Lacker Says Fed Buying T-bills to Keep Reserves "Ample," Would Have Dissented on Rate Cut

Former Richmond Fed President: T-bill purchases driven by credit-conditions, not monetary policy path; Fed focus on its staff's BLS revisions misguided, not useful

Jeffrey Lacker was president of the Federal Bank of Richmond during an historic period of extreme economic turbulence and groundbreaking policy moves.

He started riding the monetary policy waves in 2004, when a bursting subprime mortgage bubble was about to open the door to the worst recession since the Great Depression and kick off the Great Financial Crisis, all the way through to 2017 during the years when the Fed took ground-breaking steps with bond purchases to put the economy back on a growth track and push inflation back up towards the Fed’s 2% target.

Jeff also has had a long and distinguished career in professorship and research at several universities over the years and in fact is known for drawing on the Fed’s history and its monetary theory in his work, with one big area for him being the Fed evolution of its credit policy.

So this is one big reason why I asked him to join me after the Fed’s policy-making Federal Open Market Committe decided not only cut its key rate by 25bps this week as widely expected, but even more so because it surprised markets with it’s decision to start buying Treasury bills this week to maintain financial stability — a step that was not expected until well after the first of next year.

The stock market saw this as “QE light,” referring to the quantitative easing steps of the recent past where the Fed bought Treasury bonds to bring down long-term interest rates in order to boost the economy and make sure that financial markets would keep functioning smoothly.

Jeff emphatically disagrees. “It has nothing to do with monetary policy,” that is, setting the fed funds rate at a level they deem necessary to achieve their dual mandate of price stability and a healthy labor market.

What the T-bill purchases DO have to do with is the level of bank reserves in the system and how the Fed sets a rate on those reserves to which the Treasury bill rate “must adjust through basic arbitrage.”

Does this sound too technical, does it make your head hurt to think about bank reserves and why you must understand how the credit-policy-tools side of the Fed works?

Don’t give up. Instead, dive in and let professor Lacker give you an in-depth, understandable lesson on the fascinating history of all of this going back to 1950’s and encompassing the current state of the Fed’s affairs.

As for the Fed’s highly-dissented rate cut, find out why he would have dissented too if he were still on the FOMC, and was surprised that Chair Powell was not more hawkish at his press conference. Spoiler alert: a labor market that doesn’t look like it’s getting a lot weaker, and above-target inflation are key reasons to him.

And hear what Jeff makes of the Fed’s decision to approve the reappointment of its regional Fed bank presidents and vice-presidents on the day after its policy meeting at after the close of the trading day - the other big surprise news-making event of the Fed’s week.

Fed Bill Purchases are not about monetary policy 00:03:22:13

It has nothing to do with monetary policy. And, I’ll explain, trying to be very precise about what I mean by that. The Fed sets an interest rate that it pays on bank reserve account balances and the supply of reserve account balances, the amount that’s in the system is determined by the Federal Reserve, and that number is in the trillions. I think it’s like $4 trillion right now. So, that is so much, reserves that any bank at the margin isn’t going to pay any other bank that everyone has more reserves than they need. The banks hold a liquidity buffer. It consists of these reserve balances at the Fed plus treasuries, short term Treasury securities and short term, Fannie and Freddie debt.

Reserve balances are a portion of banking sector liquidity 00:04:11:07

And, these reserve balances are a fraction, maybe a third of their total liquidity buffer of the banking system. At the margin, they’re <Banks> kind of indifferent between T-bills in these bank reserves and the way that happens is the Fed sets an interest rate on reserves, and the t-bill rate has to adjust so that banks are indifferent. It’s a basic arbitrage relationship.

The interest rate is monetary policy 00:04:37:07

And that relationship spreads like, like, ripples on a pond. Throughout the for the banking system and all the interest rates around. Once the Fed sets the interest rate on the reserves, it’s done with monetary policy. Everything else is something else besides monetary policy.

