On October 6, 1979, the Federal Reserve announced that it would begin targeting bank reserves rather than the federal funds rate in order to curb inflation and “speculative excesses in financial, foreign exchange, and commodity markets.” This meant that the Fed would allow interest rates to vary much more widely and climb much higher in reaction to changes in demand for money and bank reserves.
You might think that this would be a simple thing for the Federal Reserve to implement. After all, the Fed is the money supplier of reserves. The banking system only has as many reserves as the Fed supplies. Can’t it just shut off the supply of reserves?
But the Fed’s monopoly power over the supply of reserves is limited by its need to meet its policy goals. And the Fed’s difficulty in limiting reserves following the 1979 procedural change demonstrates how impressive these limitations can be.
We can follow along with the Fed’s thinking in a pair of documents published at the time by the Federal Reserve. The first is titled “The New Federal Reserve Technical Procedures for Controlling Money.” It is an internal Fed staff document detailing how the Fed planned to implement the new policy. The second is “The FOMC in 1979: Introducing Reserve Targeting,” which is intended for general consumption. (Or, you know, a general as consumption as can be intended for a document about reserve targeting.)
The Fed realized immediately that it could not directly limit the supply of total reserves. In order to do so, the Fed would have to close the discount window entirely. Any bank that found itself unable to borrow more reserves from other banks, would have to be turned away.
This would have been calamitous, as it would put the entire payments system in jeopardy, encouraged reserve hoarding and probably cause an almost instant financial collapse as banks wondered which other lenders might be short of reserves. The Fed never really even considered shutting down the discount window.
This is important, because as long as the discount window remains open, bank lending is not strictly constrained by the amount of reserves currently in the system. Instead, lending is influenced by the interest rates banks must pay to obtain reserves. That interest rate is determined by competitive bidding for reserves among banks on the fed funds market and the discount rate window, where banks can borrow if they find reserve funds unavailable or priced too dearly on the market.
A Brief Digression on the Discount Window
(Note: feel free to skip this section altogether, if you already know every you care to about discount window operations.)
The discount window serves as a very important policy tool. We often think of it as a “lender of last resort” measure, a kind of bailout system for banks that are short of reserves. But this isn’t quite right. It’s actually a safety valve for a failure of Fed policy rather than a failure of a bank.
When the Fed is targeting interest rates, it is constantly attempting to predict the amount of reserves required by the banking system to hit the target. Imagine the Fed is attempting to keep the fed funds rate stable. If it thinks demand for reserves is going to increase, it supplies more reserves by buying securities from banks. If it thinks demand for reserves is going to fall, it drains reserves by selling securities. Alternatively, the Fed could simply allow the interest rate to rise—raising its rate target to reflect the higher demand for reserves.
There are several reasons the Fed’s estimates of the reserves required to hit the interest target might be wrong. For example, the economy might be running hotter than expected. (In that case, the Fed could theoretically decide it is better to miss the target but it is more likely that it will wait to reset it to a higher level, preserving its credibility.) Alternatively, banks may be hoarding reserves and refusing to lend them out because of financial distress or anticipated regulatory changes. Or an uneven distribution of reserves through the system could leave some banks short of reserves and others with oligopolistic pricing power.
If the Fed misses the mark, interest rates will rise beyond target if the Fed doesn’t take further action. As I mentioned, the Fed could let this stand—at the risk of undermining its credibility. After all, the Fed said it was going to target a rate. Failure to do so can make the Fed look ineffective and hurt the ability of the Fed to influence the economy.
This is where the discount window comes in. The discount window sets a ceiling of sorts on the fed funds rate. If the effective rate climbs higher than the rate available at the discount window, a rational bank just borrows from the discount window. (Note: sometimes this doesn’t work out because banks worry that borrowing from the window will be seen as a sign of weakness.) If it turns out that the reserves supplied though open market purchases of securities are insufficient, the discount window “rescues” Fed policy. It’s really a bailout for the Fed rather than the banks.
The ability to pay interest on reserves performs the opposite function—allowing the Fed to keep interest rates near the target if open market operations have oversupplied reserves. In the case of oversupply, the fed funds rate would drop below target if not for interest on reserves. A rational bank, however, would rather collect the interest on reserves then lend it out for less that the Fed rate.
(If this stuff really excites you, God bless. Here’s a recent blogpost from the New York Federal Reserve Bank’s Liberty Street Economics on discount windows and interest on reserve floors.)
Back to Volcker
The Fed’s new plan began by setting a limit on the rate of increase of money it sought to achieve. It then would set the “reserves path” that it believed would achieve that money growth.
The plan to limit reserves began with the understanding that it could, as a practical manner, only target “non-borrowed reserves.” That is Fed speak for reserves created through securities purchases in Open Market operations. “Borrowed Reserves” are reserves from the discount window, which it knew it couldn’t control directly without causing catastrophe.
So what the Fed planned to do was to set out to limit the supply of reserves supplied through the open-market operations while leaving the supply of reserves available through the discount window unlimited. Which is to say, even under a regime in which the Fed was attempting to limit the supply of reserves, it actually left the quantity reserves unlimited. Banks could still summon forth reserves from the discount window.
The Fed realized this created a disconnect between policy goals and possible actions. It wanted to limit the amount of total reserves but it could only directly limit the amount of non-borrowed reserves.
“Thus total reserves represents the principal over-all reserve objective.—However, only nonborrowed reserves are directly under control through open market operations, though they can be adjusted in response to changes, in bank demand for reserves obtained through borrowing at the discount window,” the Technical Procedures paper explained.
To put it differently, the Fed was trying to implement an alternative to interest rate targeting. But its alternative still involved the Fed attempting to guess in advance what the demand for reserves might be and buy or sell securities based on that demand. It was conducting the same operation—buying securities—using the same forecast of reserve demand, but aimed at a different goal—reserve quantity rather than interest rates.
The Fed understood that the discount window meant it couldn’t directly control the quantity of reserves. From the Technical Procedures paper:
[An unexpected] increased demand for money and also for bank reserves to support the money would in the first instance be accompanied by more intensive efforts on the part of banks to obtain reserves in the federal funds markets thereby tending to bid up the federal funds rate, and by increased borrowing at the Federal Reserve discount window. Because of the latter, total reserves and the monetary base would for a while run stronger than targeted.
The answer to this problem was not to close the discount window. It was to either supply fewer non-borrowed reserves through open market purchases or raise the interest rate charged at the window. Raising the rate at the discount window would allow fed funds rates to climb even higher and make borrowing reserves more expensive. This would make some loans economically impractical and raise rates on other loans, making them less attractive to borrowers. Banks would then require fewer reserves and would be less likely to borrow from the discount window.
But notice: there is no option to directly limit the supply of discount window reserves. Monetary tightening occurs through the Fed influencing price by limiting supply of reserves in the non-borrowed market and raising prices at the discount window. Even in the Volcker era of targeting reserve quantity, there was no way to directly cap reserves.
Our current system doesn’t even attempt to aim at reserve quantities. We have interest rate and inflation targets instead. So there shouldn’t be much controversy over the idea that the Fed will supply whatever reserves the banks demand (at the prices set by the Fed) under our current system. That’s what the Fed did even when it was operating under Volcker’s reserve targeting regime.
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