to have—we don’t really have a direct observation of what we would get if it were entirely voluntary. The evidence that I see from our experience of clearing balances and from the Bank of England is encouraging that we would get, even with a very simply designed set of voluntary targets, a good aggregate level and distribution of voluntary targets. But right now, based on what we know, it is an uncertainty.

  • The big risk would be if the voluntary balances were really low.

  • So let’s say that actually happened, that they were zero. Then what? Let’s say we implemented this and they came out at zero. What are our options?

  • You’d have to change the incentives somehow.

  • Right, and that would be the answer.

  • But you could. You could raise the cost of daylight overdrafts.

  • Right. You could raise the cost of daylight overdrafts, or you could adjust the interest rate that you pay on reserves to get it right. That could solve the problem.

  • As long as you have enough parameters that you can adjust to change the incentives, you’re probably going to be okay in that environment. But if you have a system in which there aren’t any parameters that you can actually move, then you have a real problem.

  • But in the context of the law, we would have the ability to adjust these parameters.

  • Governor Mishkin, to state the obvious, we’d want to avoid that situation completely. We want preparation and consultation with banks ex ante as to how they would react under various subparameterizations.

  • As Steve noted, we already have $7 billion in required clearing balances with a rate of remuneration that’s only 80 percent of the T-bill rate. So in all likelihood, we would have a positive number. How large that number would be is the question mark.

  • I have a comment, not a question.

  • Thank you. This represents a once-in-a-generation opportunity to reengineer our monetary policy operational framework, and I think it’s important that we do our best to get it right. I want to start by applauding the staff for taking a very deliberate, very thoughtful approach to this project. I was able to attend the workshop on foreign central banks’ operations. I found it very illuminating, instructive, well organized, and well thought out. So far the work has been well organized, and the broad-based involvement has been very good. I want to compliment you on sifting down. The combinatorics must have been mind-boggling given the number of free parameters in the design of one of these schemes. I want to applaud you for boiling it down to a good, representative set that spans everything that I think we’d want to consider. What you produced—with one slight exception that I’ll talk about in a bit—is a very thorough and careful analysis.

    In Richmond, we have thought about the issue of interest on reserves for many, many years—even before the Congress considered it. Toward the end, I’m going to argue that option 4 deserves serious consideration, and I’d like to see you focus on that as well as the other options going forward. Before I do, though, I want to comment briefly on the objectives. You asked for feedback on this. In particular, I think objective 3 needs to be interpreted very carefully. The report often seems to interpret objective 3 as implying that anything that reduces the amount of lending in the fed funds market must reduce financial market efficiency. I just don’t think that’s right.

    The prohibition of interest on reserves is obviously a tax on reserve holdings. You have focused on the tax that it implies on reservable liabilities, but the fact that we also don’t pay interest on excess reserves is a tax on excess reserve holdings. If we eliminate reserve requirements and we still don’t pay interest on reserves, we’ll still be taxing reserve holdings. That gives rise to inefficiencies for the same reason that the lack of interest on currency gives rise to inefficiencies, and so in this setting, obviously banks do a lot of things to avoid the reserve tax. Some of the measures involve a lot of monitoring of the reserve account, monitoring of the prospective payment flow, and making sure that they can predict where they’re going to be at the end of the day.

    But some of the measures undoubtedly involve some transactions—such as fed funds loans, purchases of Treasury securities, repo lending, and the like—that are aimed at minimizing their non- interest-earning balances. Such transactions are exactly analogous to the classic shoe-leather costs of inflation. Additional transactions that are induced by the tax on currency are a waste. Reducing the inflation tax results in fewer trips to the bank or to the ATM to get money out, and that reduction is a good thing, not a bad thing. It would be a benefit, and that is exactly what it means to reduce the dead weight burden of inflation. Similarly, I think that paying interest on excess reserves will reduce transaction volumes in the fed funds market, but we should count that as a benefit, not a cost. Put more generally, the effectiveness of a market isn’t the same as the quantity of transactions.

    I bring this up because one of the main objections to option 4, at least in the report—it didn’t appear in the slides—is that it could reduce fed funds market lending. I think it should be obvious at this point why that wouldn’t necessarily be a bad thing. It’s sort of like saying that reducing inflation would be a bad thing because people would make fewer trips to the bank. I don’t think you’d say that.

    Even if we believed that fed funds volume is important, I think a quick look at the numbers would suggest that it’s not likely to be that big a problem. The staff estimates that the fed funds market is about $225 billion, on average. So how much by way of reserves will we need to add to ensure a negligible chance that our autonomous reserve factor drains reserves enough to drive the funds rate up? You showed a graph, and there was a flat spot, and you had supply way, way, way out on the curve. But it doesn’t need to go out that far. It just needs to go out so that you’d know that you’re not going to accidentally go in on the upward part. My reading of your intermeeting report is that reserve misses are typically on the order of $1 billion or $2 billion. I think the average absolute value is about $990 million. Two is pretty rare. It happens every now and then. So it seems as though $5 billion would do plenty. The report says that $35 billion would be how much reserves you’d need to add. I’m a little curious about where that number came from. It’s hard for me to believe we’d need that much. But certainly more broadly than that, if you think about the market, is that right now $225 billion in lending is going on. If you do the thought experiments about current equilibriums and you are a bank that just walks into the market and needs some reserves, will it be hard to get reserves? Well, you’re going to run into $225 billion worth from banks that are already lending their reserves with interest. So if you’re going to get your loan, you’re going to have to pay a competitive rate and shake loose some money from one of them. If we are paying interest on $35 billion in reserves, will that change that calculus much? I don’t think so. I think that your markets are still going to work the same way. If you want reserves, you’re going to have to pay a competitive rate for them. If you’re not getting reserves at that rate, you’re going to bid up until you get them. So I just don’t quite get this concern about the volume of transactions in the funds market.