Repo rates really matter 00:05:36:19

It’s an interesting question. So, as I said, the amount of reserves in the system is so large, that no one, no banks are willing to pay any other bank to borrow them. Everyone has as much reserves as they want centrally. So the interest rate in the marketplace on loans between banks has fallen to, it’s actually below the interest rate on reserves. And, banks essentially don’t borrow from each other. The only, the only people working in the funds market are institutions that are not, by law, allowed to get interest on reserves. So the fed funds rate is a little below the interest rate on reserves. So set that aside… Repo rates are really important. In fact more important, arguably much more important than the federal funds rate. And they track with, the interest rate on reserves because, you know, the arbitrage relationship means that banks can either hold reserves or they can invest those reserves in, in RP lending, and make money that way. And so they have to be sort of indifferent at the margin. Otherwise, you know, there’s going to be some adjustment in rates that has to take place.

Context…the way things USED TO work… 00:06:56:10

So <right now> the reserve balances are so high that they, they just squash any differences between these two things. Let me contrast this with before 2009… So in 2008 and earlier the fed didn’t pay interest on reserves. It wasn’t allowed to by law until October 2008. And…it kept the funds rate high, you know at times it was five-, six-, seven-percent. And it did that by shrinking reserves down to very close to required legally required reserve requirements, for the banking system. So the banks, they’re required by law to meet a reserve requirement over a two-week period, and the Fed would give them just a little bit more than that and a little bit extra, called ‘excess reserves.’

An excess reserves buffer -- 00:07:48:00

And it was sort of a little big buffer that banks would keep. But it was like 1 billion or 2. It wasn’t very much at all. But here I’m going to ask you to recall a bit of econ 101. Okay. So, in any market, there’s a price, and in a market with a price, there’s a demand curve and it slopes down. So the lower the price, the higher the demand. So, when there’s only, like, 1 billion or 2 in the market, in excess reserves, that drove up the price, and the fed would manipulate that amount to change the federal funds rate. When the FOMC voted to change the federal funds rate target. So fast forward, if you add a lot of quantity that’s going to drive down the price, you’re going to move down the demand curve. And what I was telling you before is essentially that reserves are so large. The system’s reserve balances are so large that they’ve driven the price of reserves in the market, the overnight lending market, down to what the fed pays in interest on reserves, in fact, below. So think of this demand curve as like, pretty high when excess reserves are about $1 or $2 billion.

Bank reserves and their demand curve 00:09:09:01

And now we’re out at $4 trillion. So the price is very close to the interest rate we pay in reserves. Now when the the over the last decade and a half, the fed has varied reserve balances. There’s been quantitative easing then quantitative tightening then some more easing, then some more tightening. And through that they they’ve been able to trace out, the relationship between the interest rate and reserves and the federal funds rate, but more importantly, the interest rate and reserves and repo rates, which is the rate that has more of an effect than the economy. And what they found. Right. This is what you’d expect. Right? So with reserves really high, repo rates are really close to the interest rate and reserves. When reserve balances are low, like 2 billion, they’re really high. You know, the interest rates are driven well above what the interest on reserves is. And then it sort of slopes down in between.

Regimes of reserves 00:10:08:13

They’ve detected, you can detect, in the data. Since 2010 we’ve never had reserves below, you know, a trillion or so in that time period. But you can detect that there’s like a little, a little uptick in the demand curve. So the, the demand curve starts going up very slowly but slightly going up. And the Federal Reserve, the FOMC, decided several years ago that, they were going to categorize the amount of reserves in three categories.

Scarce, ample, and abundant reserve regimes 00:10:41:06

One is scarce. The regime before 2008 reserves is scarce. You drive the interest rate up well above the interest rate on reserves. When reserves are abundant, the demand curve is virtually flat and then starts to slope up a little bit. Reserves are ample. Scarce, but they’re not abundant. So this in this there’s a, a range between abundant and scarce called ample reserves, where our rates repurchase repo rates, and the federal funds rates start rising a little bit relative to the interest rate on reserves.

