The Federal Reserve Bank of New York today released Divorcing Money from Monetary Policy—a new forthcoming article in the Bank’s Economic Policy Review series.
In recent decades, the primary focus of monetary policy for central banks has shifted from measures of the money supply to the value of short-term interest rates. However, the quantity of money and interest rate policy remain fundamentally linked, as the supply of reserves must be set precisely in order to implement the target interest rate. This relationship can generate tensions with central banks’ other objectives, as reserves play other key roles in the economy.
Evaluating central banks’ ability to “divorce” the relationship between the quantity of reserves and the interest rate target, authors Todd Keister, Antoine Martin and James McAndrews suggest that paying interest on reserve balances at the target interest rate can eliminate the tensions between monetary policy and the money supply. This would allow a central bank to set the quantity of reserves and the interest rate target independently of one another. This feature may be particularly important in times of acute market stress, as it would allow for an increase in the supply of reserves without driving market interest rates below the target.
Using a graphical model of the monetary policy implementation process, the authors show how paying interest on reserve balances creates a “floor system,” which allows the central bank to set the supply of reserve balances according to the payment or liquidity needs of financial markets while simultaneously encouraging the efficient allocation of resources.
Keister, Martin and McAndrews note that policymakers should carefully evaluate the potential challenges this floor system may create, both operationally and in terms of the potential effects on financial markets.
Todd Keister and Antoine Martin are research officers and James McAndrews a senior vice president at the Federal Reserve Bank of New York.