    A related objection is the issue of hoarding—the idea that one bank might decide to hold a whole bunch of reserves. The staff cited the example of New Zealand. I thought that was a really interesting discussion at the workshop. One bank accumulated $8 billion or $9 billion in reserves, I think it was, which was large for them, and they had to add a large amount of reserves to accommodate that demand plus the demand of other banks in the system. Now, the problem for the Bank of New Zealand is, as I understand it, that the government doesn’t issue debt. When they have to issue deposits, they have to acquire foreign exchange reserves, and that involves a fiscal risk that they’re reluctant to take on. My sense of the conversation is that they don’t like to accumulate foreign exchange reserves. We seem to be quite willing to expand our balance sheet. Plus, there are plenty of government securities around. So I just don’t see why it would be a problem for us if reserve demand was unexpectedly high or some bank decided to hold $50 billion in reserves.

    I want to talk about one more thing, which is the issue of the rate. The way you have written it up is that what we target now is the average rate of brokered deposits. You said it was $80 billion to $100 billion out of $225 billion, on average—so less than half the market—just the weighted average of trades during the day that go through brokered channels. That doesn’t include direct credit funds. The approach you envisioned is that we try to set a remuneration rate so that the effective rate, that average, comes out at the target rate that the Committee sets. A very natural alternative, it seems to me—and I think this is the way the Bank of England does it—is that our policy rate is now the deposit rate. When we issue a press release, we say we’re changing the policy rate—I don’t know whether or not we would rename it.

    Now, you folks estimate that the risk premium that would, on average, be the gap between this deposit rate and this effective fed funds rate you measure might be 10 basis points. We now set the funds rate target in ¼ point increments. In theory, we could set our policy rate 10 basis points below ¼ point increments. That seems a little bizarre. I’m not sure that we have such precise confidence in the optimal funds rate that we’d know that it should be on the ¼ point and not 10 basis points below or above. It strikes me that a natural version of option 4 or any of these options would be to set the remuneration rate at ¼ point increments and have that be the policy rate, and just make that the reference point for how we do. Admittedly, econometricians would have to do a lot of work in the future to splice these series together, but I think that’s a workable alternative we ought to think about.

    I think that option 4 has some obvious benefits over the other options. Intuitively, if you were given a limited budget and were asked to peg the price of a commodity—minimize the variance of a commodity price around a given target—your natural inclination would be to stand ready to buy and sell that commodity at the target price. That would be, right out of the box, the first thing every economist would say. Option 4 is the closest practical analogue to that. It’s clean. It’s simple. I think it’s eminently workable. I just don’t see the force of the objections. In comparison, option 5, which is the one that comes closest to option 4, involves the monitoring of voluntary targets. You have to monitor these bands. You have to check the balances every night against the bands. It just seems like a lot of superfluous machinery.

    Option 4 would go furthest toward reducing our dependence on forecasting uncertain autonomous factors. It would also go furthest toward solving the problem that the primary dealer credit facility has given rise to, which has been particularly acute in the last intermeeting period, which is that rates are firm. You’ve done a pretty good job with the average daily rate, but it crashes at the end of every day. More than half the time you look at the low for the day and it’s under 1 percent. It’s like ½ percent. So we have a chronic intraday problem of rates being firm and then crashing because you don’t know. Primary dealers come in, that stuff goes on the market, and the rate crashes.

    I think option 4 would also be the most transparent approach. It would be the easiest to explain to people. It would go furthest toward eliminating the risk of the downside target misses and concerns about stealth easing. Option 4 would also facilitate long-run moves toward lesser lines of daylight central bank credit, and I think that’s an important consideration. It shouldn’t be the deciding consideration, but it is important. In terms of the timeline, you have yourselves focusing on two options before the results of the public comment come in. To some extent that’s prejudging where the public comment is going to come in. So, in short, option 4 strikes me as the most straightforward and practical way to do it, and I’d urge that we direct the group, which has done great work so far, to focus on option 4 and to keep it as a live option. Thank you, Mr. Chairman.

  • Thank you. Just a procedural question. You kind of segued into the positions. Does anyone have a short question of fact? Governor Kohn.

  • I actually have a couple of questions rather than positions. One is a bit more about what we’ve learned in this period of stress. For example, on page 26, you list a bunch of banks that don’t seem to have taken advantage of primary credit. I assume that you have talked to them, and I wonder how they had rationalized their concerns about stigma and what they said about that. Along similar lines about stress, and following up on Governor Mishkin’s question, how did the U.K. system work in this period of stress? My impression is that they had problems. Initially the banks wanted to increase their voluntary targets and that required the Bank of England to be a little more flexible than it started out to be. I’d be interested in how option 2 behaved under stress and then any new insights you have about bank behavior in this period that produced the oscillations that we saw.

    A second point is that Brian, Scott, and I have been talking about asking the Congress to allow us to pay interest on reserves sooner rather than later. Are we pursuing that? If we got that authority, I assume that it would not involve implementing this over four years but that we could implement something in one or two weeks, in the maintenance period after we got that authority. How would you go about that? What are you thinking in that regard? I think I’ll stop there.

  • If I may start with the last question, we can work our way up or around the list. On pursuing legislative authority, the Federal Reserve is interested in accelerating that authority. We have had some conversations with congressional staff about this. For instance, the staff of Senate Minority Leader McConnell has asked us recently whether we’d be interested in legislation to accelerate the authority. Of course, we responded enthusiastically. We did say to them that it would be helpful if it were clear that we could use that authority in such a way as to be able to pay interest on excess reserves or, rather, to buy federal funds as a way of paying interest on excess reserves, in effect. Buying federal funds when the rate is falling would help us put a floor under the funds rate. So we would want to be sure—perhaps Scott wants to comment on this—that the legislation clearly permitted that. Presumably we would be able to use that authority fairly quickly at an operational level—Bill or Spence may want to comment on this.