Ample has been the destination now Reserve management kicks in 00:12:42:20

So, yeah, the kind of both those views are. Right. In a sense. So the Fed does not intend this as a separate monetary policy tool, as the use of a monetary policy tool to alter economic conditions. That’s what it says. That’s its intention. And I take them at their face value. They’re executing on a strategy that they articulated years ago of reducing reserves that were abundant and then stopping when they got to ample, and then when they got to ample, they were going to have to keep reserves at a level that was just ample.

Ample is not defined <found>, not by size, but by effect> 00:13:30:08

They didn’t really spell out, quantitative measures for what ample was. They didn’t know they were going to probe until they saw when the spread between the repo rate and the, interest rate on reserves changed when it started to go up a little bit, they were going to change policy then and stop shrinking the balance sheet, but they didn’t know where that was, and they hit it, at/or before the last meeting, the one in October, they hit the point where they were starting to see some upward movement in the repo rate and the funds rate.

Fed found the ‘sweet spot’ 00:14:13:02

And so they stopped selling. And then, the so they kept things sort of flat. And then in the since then, in this last intervening period, that spreads started firming even more. So the repo rate went up a little bit, relative to and the funds rate went up a little bit relative to the interest rate on reserves.

A need to fine tune around this level 00:14:37:07

And so they deemed that a strong enough signal that they were in the ample reserve regime, ample reserves. Range. And so they intend to keep reserves in a range in which fluctuations in demand and, technical factors and supply things like tax payments, year end flows that those things don’t disturb, that spread.

Fed is buying bills but still hold a lot of bonds 00:15:08:09

Well, that’s a really interesting question. About the Fed buying only bills…So, your listeners will probably be well aware, that the Fed is, has negative net worth and has not been making remittances to the US Treasury for many years now. What happened is that they bought a lot of long term securities, at very low interest rates in the decade of 2010 and after the pandemic. And then inflation rose as and when inflation rises, interest rates rise. When interest rates rise, the value of long-term bonds falls. The interest rate the Fed pays on its liabilities, the interest rate on reserves <essentially overnight or short term interest rates- THE policy rate> goes up a lot. But the interest earnings on the Fed’s portfolio doesn’t adjust as rapidly because they have a lot of long term securities <that are still paying out fixed low rates from those earlier periods>.

Fed’s ’losses’ and negative net worth…do they really matter? 00:16:01:02

So I think I think although the economic impact to the world at large of the Fed not making remittances < to the US Treasury of tis profits>, or the Fed having negative net worth, can be debated. Some say, you know, if you just look at the economics of it, it doesn’t kind of matter right now. Nonetheless, it was politically embarrassing for the Fed, and it’s been a source of, criticism from some, outside the Fed. And so I think the fed would like to avoid that in the future to the degree. And so what the Fed’s moving toward is more of a ‘matched book,’ okay, in the technical term. So the interest rate on reserves are going to fluctuate with the interest rate paid on reserves, which is what drives interest rates. So they want short term <assets>. If they have T-bills then they’re much less exposed to the risk that the remittances go down. Okay. And that they suffer these capital losses. I mean, they still have $800 billion in unrecognized capital losses on their [Marked-to-market] balance sheet, $800 billion. So there is negative net worth now. They don’t use fair value accounting. They use book value accounting. So it doesn’t affect their registered capital. < But the private sector uses GAAP {Generally Agreed upon Accounting Principles] and under that framework the Fed would mark-to-market and its position would not look so good>

Embarrassment is not lethal but it may dent credibility 00:17:20:03

But that’s still embarrassing to besides the fact that remittances went to zero. So, they recently began making the recently stuff. Yeah. They recently began making remittances. But, that’s another story. Anyway, that’s why they’re trying to shift the portfolio from long to short. And this is something that I’ve pushed for for years. It’s a return to the policy in the 50s.

