Floor Systems

The quantity of reserves held by US financial institutions is now approaching $1.6 trillion, and the Fed has promised to increase that stock by $85 billion per month for the indefinite future. Thus, it seems safe to say that the Fed will be working within a monetary regime with a large quantity of excess reserves for a very long time.

In a financial system, like the one we have in the US currently, in which there is a positive stock of deposits with the central bank overnight, and the interest rate on those deposits essentially determines the overnight interest rate, the central bank works within a floor system. I have discussed that in several blog posts, including this one. To quote myself:

A floor system is different. Under such a system, the central bank sets an interest rate on reserves and a central bank lending rate, and plans to have a positive supply of reserves in the system overnight. As a result, the overnight rate must be equal to the IROR, by arbitrage. An open market operation in short-term government debt in a floor system will have no effect, at the margin, as the central bank is simply swapping one interest-bearing short-term asset for another. The instrument of monetary policy in a floor system is the IROR, which determines short-term nominal interest rates.

Currently, the Fed operates under a floor system. The supply of excess reserves is enormous, and the IROR determines short-term interest rates. There are some weird features of the system, such as the fact that the GSEs receive no interest on their reserve accounts, and there is some lack of arbitrage which results in a fed funds rate less than the IROR, but I think those weird features are irrelevant to how monetary policy works.

Under a floor system, we are effectively in a perpetual liquidity trap. Conventional open market operations in short-term government debt do not matter, whether the IROR is 5%, 0.25%, 10%, or zero. But, not to worry, the central bank can always change the IROR except, of course, when it hits the zero lower bound (neglecting the possibility of taxation of reserve balances, which is another issue altogether).

Steve Randy Waldman seems to agree with that. Paul Krugman does not. Here's what Krugman says:

Now, under current conditions that doesn’t matter; dead presidents don’t pay interest, but neither do T-bills, so short term debt and currency form an aggregate (a Hicksian composite commodity, for the serious nerds out there), whose composition doesn’t matter. But interest rates won’t always be zero, and at that point the size of the monetary base — dead presidents plus a sliver of bank reserves that can be converted into dead presidents at will — will matter again.

That's incorrect. The nature of the liquidity trap does not change if the interest rate on reserves (IROR) rises. With a positive stock of reserves in the system, there's a liquidity trap no matter what the IROR is. If the Fed swaps short maturity debt for reserves it's essentially irrelevant - the two assets are roughly identical. It's not a big deal though, as the Fed would conduct monetary policy in exactly the way it did in 2007. The policy rate is the IROR (not the fed funds rate), and moving the policy rate will have essentially the same effects as targeting a particular fed funds rate through open market operations.

Addendum: Where I don't agree with Waldman is on this:

Consistent with the “Great Moderation” trend, the so-called “natural rate” of interest may be negative for the indefinite future, unless we do something to alter the underlying causes of that condition.

I haven't seen a convincing explanation for why the "natural rate of interest" is currently low, or worse still, persistently low. See this post.