    Paying interest on required reserve balances is, of course, a whole other matter. That involves complicated systems, and we would simply want to be sure that we made this clear to the congressional staffs, that it would take a longer time before we could implement that.

  • We think we could implement it pretty quickly. Another benefit would be not just addressing the crashes of the funds rate late in the day but also enabling us to actually expand our balance sheet if needed.

  • Just to clarify, what are the implications for scoring?

  • It’s pretty small if you just confine it to excess.

  • My impression is, as Bill said, that it is small and there may not even be positive costs if you confine it to excess. The issues of paying interest on required reserves are possibly a little more troublesome, but that may be viewed as a worthwhile cost to undertake at this point.

  • Let me interject. If there’s a sense of the Committee that this is something we should escalate, let’s move it up the ladder and do that. But anyone who wants to comment on that during the go-around, please feel free. There was a second part about the United Kingdom, I believe.

  • With respect to the U.K. system during the period of turmoil, banks’ initial reaction was to lower their reserve deposits, their contractual commitments. But they came to their senses and realized that holding more rather than less was a more sensible approach, and the Bank of England accommodated the banks’ desire both to increase their targets and to widen the bands.

  • Pretty dramatically, in fact.

  • Quite dramatically, to avoid the end-of-period spike in rates. In terms of rate volatility, the Bank of England, the ECB, and the Fed all achieved about the same rate volatility during the period of market turmoil. For the Bank of England, the spikes just tended to be more on the upside than the downside, but that had to do with their implementation procedures and not getting to the end of the period and being willing to accommodate.

  • I assume it was the stigma problem as well.

  • Though they had a few trades above their lending rate, in fact that was not much of a problem. Their system worked quite well. Interestingly, the country with the smallest rate volatility during the whole period of market turmoil was Canada, and that’s because they knew the demand for balances at the end of every day and could adjust the supply by adjusting the government balance at the end of every day. So they hit it basically every day.

  • Other short questions? President Fisher.

  • A very short question having nothing to do with what everybody else has asked about—but going back to page 33, what are the governance issues, and how do you resolve them, in 30 seconds or less? [Laughter]

  • Well, the governance issues are that the FOMC is in charge of open market operations and setting the target for the federal funds rate, at least under current approaches to policy. The legislation specifies that the Board is in charge of setting the rates paid on balances to institutions. For instance, there may be differential rates as in option 1 on required reserve balances and excess reserve balances. Presumably, if we went with option 1, for instance, one approach would be to simply set them by formula relative to the target federal funds rate. We don’t mean to say that this is likely to be an enormously large issue, at least in some of the options, but it ought to be handled carefully.

  • My question is about intraday and day-to-day volatility in the funds rate. I would think that as long as we hit the target on average, that kind of volatility wouldn’t have any significant macroeconomic consequences. So why would we care?

  • That’s our impression, that it doesn’t have macro consequences. Maybe it’s a tempest in a teapot, but for the participants in that market, the uncertainty and the costs that are borne by borrowers and lenders are an important issue. But the macro fallout, the effect on longer- term rates, doesn’t seem to be significant.

  • What we don’t know is whether that volatility somehow has consequences for term funding. How do you know the linkage between the two because they’re happening sort of simultaneously? But I agree with Spence that we don’t think there’s any significant macro effect. There may be some marginal effect of volatility creating a greater risk premium in the market, but it’s hard to say.

  • There is an effect on swaps, like foreign exchange swaps, right?

  • Well, for a lot of what we seem to get—like the Eurodollar rates and LIBOR and foreign exchange swaps and the way they relate to what goes on in our overnight funds market—the typical intraday pattern is firm in the morning and coming off late in the day. Those higher morning rates are the ones that are linked to the other rates—Eurodollars, swaps—and so it’s not the average rate over time that seems to get priced into these other vehicles.

  • The high morning rate could conceivably affect other rates in a way that’s—

  • It sounds like an obvious arbitrage opportunity.

  • Well, we’re not seeing much arbitrage.

  • We are finding a great reluctance to do intraday arbitrage. We’re hearing this from the banks that in the past would do that from time to time. Coming back to one of the other questions that Don had about what we are hearing about stigma from some of the banks, one of our better contacts, Citibank, as Jim mentioned, used to do a lot of arbitraging and using the discount window, the primary credit facility. On occasion, after they borrowed to re-lend in the market at a higher rate last year or so ago, they would call us in the morning to let us know how it was that they were helping us out with the funds rate. That has pretty much stopped cold, and they have decided on sort of classic stigma. They routinely point to the publication of borrowing data in the H.4.1 release, and they are just not interested in the small gain from that kind of activity while taking the risk in the market of being seen as in dire need of liquidity.

  • The TAF auction results underscored the idea of stigma at the primary credit facility. It’s possible that we have actually a bit more stigma now than we did before because you can just see very clearly that there would have to be stigma for people to be bidding that much in the TAF auction.

  • President Evans had a two-hander.