WWII monetary policy, the pre-accord Fed, & Inflation 00:18:12:18

Well, and this is a big challenge for the fed, and I don’t think this is widely enough appreciated. I’ve been sort of on a warpath about this. So back in the 1940s, the Federal Reserve, submitted to the Treasury and, committed to purchase to cap the yields on Treasury securities. Treasury was issuing a ton of securities to fight World War two, and the Fed helped out by capping the yield on long term debt that Treasury issued.. There were like three different tiers of of maturities. And they they had like three different yields. They just kept caps on. Well, to do that they had to buy a bunch of U.S government securities as the Treasury was issuing them, and that meant they had to increase the money supply and that meant inflation. So then there was a program of wage and price controls, rationing, coupon books, stuff like that.

Fed kept under Treasury’s thumb until Korean War…then 00:19:05:09

So during World War two there was resort to inflationary finance to some extent. But, you know, some measures tried and ameliorate it. So after the war, the Fed wanted to get out from under this peg and the Treasury wouldn’t let them. And then the Korean War comes along. Truman’s precedent. There’s a big defense buildup coming. Clearly that’s driving commodity prices up.

Inflation rises… a power struggle, the Fed escapes: The 1950 Accord 00:19:30:00

Inflation rises in 1950. The fed wants to raise interest rates. It wants out from under this peg. And it’s not going to be able to do it. If it if the Peg stays in place and they’re forced to buy Treasury long term Treasury securities in order to finance the Korean War. So there’s a big fight. I won’t go into that. It’s a fascinating story. Involve involving the president, lying to reporters about a meeting with the FOMC and the white House, leaked memos, embarrassment sources for, to it. So, anyway, after this whole period the Fed and the Treasury agreed to what’s called ‘the accord.’ Yes. And the accord meant said that basically the Fed could let the Treasury market do what it wanted, and the Fed wasn’t under any obligation to cap rates.

Fed Chair William McChesney Martn was NOT what Truman expected 00:20:26:06

And the Fed could manage monetary policy to keep inflation low and stable. So. Okay, over the course of the next year or two that was implemented, a new Fed chair was appointed and Truman appointed his own man, William McChesney Martin. He was a Treasury official, and he was the Treasury senior official who had negotiated the accord with the Fed. Well, he comes into the Fed, and this is a great example of a Fed chairman that doesn’t do what the president wanted him to do. An independent! So, you know, and we might get something like that. You never know. So anyway, he wants to free up the treasury market… The idea was that when the Fed in New York was intervening to support Treasury prices, and when the Treasury went to market with an auction, The Fed would buy in the ‘when issued’ market then would buy after the auction to keep the newly issued securities from going below par. <Explanatory Note: ‘WI’ or ‘When ISSUED’ securities are a device to trade securities that are being auctioned and do not yet exist. Bonds are traded by price but to do that a bond needs to (1) have been issued, (2) have a maturity date and, (3) a coupon rate. So, to facilitate trading around auctions of a bond that dees not fit these needs a ‘WI’ trades based on yield. Then, when the auction settles and these pricing needs are satisfied, the yield is converted to price on the issued bonds using the relevant data. This allows markets to smooth-over and trade securities before, during, and immediately after an auction smoothing out volatility.>

Martin from Treasury…did not back continuing this practice… 00:21:24:10

You know, typical sort of market manipulation. But Martin’s point was, hey, you know, you’re not going to get investment companies and banks investing in market making in the treasury market. To the degree they could if they think that at any time, for sort of capricious reasons, the fed could come in, okay, move prices around. So he he pushed the fed to a policy of bills only. They would only buy Treasury bills and they wouldn’t intervene in the market. They wouldn’t mess around trying to, make sure auctions went well. So essentially the Fed was standing aside and letting the Treasury face the market and okay, you know, okay, take your medicine.

