The Third and Final Transformation of Monetary Policy

By John Mauldin | April 26, 2015

The Fed Funds Rate: R.I.P.
San Diego, Raleigh, Atlanta, New York, New Hampshire, and Vermont
The law of unintended consequences is becoming ever more prominent in the economic
sphere, as the world becomes exponentially more complex with every passing year. Just as a
network grows in complexity and value as the number of connections in that network grows, the
global economy becomes more complex, interesting, and hard to manage as the number of
individuals, businesses, governmental bodies, and other institutions swells, all of them
interconnected by contracts and security instruments, as well as by financial and information
flows.
It is hubris to presume, as current economic thinking does, that the entire economic world
can be managed by manipulating one (albeit major) subset of that network without incurring
unintended consequences for the other parts of the network. To be sure, unintended consequences
can be positive or neutral or negative. This letter you are reading, which Ive been writing for over
15 years and which reaches far more people than I would have ever dreamed possible, is partially
the result of a serendipitous unintended consequence.
But as every programmer knows, messing with a tiny bit of the code in a very complex
program can have significant ramifications, perhaps to the point of crashing the program. I have a
new Microsoft Surface Pro 3 tablet that Im trying to get used to, but somehow my heretofore
reliable Mozilla Firefox browser isnt playing nice with this computer. Im sure its a simple bug
or incompatibility somewhere, but my team and I have not been able to isolate it.
However, thats a relatively minor problem compared to the unintended consequences that
spill from quantitative easing, ZIRP, and other central bank shenanigans. We have discussed the
problem of how the Federal Reserve has pushed dollars on the rest of the world and is playing
havoc with dollar inflows and outflows from emerging markets. More than one EM central banker
is complaining aggressively.
My good friend Dr. Woody Brock makes the case that an unintended consequence of QE is
that the Federal Reserves normal transmission of monetary policy through periodic changes in the
fed funds rate has been vitiated. He contends that soon we will no longer care about the fed funds
rate and will be focused on other sets of rates.

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This is an important issue and one that is not well understood. Woody has given me
permission to reproduce his quarterly profile. For Woody, this is actually a fairly short piece; but
as usual with Woodys work, you will probably want to read it twice.
Woody is one of the most brilliant economists I know, and I make a point of spending time
with him as our schedules permit. We are making plans to get together at his Massachusetts retreat
in August. He is restructuring his business in order to spend more time writing and less time
traveling, and he intends to lower the price of his subscription. It will still be pricey for the average
reader, but for funds and institutions it should be a staple. You can find his website at
www.SEDinc.com or email him at [email protected].
Before we go to Woodys letter, if youre going to be at my conference this coming week,
youve already made arrangements. I know a lot of people wanted to go but just couldnt work it
into their schedules. I wont say its the next best thing to being there, but you can follow me on
Twitter, where my team and I will be sending out real-time tweets about the important ideas and
concepts we are hearing, not just from the speeches but from all the conversations that spring up
during the day and late into the evening. If youre curious as to who will be there, heres a page
with the speakers. If youre at the conference, look me up.