  • My primary comment in all of this is related to what President Stern, I think, said. The way the objectives are worded here is “enhanced monetary policy implementation,” and the memo is worded more like, “How do we get our federal funds rate target effectively?” or something like that. But there is really no discussion that I could find about the transmission of our policy actions to the economy and to inflation. Under our current regime, we think, quite confidently, that the short-term federal funds rate prices short-term risk-free assets along the yield curve all the way up to the Treasuries and then corporates are priced off all of that. I associate that with Marvin Goodfriend, who taught me that quite some time ago. It’s not money; it’s not liquidity; it’s not the reserves per se. It would be nice if, for each alternative, there were some discussion that we are preserving our understanding of the policy transmission mechanism or that we are enhancing it or whatever. President Lacker mentioned the Bank of England—maybe we could set the policy rate as they do. The question is, What will the markets do in terms of actively arbitraging something that helps price these securities? This may not be an issue for many of these systems, but until there’s some kind of analysis, I’m not so sure. It’s not just averaging over the maintenance period, and I think that analysis would be useful.

  • Governor Kohn shamelessly stole my question. [Laughter]

  • Governor Kroszner, do you have a question?

  • Yes. In a lot of the discussion you just take as given the stigma associated with the primary credit facility, and you were just discussing that related to the publication of information about the facility. Is that something that could also be on the table? That seems to be potentially an instrument for which we might have to consider how much information to provide or about making it less or more attractive, which then would affect which options are more or less attractive. Is there some reason not to do that?

  • I think that’s worth some further thought, Governor Kroszner. One issue though, as I’m sure you know, is that the Board is required by law to publish weekly information on the individual Banks’ balance sheets as well as the consolidated balance sheet with a certain amount of detail. I don’t remember the exact legal wording, but at least within the current law, to back away from that might be difficult. Of course, you could conceivably pursue a change in the law, but I think we would want to think about the pros and cons of that before you went in that direction.

  • For sure, but just thinking about whether there are other things that we could do related to stigma might be worthwhile in this context.

  • Absolutely, we agree. Of course, when the Board adopted the primary credit program in 2003, we gave a lot of thought before that and did considerable work after that to try to minimize the amount of stigma by trying to make very clear to banks that in our view use of the window didn’t entail stigma. But the fundamental problem still is that banks are concerned that their use of the window may be detected in the market one way or another, especially in a period of financial stress, and that is just not a cost worth incurring.

  • President Plosser, did you have a question?

  • Yes, just an implementation question. One thing you talked about was in periods of stress, the way we’ve conducted policy intraday, you have had firmness in the funds rate in the morning and then weakness in the afternoon causing some intraday volatility. The difficulty of hitting the target was partly the fact that we were entering the market only once a day, in the morning, and you had to see through that. With all these other strategies, as they are implemented in other countries, are the central banks doing the same thing? Are they entering the market only once a day, or do they come in several times a day? I just wondered if there are differences in their approaches as to how often they interact in the marketplace.

  • I would say, as a general characterization, that the common practice is to intervene only once a day, in the morning—not unlike what we do. Where there’s an exception, it’s like with the Bank of Canada. They have access to information that would allow them to know with precision late in the day what the supply of reserves is in the absence of any further open market operations, and then they make an adjustment accordingly.

    The fact is that, even if we were to operate late in the day but still before the close—let’s say, 5:30 or 6:00—we really have no more information than we had at 9:30 in the morning upon which to make an estimate of that day’s reserve supply. We can observe rates, but we don’t know what amount of a reserve adjustment would be needed to bring supply in line with demand. The risk of just opening up and offering to be one side or the other of the market in that situation late in the day is that we could get the entirety of one side of the market and actually create a reserve imbalance in the other direction between that time and the close of the day. So simply being willing to operate late in the day isn’t really enough. You do need reserve information as well upon which to size those operations.

  • Just to make this clear, Spence, is it the number of banks that make that information more accessible in Canada, or is it something else? Is it fundamentally that they have just five banks?

  • No, it is that they know the balance sheet. They know it by late in the day with certainty. They have few sources of uncertainty to begin with, and their major source of uncertainty, government balances, is something that perhaps the small number of banks they’re dealing with facilitates. But it is that they know by late in the day what the supply of reserves will be with real precision.

  • Basically everything clears through their equivalent of Fedwire, so they know in real time what the balances are.

  • Okay. Did you have a question?

  • A comment about stigma. Every financial transaction that a substantive firm engages in that becomes known is relied upon by market participants to make inferences. There’s a huge literature on the effect on equity values of the announcement of a bank line of credit; and like through this last crisis, if you talk to funding-desk guys, they’re very aware at the tactical level about what counterparties are revealing by their actions in funding markets. They take that on board, and they’re very strategic about what they reveal with their market transactions. We can try to keep it secret, but there’s a broad ability in the market to infer when somebody goes to the window by their behavior before that. I’m saying that I don’t think we should get our hopes up about ever eliminating stigma.

  • Okay. Let’s take positions and comments, keeping in mind that lunch is being held hostage. [Laughter] President Rosengren.

  • Okay. Just a quick question, which doesn’t have to be answered now—given all of the financial turmoil, it would be interesting to see whether in other countries that have these different arrangements there was a decrease in either overnight or term lending with counterparties. Given the extent to which you can just work with a central bank rather than counterparties, is there any evidence in these other regimes that interbank lending transaction volume disappeared in some of these countries? I would be interested in seeing that. Regarding Governor Kroszner’s comment on the H.4.1 release, it does seem that we could probably have a materiality requirement in our balance sheet. Under most circumstances, what we are doing at the discount window would seem not to hit that materiality criterion. I think we could be a little more innovative—I agree with President Lacker’s point—but I think that the H.4.1 does seem to have an effect; and if we will be doing all these other things, taking another look at the H.4.1 and making sure that we don’t have more untapped flexibilities probably makes a lot of sense.

    I would like a little more discussion of “promote efficient and resilient money markets and government securities markets” as a criterion. I’m not sure I would weight those criteria equally. It seems that all these criteria, for the most part, take care of most of the dead weight loss; and given that the banks still have to administrate for daylight credit, I am not sure that the burden is all that different across these various regimes. But I can imagine that that one might be different, and given we just had financial turmoil—I know this is a bit different from what President Lacker said—I would put a little more attention to that.