Relevance for today? Right here: 00:22:11:07

So all right. So fast forward to today. The Fed in recent years. So it has QE, it’s entered in. You know it had some big Treasury security programs focused on the long end. Then there was in 2020 a big intervention for the sake of what they called market functioning. If market functioning sounds ill-defined and vague, it is, because it absolutely is. When full market views change a lot, prices change. And when prices change a lot, it it’s usually the case that they change a lot more. They get more volatile. Market makers pull back. They don’t put as much capital into making markets. Spreads widen. That’s the way markets are supposed to function, when everybody’s views change. So the danger here for the Fed is that they don’t have a clear criteria for what market functioning is, and something could affect the market’s view. And when I say the market, I include foreign official institutions and the like, foreign investors that buy a lot of the U.S. Treasury securities. If something changed suddenly about their views about, you know, the U.S. fiscal situation that could prompt a sharp change in Treasury yields…well…

And the risk here is… 00:23:35:22

And the fed could be faced with a situation where, on the basis of market functioning, people might expect them to intervene. On the other hand, if they intervene, they could be viewed as propping up and monetizing a big deficit that’s not sustainable.

Fed’s role in the Treasury market is ambiguous and murky 00:24:48:01

I think the Fed’s role in the Treasury market is ambiguous and murky. And I think it’s that, they’d be well served to clarify that because this question’s going to arise. One thing that makes this more risky than usual is in the past, when presidents have attempted, to pressure the Fed for lower interest rates, it’s been for the sake of their electoral, prospects.

The road to hyperinflation… 00:25:12:07

It’s been for Nixon wanting to get reelected or someone just generally wanting a lower unemployment rate and stronger labor market. What we have seen this year, for the first time in a long, long time is pressure to reduce interest rates for the sake the federal government’s financing cost. And that’s the road to, you know, hyperinflation. Now, that’s sort of a, kind of a hysterical way to put it. But that’s the road to, deliberately, monetizing debt, for the sake of government finances. That’s a different kettle of fish. And, that’s another reason I think, that’s a big reason. I think the fed needs to clarify that it’s going to let the Treasury face the music. In the market, and it’s not going to try and interfere with that process.

AMPLE Reserve Regime leaves questions unanswered… 00:26:07:22

And I think it’s this market functioning thing. This ample reserve regime leaves a lot of questions open about that, because one of the things they’re going to do with the ample reserves regime is, to offset movements in the Treasury general account. And that’s, you know, that kind of smacks of financing.

Fed district bank Presidents unexpectedly reappointed! 00:27:55:10

I admire them for taking this issue off the table. You know, this arcane little, aspect of the appointment process for reserve Bank presidents is that, they’re appointed by their board of directors, subject to the approval of the board of governors. But the appointments are for, a set of five year terms. And those, the Board approves, every five years. And they’re everyone’s on the same terms. So it’s all aligned. It was virtually, it was perfunctory, let’s put it that way. It was it was kind of a rubber stamp process. I don’t know of any case in history of of that process being used to oust the president. Other things have caused the ouster of a president, usually it involves negotiations between the board of governors and the board of directors of the president’s bank.

Was the Fed at risk for a ‘house cleaning? 00:28:20:23

And usually and it’s generally been for some cause or another. Now, it, it kind of surfaced publicly in 2017. Go into that if you want. But then, this year it became an object of attention. And I think what people were thinking… they were looking at kind of the purge that took place at HHS, where they kind of cleaned out a bunch of scientific advisory panels, wholesale firings and stuff. So, yeah, you saw these. I’ve been seeing these stories in the press about the possibility of of, incoming chair and incoming, white House appointees, engineering some mass, firings of presidents they don’t like. So I’m happy they did this early. I can’t recall when they did it in the past. I don’t know if this was an acceleration or not.

Fed independence defended- 00:29:12:13

It’s not too far ahead of time to be viewed askance. They have pretty robust process. My understanding is that the documentation to be submitted by the Reserve Bank has been beefed up substantially since 2017. So, yeah, it’s good of them to do. It takes off the table, an avenue to attacking the Fed’s independence. That, was ill advised and kind of a bad idea. And so it kind of bolsters their independence, makes it makes the transition over the next few months, a little bit more, you know, sort of a, a wild, extreme scenario gets taken off the table.

Rate cut quite a split decision for the entire FOMC 00:31:14:10

So I think the proponents of of a cut where, I think they’re aware of, the tenuous ness of the assessment, they rest on and, and vulnerability to counter arguments and you can see that in these dot plots. I mean, they’re apparently six people, two dissenters and four others, at least, who, disagreed with the decision yesterday and wouldn’t have cut rates at all.