The Fed Funds Rate: R.I.P. The Third and Final Transformation of
Monetary Policy
By Woody Brock, Ph.D.
Strategic Economic Decisions, Inc.
The policy announcements of the US Federal Reserve Board are dissected and analyzed more
closely than any other global financial variable. Indeed, during the past thirty years, Fed-Watching
became a veritable industry, with all eyes on the funds rate. Within a few years, this term will
rarely appear in print. For the Fed will now be targeting two new variables in place of the funds
rate. One result is that forecasting Fed policy will be more demanding.
To make sense of this observation, a bit of history is in order. During the last nine years, US
monetary policy has been transformed in three ways. To date, only the first two have been widely
discussed and are now well understood. The third development is only now underway, and is not
well understood at all. To review:
First, the Fed lowered its overnight Fed funds rate to essentially zero, not only during the Global
Financial Crisis of 20082009, but throughout nearly six years of economic recovery thereafter.
The average level of the funds rate at the current stage of recovery was about 4% during the past
dozen business cycles. It was never 0% as it is in this cycle. In past essays, we have argued that
this overutilization of ultra-easy monetary policy reflected the failure of the government to
utilize fiscal policy correctly (profitable infrastructure spending with a high jobs multiplier), and to
introduce long-overdue incentive structure reforms. It was thus left to monetary policy to pick up
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the pieces after the global crisis of 2008. This development was true in most other G-7 nations, not
just in the US.
Second, the Fed inaugurated its policy of Quantitative Easing whereby it increased the size of its
balance sheet five-fold from $900 billion to $4,500 billion. Such an expansion would have been
inconceivable to Fed watchers during the decades prior to the Global Financial Crisis. In the US,
QE is now dormant, and the only remaining question (answered below) is how and when the Fed
will shrink its bloated balance sheet back to more normal levels.
Third, the way in which the Fed conducts standard monetary policy (periodic changes in the funds
rate) is currently undergoing a complete makeover. In particular, the traditional tool of changing
the funds rate via Open Market operations carried out by the desk of the New York Fed no longer
works. For as will be seen, the vast expansion of the size of its balance sheet (bank reserves in
particular) has rendered traditional policy unworkable. From now on, therefore, the Fed will
conduct monetary policy via two new tools that were not even on the drawing board of the Fed
prior to 2008.
Summary: In this PROFILE, we explain in Part A why traditional (non-QE) monetary policy has
been vitiated by QE. In Parts B and C respectively, we discuss the two new tools that will be used
in the future to conduct standard (non-QE) monetary policy: what exactly are these tools, and how
do they work? In Part D, we discuss why these new tools will not be required by the European
Central Bank, which has a different institutional structure than the US Fed. Finally, in Part E, we
turn to QE and discuss when and how the Fed will shrink its balance sheet back to a more
traditional size in the years ahead.
In this write-up, we largely rely on the remarks set forth in a recent paper by Fed Vice Chairman
Stanley Fischer, formerly chief economist of the IMF, Governor of the Central Bank of Israel, and
professor of economics at MIT. We also benefitted from clarifications by Professor Benjamin
Friedman at Harvard University.
Part A: So Long to Setting the Funds Rate via Open Market Operations
Prior to the financial crisis, bank reserve balances with the Fed averaged about $25 billion. With
such a low level of reserves, a level controlled solely by the Fed, minor variations in the amount of
reserves via Fed open market sales/purchases of securities sufficed to move the Fed funds rate up
or down as desired. Analytically, the market for bank reserves (Fed funds) consisted of a demand
curve for bank reserves reflecting the nations demand for loans, and a supply curve reflecting the
supply of reserves by the Fed. The so-called Fed funds rate is the point of intersection of these two
curves (the interest rate). If the Fed targeted, say a 2% funds rate, it achieved and maintained this
rate by shifting the supply curve left or right by adding to/subtracting from the quantity of reserves.
As the Fed was a true monopolist in the creation/extinction of reserves, it could always target and
sustain any funds rate it chose.
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These operations constituted monetary policy for many decades. But this is no longer the case,
as was first made clear in a FOMC policy pronouncement of September 2014. To quote Dr.
Fischer in his 2015 speech, With the nearly $3 trillion in free bank reserves (up from pre-crisis
reserves averaging $25 billion), the traditional mechanism of adjustments in the quantity of reserve
balances to achieve the desired level of the Federal funds rate may not be feasible or sufficiently
predictable. What new mechanisms will replace it? There are two.
Part B: The Use of Interest Rates Paid by the Fed on Free Bank Reserves
Instead of the funds rate, we will use the rate of interest paid on excess reserves as our primary
tool to move the Fed funds rate. The ability of the Fed to pay banks an interest rate on their free
reserves dates back to legislation of October 2008. This rate has been set at 0.25% during the past
few years. (Excess or free bank reserves are defined as the arithmetic difference between total
reserves and required reserves. Currently, as of March 30, required reserves were $142 billion, and
total reserves were $2.79 trillion.)
The Logic: Whatever the level of the reserve interest rate that the Fed chooses, banks will have
little if any incentives to lend to any private counterparty at a rate lower than the rate they can earn
on their free reserve balances maintained at the Fed. The higher the reserve remuneration rate is,
the greater will be the upward pressure on a whole range of short-term rates.
Part C: The Use of the Reverse Repo Rate
Because not all institutions have access to the excess reserves interest rate set by the Fed, we will
also utilize an overnight reverse repurchase purchase agreement facility, as needed. In a reverse
repo operation, eligible counterparties may invest funds with the Fed overnight at a given interest
rate. The reverse repo counterparties include 106 money market funds, 22 broker-dealers, 24
depository institutions, and 12 government-sponsored enterprises, including several Federal Home
Loan Banks, Fannie Mae, Freddie Mac, and Farmer Mac.
The Logic: Fischer continues: This facility should encourage these institutions to be unwilling to
lend to private counterparties in money markets at a rate below that offered on overnight reverse
repos by the Fed. Indeed, testing to date suggests that reverse repo operations have generally been
successful in establishing a soft floor for money market interest rates.
Summary
Due to the explosion of the size of its balance sheet (bank reserves in particular), the Fed has been
forced to abandon management of the Fed funds rate via traditional open market operations. This
activity is now being replaced by two new policy tools, both of which are somewhat softer than
the older tool. First, banks free reserves now earn an interest rate on excess bank reserves which is
available to banks with access to the Feds reserve facility. Second, financial institutions such as
money market funds lacking access to the reserve facility will be able to lodge funds overnight
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(not necessarily merely one night) at the Fed and receive the reverse repo rate offered by the Fed.
Part D: Irrelevance of these Developments to the European Central Bank
Interestingly, the European Central Bank does not need and will probably not implement the policy
innovations now being implemented by the US Fed. The reason is that in Europe, lending is
dominated by banks far more than here in the US. Moreover, most all European financial
institutions can in effect deposit funds with the central bank. Finally, the ECB has long been able
to vary the reserve remuneration (interest) rate that it pays for excess reserves. As a result, the ECB
does not need to utilize the reverse repo rate tool that the Fed is introducing.
One final point should be made. Whereas Professor Fischer above asserts that the primary tool of
the Fed will be variations in the reserve remuneration rate applicable to banks, other scholars
believe it is the reverse repo rate that will be the primary tool of US monetary policy. This is partly
because of the ongoing reduction of the role of banks in lending to private sector borrowers, a
longstanding development that has accelerated with the new regulations imposed on banks since
the Global Financial Crisis.
Part E: Will the Fed Shrink its Balance Sheet Back Down? If So, How?
Professor Fischer answers this point directly. Yes, the Fed will shrink its balance sheet, but not to
the size of yesteryear. More specifically:
With regard to balance sheet normalization, the FOMC has indicated that it does not anticipate
outright sales of agency mortgage-backed securities, and that it plans to normalize the size of the
balance sheet primarily by ceasing reinvestment of principal payments on our existing securities
holdings when the time comes... Cumulative repayments of principal on our existing securities
holdings from now through the end of 2025 are projected to be $3.2 trillion. As a result, when the
FOMC chooses to cease reinvestments of principal, the size of the balance sheet will naturally
decline, with a corresponding reduction in reserve balances.
Hopefully these remarks have helped clarify past and future changes in Fed policychanges that
amount to a thoroughgoing transformation of US monetary policy that would have been
unimaginable a decade ago.
In the future, we suspect that the press will refer to the Feds targeting of the reverse repo rate in
place of the Federal funds rate when analyzing prospective monetary policy.