    Overall, I like option 2 and option 5. I’m comfortable with those two. I’m attracted to the voluntary balance program. On net, I would probably prefer a longer maintenance period to a one-day maintenance period, but I don’t have a strong preference and could easily be convinced otherwise.

  • Thank you. President Evans.

  • Thank you, Mr. Chairman. As I mentioned earlier, I would find some discussion about the transmission mechanism useful—at what rate we think the markets would be picking up the price of risk-free yield curves. I think that would help. To the extent that we can align this with other foreign central bank experiences, we might be able to draw on how they view that and what the financial market data look like. So I am comfortable with focusing primarily on options 2 and 5. I was thinking along the lines of President Hoenig, which is that the Federal Reserve tends to go slowly. Vince isn’t here, but he often reminded us of that. Option 1 is the easiest one. If we have enough information about it, then that’s fine. I think that’s all I have.

  • I have only two comments. I would drop option 1. I just think it doesn’t do enough to reduce the burdens and dead weight losses. As long as it’s there, there will be a tendency to fall back to it for all sorts of reasons, given bureaucratic tendencies. So I would just discard it. I would not discard option 4, so I would include options 2, 4, and 5. I was originally attracted to 4. I read the reservations in the report and thought, okay, it’s not worth pursuing. But I listened to President Lacker, and he reconvinced me that there are some significant merits there.

  • Thank you. First, I do really appreciate all the excellent work the staff has done on this topic. I really learned a lot from these papers. I thought they were very clear and very comprehensive. I have just a couple of comments on the questions that Bill and Brian raised in the memo. The first one has to do with whether or not we agree with the objectives, and I do have a couple of issues.

    First, I think that the stated objective of reducing the burdens and dead weight losses associated with the current reserve tax is too narrowly framed in the paper. My starting point is, about burden, that to cover a given program of government spending, the Treasury has to obtain revenue from some source, and nondistortionary lump-sum taxes are not one of the available options. So the real question from the public finance standpoint is what to tax and how much. That means, to my mind, that the issue here is how the magnitude of the welfare gains that would come from lowering the dead weight loss due to the implicit tax on reserves compares with additional dead weight losses that would result from the alternative taxes that would have to be raised to make up for this lost revenue. Now the answer depends in part on the interest elasticity of demand for reserves, I believe. I think it is the case that, if the interest elasticity is relatively small, the dead weight loss from the reserve tax is relatively small, and the net welfare gain, taking into account the burdens of raising other taxes to make up for the lost seigniorage, in effect, could easily turn out to be negative.

    Let me give you an example of where this comes into play. There is a well-known paper by Martin Feldstein in which he looks at the benefits of moving to price stability, zero inflation, which he favors. He looks at this issue in that context, and he concludes that there would be net social losses, not gains, from the reduction in seigniorage that would be associated with a move to zero inflation from positive inflation because the dead weight loss due to the shoe-leather cost, also known as the Bailey effect, is smaller than the dead weight losses that would be associated with alternative taxes. In his analysis they are taxes on labor supply and saving. I actually think that this is a serious problem with the framing of the objectives in this paper. It is, in effect, saying, “We think we should give a tax cut. We think we should give it to banks, and we think that, because there is a welfare loss—a Harberger triangle—associated with that, this is clear welfare gain.” Now, I am not pretending to know exactly how this would come out, but I do think that’s the issue. If it were to come out that this is a net loss, not a gain, a possible implication is that if there were a fallback to option 1—I’m not saying that I favor option 1— there could be a case for paying no interest on required reserves rather than paying interest at the federal funds rate but paying interest on excess reserves at some rate that we would determine.

    There are administrative costs with having voluntary target balances, and it seems to me that the paper, as we come out with it, ought to try to at least estimate what the administrative burdens associated with options 2 and 5 would be.

    Another comment on the issue of objectives: If we are coming out with a white paper, it seems to me that the objective that everybody is now discussing and that was just discussed— namely, that paying interest on reserves would enable us to expand the size of our balance sheet in times of financial crisis, like now, and perhaps greatly enhance the scope for liquidity-altering interventions that would be possible without having to push the federal funds rate to zero—is a real improvement in the tool kit that is available to us to address market disruptions. I would see it as an advantage of paying interest on reserves. If you are discussing this right now with the Congress and it is much discussed in the press, I think it is kind of odd to come out with a paper that doesn’t even mention it. Maybe there are disadvantages and not just advantages. But it seems to me it should be there.

    Also, I would just say on the question of options 2 and 5 versus options 3 and 4, an advantage that the paper attaches to having voluntary targets is the ability to moderate the volatility in the federal funds rate. So it does seem to me that—I understand it may be difficult—the possibility of intervening multiple times during the day as an alternative, if it were possible to change the procedures so that there could be multiple interventions to reduce volatility, would mean that 3 and 4 could be on the table, and there might be less burden associated with those. So I think that possibility deserves at least careful consideration.

  • Thank you. President Bullard.

  • Thank you, Mr. Chairman. This is a proposal for study. The timeline seems fine to me. The study period is pretty important in this case because it is not clear to me which option is best, and so I think maybe we should keep more of the options on the table. One question that I have is, To what extent are current reserve requirements actually binding for depository institutions? There is a past study by the St. Louis staff—Dick Anderson and Bob Rasche—suggesting that, by and large, existing reserve requirements are not binding. To me that calls into question whether objective 1 for this study group is really appropriate. Dead weight losses make sense to me only if there is a binding reserve requirement. In that regard, I’d like to endorse President Yellen’s comment, which I thought was right on target, about whether you are going to make up for lost revenue from somewhere else and how distortionary that would be. There is a bit of political risk here that, if this starts to get painted as a handout to banks, maybe it wouldn’t serve us well.

