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What’s Going on at the Federal Reserve?

David Beckworth, Patrick Horan, Christopher M. Russo, and Scott Sumner
Discourse Magazine
Published July 12, 2021 (1026 words)

Twice each year, the Federal Reserve Board submits a report to Congress on monetary policy and economic developments, and the Federal Reserve chair testifies before House and Senate committees. When these hearings take place later this week, members of Congress will once again interview Fed Chairman Jerome Powell.

The Fed faces many challenges as the economy continues to recover from the COVID-19 pandemic. The labor market is recovering, including falling unemployment and rising labor force participation, but it is not back to pre-pandemic levels. There are mixed signals for inflation as policymakers “aim to achieve inflation moderately above 2% for some time.” The Fed’s balance sheet has reached more than $8 trillion, nearly doubling in size during the pandemic.

Since monetary policy can be complicated even without a pandemic, the Mercatus Center’s monetary policy scholars now share what they believe are the most important questions for members of Congress to ask Chairman Powell.

Achieving the Fed’s Congressional Mandate

The Fed has a congressional dual mandate to promote “maximum employment” and “stable prices,” but it has latitude to interpret these objectives. In 2012, the Fed adopted an inflation target of a 2% increase in consumer prices each year, which it considers most consistent with its objectives. Low—but not zero—inflation keeps interest rates above zero, giving the Fed space to support employment during recessions by cutting interest rates.

However, the Fed has persistently undershot its inflation target. In 2020, the Fed modified its inflation target to counteract this bias. Instead of targeting 2% inflation each year with no consideration for previous misses, it now aims to achieve 2% inflation on average over time. This policy of “flexible average inflation targeting” (FAIT) states, “Following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”

How will Fed officials evaluate the effectiveness of FAIT? What time frame will the Fed use in constructing the averages? In particular, when does the clock start? Do officials intend to offset the inflation undershoot during the 2010s or instead have inflation average 2% during the 2020s? It is mathematically impossible to do both.

Does the Fed need Congress to authorize additional tools to hit its mandate when interest rates are close to zero? Some examples might be the ability to purchase a wider range of assets; the assurance that Congress would recapitalize the Fed if it were to become insolvent due to large-scale asset purchases; or the ability to pay negative interest on bank reserves. In other words, is the Fed now able to do “whatever it takes” to achieve its mandate, or are additional tools required?

A Central Bank Digital Currency for the Fed?

The Fed is planning to release its study on central bank digital currency (CBDC) this summer. CBDCs are digital assets that would be issued by central banks and could be used for retail payments between consumers and businesses or for wholesale payments between businesses and financial institutions. Other central banks, such as the European Central Bank and the Bank of England, are also considering the adoption of CBDCs. In May, China’s central bank became the first to issue its own CBDC, the digital yuan.

As with nearly all proposed policies, CBDCs come with both potential benefits and costs. Proponents argue that CBDCs could lead to better financial inclusion, produce faster payments and even augment monetary policy. Critics believe that innovation in digital currency is best left to the private sector and that CBDCs threaten to undermine innovation. Moreover, CBDCs also pose questions for user privacy.

Why all the interest in CBDCs now? Is there a demand to which you are responding? What can a Fed CBDC do that can’t already be done by the private sector? Or is this a case of trying a “build it and they will come” approach to provide a better framework for stablecoins (digital assets whose value is pegged to the value of traditional currencies) and cryptocurrencies to operate in?

Also, do you have any concerns about a Fed CBDC? Might it cause problems for traditional banking, or will it be a complement to this industry? Would a CBDC help or hinder Fed policy during a recession? How so?

Do you have a timeline for the rollout of a Fed CBDC?

The Fed’s Involvement in the Overnight Treasury Repo Market

A repurchase agreement (repo) allows an investor to cheaply raise cash by selling an asset and agreeing to buy it back at a higher price, usually the next day. Investors can “roll” these short-term borrowing agreements to finance risky, long-term investments. The repo market for Treasury securities is one of the world’s most important financial markets. When repo stops, financial markets grind to a halt.

Before the 2007-2008 financial crisis, the Fed used small amounts of Treasury repo to target the Fed funds rate. Lending (borrowing) in the repo market would increase (decrease) the money supply and decrease (increase) short-term interest rates. The Fed abandoned this system in 2008 because its other actions tremendously increased the money supply. The Fed now targets the Fed funds rate primarily by paying banks interest on their dollar deposits at the Fed. It uses repo only to prevent extreme swings in the money supply.

The Fed’s asset purchases since March 2020 have caused such an extreme swing. The banking system is seemingly unable to accommodate the influx of dollars, and short-term rates have flirted with zero, possibly due to post-crisis financial regulations like the Supplementary Leverage Ratio (SLR). The Fed’s overnight reverse repo (ONRRP) facility has dramatically expanded to soak up excess dollars. As of June 30, the Fed conducted $991 billion in ONRRP, compared with $871 billion in comparable private transactions tracked by the Secured Overnight Financing Rate.

Does the Fed’s large, sustained presence in the repo market harm—or risk harming—the competitiveness and dynamism of U.S. money markets? If such harms or risks were evident, would they warrant tapering asset purchases, quickening balance sheet runoff or modifying financial regulations? If so, how? For example, what are your views on permanently exempting reserves or Treasurys from the SLR?