San Diego, Raleigh, Atlanta, New York, New Hampshire, and Vermont
I am excited about going to the 2015 Strategic Investment Conference on Tuesday. If for
some reason you get there early on Wednesday, I intend to be in the gym at the hotel about 2:30,
so come by and lets work out together. Again, dont forget to follow me on Twitter while Im at
Thoughts from the Frontline is a free weekly economics e-letter by best-selling author and renowned financial
expert John Mauldin. You can learn more and get your free subscription by visiting www.mauldineconomics.com

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the conference.
In the middle of May I go to Raleigh to speak for the Investment Institute and then on to
Atlanta, where Im on the board of Galectin Therapeutics. Im going to New York the first week of
June, then up to New Hampshire, where I will be speaking with a number of friends at a private
retreat. I will then somehow get to Stowe, Vermont, to meet with my partners at Mauldin
Economics. The rest of the summer looks pretty easy, with a few trips here and there.
Next week I intend to share my speech at the conference, or at least the gist of it. I have
been thinking about it and working on it for some time. I had dinner this week with Mari Kooi,
former fund manager who has become deeply imbedded with the Santa Fe Institute, an intellectual
hotspot famous for its maverick scientists and interdisciplinary work on the science of complexity.
Some of their people are working on something called complexity economics, which is an attempt
to move on from the neoclassical view of general equilibrium. If you wonder why the theories and
models dont work, it is because traditional economists are still busy trying to describe a vastly
complex system by assuming away all the change except for that they believe they can control
with the knobs they twist and pull. Their model of the economy resembles some vast Rube
Goldberg machine where, if you put X money in here at Y rate, it will produce Z outcome over
there. Except that they dont really know how the actions of the market will play out, since the
market is made up of hundreds of millions of independent agents, all of whom change their
behavior on the fly based on what the other agents are doing. Not to mention the effects of herding
behavior and incentive structures and a dozen things beyond the ken or control of economists.
There is only equilibrium in theory.
And thats why it is becoming increasingly difficult to predict the future. The agents of
change are multiplying and changing faster than we can keep up. But next week I will throw
caution to the wind (unless I give up in despair), and well see what my very cloudy crystal ball
suggests lies in our future.
I am really looking forward to seeing old friends and making new ones at the conference.
Have a great week.
Your trying to find simple in a complex world analyst,

John Mauldin

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INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE
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