    I would like to see more emphasis on option 3, which based on the discussion seems to be not too bad a system. That is the Canadian system. That is a tested system in an economy that is not too different from our own—certainly, an economy that is closely integrated with this one. The corridor would be narrow. There might be more volatility within that corridor, but you still seem to get pretty good results. I know they have a small number of banks, but it seems to me with today’s technology you might be able to get a good read even for a large economy. I would like to see it kept in the mix here. They have had lots of success and very low administrative burden, if that is what you are worried about. I am perhaps not so familiar with options 2 and 5, which are the favored options in this discussion. But I am concerned about the language of voluntary balance targets, which seem to be maybe not that voluntary. It seems to me to create a risk that the systems are really not as market-oriented as I would like to see or that they could be manipulated by market participants, particularly in a time of stress. Those are some of the concerns I had about this.

  • On the public finance question, of course, the Congress has acted and they score it to cost. So in some sense that is moot from our perspective. President Pianalto.

  • Thank you, Mr. Chairman. Let me also start by commending the authors of the papers that were prepared on this topic. I found the material very informative and helpful. I agree with the objectives established by the staff to evaluate the set of proposals, and I also support the process and the proposed timeline for moving the proposals forward. I think it is good that the timeline provides for comments from banks so early in the process. It will be important for us to receive their input at an early stage.

    I found option 2 to be preferable to option 1 because option 2, as we have discussed, clearly reduces the administrative burdens relative to option 1. I think that option 3 leaves too much potential for fed funds rate volatility in its corridor. I was also intrigued by option 4 with caps. However, I ultimately rejected option 4 out of the concern that it might lead to a less robust interbank lending market. But given the comments of President Lacker and others, perhaps it makes sense to keep option 4 on the table. In the end, however, I am comfortable with moving forward with our focus on options 2 and 5. Thank you, Mr. Chairman.

  • Thank you. President Lockhart.

  • Thank you, Mr. Chairman. Just to answer the questions that were posed, I am comfortable with options 2 and 5, but I thought President Lacker’s presentation made the case that option 4 deserves to remain in the mix. I think the objectives are appropriate. The only comment I have—and this is a bit vague, I realize—is to ensure that we are thinking far enough ahead to ensure that we have a durable system that can operate in different mixes of private and public in the payment system. Certainly, I think it is conceivable that in some years we will be out of the business of retail payments, so I think we have to address different mixes of private and public payment systems.

    Regarding the timeline, Governor Kohn already asked the question about approaching the Congress to accelerate. Assuming that we do not approach the Congress to accelerate this, then this timeline seems to me quite comfortable and gives plenty of time for very careful consideration.

    In the room here is Will Roberds from our research staff, who by chance was at the Bank of England talking about their experiences recently. I thought I would share a couple of things that are apropos. They tried maintenance periods other than the intermeeting period, and they found them to be not so effective, apparently because of ambiguity around the target rate. That is a useful way of thinking—that the maintenance periods would be designed around the intermeeting period. They apparently tried option 3, and it didn’t work because of too much volatility within the corridor. Those two tidbits are feedback from the visit of a member of my staff to the Bank of England. Thank you, Mr. Chairman.

  • Thank you. President Hoenig.

  • Thank you, Mr. Chairman. I would look at this meeting as an introduction to this topic, given the breadth of the discussion here, which I found extremely interesting and useful. I think we will need to come back to another discussion of it—not necessarily with another 100-page study. I wouldn’t want to put that burden on you—it might negate any savings we get from this project. [Laughter]

    To the point of the options, the one that was most attractive to me was option 2. It is a good transition. We have some familiarity with it, given the way we do clearing balances now, and I think we can work on it. The reason that I was a little questioning about option 1 is that in option 2 you are not quite sure what you are going to end up with, given how the banks may choose to target the amount of reserves and so forth. But with any choice we make, we are going to have to go up that learning curve. So of those, I prefer option 2. I am fascinated, though, with President Lacker’s comments on option 4 and will look at it again with that in mind because I thought he made some good points. But at the moment, I think option 2 is a pretty good path to go down.

  • Thank you. President Plosser.

  • Thank you, Mr. Chairman. This will be very brief. Option 2 looks very attractive to me. I think option 1 may be a fallback position, but like President Stern, given our tendency to move slow too quickly, if that makes sense, I would rather take the opportunity to make a larger step. So I think option 2 is fine. Option 5 is interesting, but its distinction is that nobody else is really doing that. So it would be a little more of a wild card in terms of how we might implement it and how it might work. But I think it has some merit.

    I had asked Bill Dudley back in the fall, when we were having trouble meeting the end- of-day targets, about why we didn’t set the price. The answer I got was, “Well, this was a good time to think about that option in the context of paying interest on reserves.” I was probably a little disappointed that we didn’t see more of what such a strategy might look like and how it would behave. Thanks to President Lacker, his interpretation of option 4 is pushing us more in that direction. I hadn’t really thought of option 4 in that context that way, but I like it. I still have the view that essentially looking at everything as a quantity-based view of how we go about doing this restricts the way we think about what our options might be. So I would like to see a little more explanation of what a price target, where we buy and sell, might actually do. How that might interact with option 4 would be an interesting way to enrich the set of options.

    Another question I had—and I don’t know the answer to this—is that we have instituted a number of new facilities. There is the TAF, there is the TSLF, and so forth. I wasn’t quite clear how those facilities would interact or be appropriate or inappropriate within the context of these things, or whether this would substitute for all of those in some sense. If we wanted to pull those off the shelf again at some future time, how would they interact with these systems? I think it would be useful to have a little discussion about what those interactions might be.