Changing standards… 00:31:39:22

So the, the, inflation rate is 2.8% the way they like to measure it as of September, no signs that’s come down in the intervening months where we don’t have data because of the shutdown. The, unemployment rate is 4.4% by historic standards. You know, at times when it was six-percent, seven-percent, or eight-percent, people would say, yeah, under five… 4.5% is fine.

Shifts in labor supply 00:32:04:15

That’s pretty close to full employment the way we, you know, it’s not it’s sort of indistinguishable from full employment. The initial, unemployment claims numbers, they’re very low. Consistent with, a market where demand and supply are in balance. Now <Labor> supply is growing much more slowly than it was a year or two ago. And it’s pretty clear that’s in large part because of changes in migration, net migration.

How do you know demand is growing less than supply? 00:32:34:07

What the case for cutting doesn’t address and doesn’t have a solid handle on is how do you know demand is growing less than supply? I mean, and if if demand is just keeping up with supply, but supply is growing very slowly. It’s not obvious. Monetary policy has any role in correcting that. And it’s not obvious what monetary policy can or should do.And in fact, you know, you’ve got inflation sitting there at 80 basis points above your target. It seems like that’s the pressing problem that you have, real strong evidence of, the idea that there are risks that, employment demand would stop growing as rapidly as employment supply seems, pretty speculative to me. So that’s kind of my assessment in the meeting.

Fed economists supplant BLS without strong evidence/rationale 00:34:34:08

Yeah, I was surprised by that. And there’s two things to note about. First, I mean, it’s, the mechanics of it are that, you know, the employment report comes out every month, and then every March they do a benchmark revision where they go back a whole year. Using more comprehensive data on, you know, the overall size of the population by month over the previous year. So sometimes, you know, analyst wise, analysts in Washington fishing around census data can figure out which way those are going to go. And in fact, before March, usually people have a sense of about how big the revisions are going to be. But here’s the here’s the catch, right? So if they revised down employment growth, it’s not going to tell you by itself whether it’s lower demand or lower supply. And in fact, you know, it’s both. Right? I mean that both demand and supply have grown less rapidly than you thought. So it’s not at all obvious that a downward revision should make you more dovish or less hawkish. So that’s the odd thing to me about him mentioning that.

FOMC argument isn’t terribly compelling to me 00:33:31:01 -

I was expecting a more hawkish press conference, and I was kind of surprised at how dovish it was. I think that I think that the proponents ar e cutting just, you know, our, committed to the idea and have looked around for lots of arguments for it. And, you know what? They’ve produced isn’t terribly compelling to me.

Oh, I would have dissented, for sure 00:33:58:15

Oh, I would have dissented, for sure. If I was voting, I would have dissented. The last three meetings….

I am currently a Senior Affiliated Scholar at the Mercatus Center at George Mason University, a member of the Shadow Open Market Committee, and a Fellow of the Global Interdependence Center College of Central Bankers. I worked at the Federal Reserve Bank of Richmond from 1989 to 2017, where I was President from 2004 to 2017. From 2018 to 2022 I was Distinguished Professor in the Department of Economics at the Virginia Commonwealth University School of Business in Richmond, VA. From 1984 to 1989 I taught at the Krannert School of Management at Purdue University. Early in my career I worked at Wharton Econometric Forecasting Associates.

You can find my academic and Federal Reserve publications from before 2017 at this Richmond Fed web page. Speeches and testimony from that time on central bank policy issues (as opposed to the economic outlook) can be found here under the “At the Fed” tab. Post-2017 work can be found at the tabs for “Recent Appearances” and “Recent Writings”. All the speeches I gave as Richmond Fed President are listed at this Richmond Fed web page. This IDEAS/RePEc page lists all my publications.

My biography on the Federal Reserve History web site is here, and the Wikipedia page about me is here. A bio is here.

https://www.jeffreylacker.org