    The last observation is related to President Lockhart’s comment. How we go about paying interest on reserves has implications for other parts of what the Federal Reserve System does—in particular the retail payment system and the way we calculate cost recoveries and our revenues under the Monetary Control Act. There are some separate study groups that are thinking about this, but we ought to make sure that we tie these pieces together as we go forward so that we know what the domino effects of going this direction might be. Maybe there will not be a concern, if we get out of retail payments, how it affects the Monetary Control Act requirements on fees for services and things like that. I would like to see that loop closed somehow before the end of the discussion. Otherwise, I want to congratulate the staff on a very thorough report. I was at the conference as well in February. I thought it was very interesting, and I applaud the staff on some good work. Thank you.

  • Thank you. President Fisher.

  • Mr. Chairman, we have been in favor of paying interest on reserves for some time. This is an excellent paper. Like everybody else, I learned a great deal from all the papers that were sent and this superb summary that was just presented. I personally tend toward option 2, but I think it is worthwhile considering options 4 and 5 as well in terms of vetting this under the timetable. I think that Charlie asked a good question about how this relates to the other facilities, but generally, the optics on this are favorable. Again, we are moving forward. The public doesn’t really understand the background of this—where the Congress has stood and what we have achieved so far. I think it would be just one other good thing for us to be modernizing the Federal Reserve.

    I asked the question on governance just because I understand that the current plan calls for rates to adjust automatically to changes in target set by the FOMC. I would want to make sure that was the case. In other words, I don’t like the potential for vesting all the power in the Board; and, of course, that potential is there. I think it is worth preserving the federal system of the Federal Reserve. That is the only reservation I have. Those are my comments. Thank you, Mr. Chairman.

  • We don’t want it. [Laughter] Governor Kohn.

  • Thank you, Mr. Chairman. I thought this was a great piece of work by the staff, and I thank them all. You did a good job of organizing it and laying out the general principles in a way that people can understand. Despite President Yellen’s comments, I have no regrets about my testimony in favor of paying interest, perhaps because I bore so much of the administrative costs over the years [laughter]—along with Stephanie Martin and her predecessors in the Legal Division. Those costs that were borne were considerable, in addition to the dead weight losses.

    I think we should consider options 2 and 5 for sure. On option 4, I think we need to understand a bit—other people have said this—what the third objective, “promoting efficient and resilient money markets,” means exactly, what is entailed, and how that would intersect with option 4. So I think that needs to be fleshed out a little more. Because you have planned to get a white paper out soon, I think perhaps including option 4 would be easier than not including it, just to get people’s comments. Perhaps because of my administrative burden experience, I would like to see reserve requirements at zero, ruling out option 1. On option 3, I just don’t think, at least with our system and in periods of crisis, that the top of the band would hold, so I don’t think that option would really work very well. Thank you all for your work.

  • Thank you, Mr. Chairman. Let me add my plaudits to those already expressed on the quality of this work, and then let me confine my comments to the timing and sequencing. First, with respect to the rollout of the white paper, it strikes me that, given that questions have been raised about what our flexibility is around our balance sheet and tools in the event of continued problems in the financial markets, we just need to be cognizant in that paper of how this discussion might be read, not in the context of a long Fed effort to get interest on reserves but perhaps as being solely responsive to what are perceived to be burdens on our balance sheet flexibility. I am just sensitive to how that white paper will be read and rolled out. More broadly, on timing—come fall, in the event that we decide collectively to go to the Congress seeking other authority with respect to the PDCF, investment banks, and other things that might or might not be concluded, even though this timeline makes a lot of sense, we might be in good stead to have a fairly good sense of the conclusions to which we will ultimately come, even if our exhaustive Fed rigor isn’t complete by that time. If there is real benefit to accelerating our new authority from late 2011 to some earlier period, we could put that in the context of some of broader asks from us with an expectation that we might get some traction there. So as a sort of secondary timeline, having that option value come fall strikes me as useful. Thank you, Mr. Chairman.

  • Thank you. Governor Kroszner.

  • Thanks. Great work, great presentation. It is impressive to get through fifty-two pages in less than fifty-two minutes, and so I applaud you on that. Basically I agree with a lot of the stuff that has been said before. The trick may be thinking a bit creatively about stigma issues, if there is any way to deal with those. I am not quite sure what you are suggesting putting out in a white paper for comment—options 2, 5, and possibly 4? Or were you thinking of putting all five out?

  • Well, I certainly think at this point the three that you mentioned first. At this stage, if we are going to go to with three, we might want to think about putting all five out, just to flesh out all parts of the spectrum and acknowledge that option 1 could be a fallback. We have to think about the pros and cons of that, but certainly the three at this point is where the consensus seems to be.

  • Doing three of them seems perfectly reasonable. Thank you.

  • I am very comfortable with the analysis and the approach, so I don’t have any major comments there. Although in the white paper you might mention them, I would like to take options 1 and 3 off the table. Option 1 has just too much administrative burden. We have enough tsuris already. Although option 3 may work well in countries with very different structures of the banking system, I don’t think it is a feasible alternative for us. So I think that we should look at options 2 and 5, and I am certainly comfortable with another look at option 4.

    One issue that I worry about a bit is that these markets do sort out some interbank credit risk issues. We don’t want to lose that, so we have to be very aware of it. I also worry a bit about setting a price when there is a credit risk element to it. When there is no credit risk element—if you want to set the Treasury bill rate—it is no big deal. But there may be an issue there, I am not sure, and it should be one of the considerations in this context. Thank you.

  • Vice Chairman. Oh, sorry. President Lacker.

  • Presumably, the rate we pay would be viewed as a risk-free rate. Presumably, any market rate would be priced relative to that to include a credit premium in the usual way. If any other dynamics are anticipated by the staff, it would be useful to know that. But the usual presumption we have is that observed market rates would have our rate plus a credit premium booked into it, or transaction costs, or whatever. I’d just make that comment.

  • Thank you, Mr. Chairman. I don’t have a conviction yet on the options, but I agree that we should narrow our focus to options 2 and 4-5. I think we should design a process that tries to force us to get conviction more quickly on which option we would prefer. I think it is possible. You have made a huge investment already. You know the alternatives. I think it is worth, again, a goal that gets us conviction more quickly, in part because we do have a brief window now in which we might be able to get the Congress to accelerate and we could implement more quickly. I would get the Congress to accelerate if I could be totally confident that it would be free, that we would pay no price, and that there would be no risk that anything else would be on the table or that it would compromise any other objective. It is very hard to have confidence on that. But if you get confidence on that, then I would go do it. But I would certainly run a process by which we get conviction early.

    I would want us to have conviction before we go out for public comment. The general rule is to figure out what you want to do and design a process that maximizes the chance that you get there quickly. It also strikes me that a process this drawn out will take much more staff time. You guys are busy. We don’t have a lot of time. We don’t have a lot of excess capital in the Federal Reserve System now relative to the challenges we face. The longer it is drawn out, maybe the smaller the tax day by day, week by week, but it is just a huge tax. I would not want to go out for public comment on a white paper in this time frame until I knew two things. One is, Are we going to get the Congress to accelerate? If so, on what? What is the probability? Are we going to ask for it? The other is I wouldn’t do it until I knew that we were closer to saying, “If we got it, we would do this in this time frame.”

    Finally, I think it is hard to have this discussion in public with the Congress now without an answer to what they will perceive to be the larger questions. What are the larger questions? I think that you can reduce some of the larger questions simply to, What are we going to do with our role as lender of last resort going forward? This is a version of President Plosser’s and Governor Warsh’s questions—what the future of our facilities is, in some sense. The staff has assured me that these options all preserve optionality on any future facility framework. They don’t prejudice those options, which is very important. But I think there is a demand now and interest in what our answer is to those broader questions. It is hard to see the architecture of our role as lender of last resort without having the answer to what the framework will be for restraints on risk-taking by institutions that have access in normal times and in extremis to those lender of last resort facilities.

    We can’t get conviction on that in the same time frame that we need to accelerate legislation on this stuff, but—and probably because—I think those things are fundamentally more important than whether we end up with 2 or 4.5 or 5 on the way to 4.5. I would try to shorten the amount of time and effort we put into this, and I would increase the amount of time and effort we put into that broader set of policy questions, which are going to be essentially about the intersection among the lender of last resort role, our monetary policy regime, the moral hazard consequences of all the stuff we have done, and how we deal with those in the future. I think that is going to take a lot of time, effort, and care.

    I don’t know how to reconcile all of what I just said in the context of a practical path forward, except just to repeat it. Why not try to run a process in which you get conviction more quickly on this relatively small set of adjustments as to how we operate? Try to get a judgment quickly about whether we can get the Congress to accelerate without any meaningful political cost, then design a process whereby we put ourselves in the position to implement early next year, if the Congress were to accelerate. And try to have the resources saved by attenuating that process devoted to these deeper questions about our future facilities and the associated constraints we are going to have to put on a broader set of institutions.

  • Thank you. On those broader questions, Vice Chairman, we are going to talk at lunch about some initiatives by which we will address some of the broader regulatory and bank supervision issues. That process will be parallel to this. What I would say about this issue is that, as you go forward, you should keep in mind the possibility we might want to go to the Congress for some kind of interim power. Obviously, there are things that we can do that are not the full panoply of things you described today. They would be interim steps, and I think that the most important thing is to make sure that whatever we ask for would not be inconsistent with or contradictory to some of the longer-term plans. We obviously don’t anticipate implementing option 5 next year, but we could take some interim steps that potentially might be useful in the current circumstances.

    Very briefly, I agree with President Fisher and President Lacker. This is a once-in-a- generation chance to modernize our system. It is a relic that we use a quantity-based management of the federal funds rate. So I think option 1 should be a fallback if we can’t make something else work, but we should try very hard to see if we can find a system that will let us manage the funds rate tightly, even as our balance sheet expands and contracts, and so on. I have the same concerns about option 3, that it might not tie down the fed funds rate very much. Options 2 and 5 are interesting. I agree with President Lacker that option 4 is worth exploring. I broached this with the staff before the meeting. Option 4 seems a lot like Friedman’s optimum quantity of money: You just throw out money until the transaction cost on margin is zero. That’s basically what it is. I don’t, frankly, fully understand what the implications would be for the federal funds market—whether the federal funds market is just a shoe-leather cost or whether it actually has some useful functions, including price discovery, credit risk management, and counterparty discipline. There may be some functions of that market that are important, and even if it still existed, if its liquidity were greatly reduced so that it wasn’t functioning in a normal way, it could be a question. To my mind, that is the main question we have to understand as we think about option 4. Once again, terrific work, and this is really exciting, interesting stuff. So thank you all very much. Are there any other comments on interest on reserves?

    Okay. If not, let’s see. First, again, the projections are due Thursday at 5:00 p.m. If anyone has changes, please make the effort to do that. We will be circulating information on the 2009 FOMC schedule to try to come to closure on that. The next meeting is Tuesday and Wednesday, June 24 and 25. In a moment, we will adjourn and get lunch, but please come back to the table so that we can have some discussion about some of our longer-term issues on supervision and regulation. Thank you very much. The meeting is adjourned.