Thread by @GeorgeSelgin

Anyone who thinks the Fed didn't hasn't started tightening has been hoodwinked.

Despite having switched to a "floor" operating regime in October 2008 (and permanently in January 2019), and thereby all but ending interbank lending on the fed funds market, the Fed continued to maintain the pretense of "targeting" the fed funds rate.

But in reality, it no longer used open-market operations to keep a freely-fluctuating interbank funds rate close to its targeted value. Instead, it adjusted its policy stance by altering the interest rate it paid on bank reserves (IOR rate).

Lending on the fed funds market didn't cease altogether only because some GSEs w/ Fed balances aren't eligible for IOR. So they lent their balances to banks for a share of the banks' IOR earnings. The fed funds market became nothing more than a locus for such arbitrage.

Because this arbitrage made the Fed's IOR floor "leaky," in late 2015 the Fed started doing ON-RRPs, in which GSEs, MMMF's, and other non-bank counterparties could take part, earning more than 0 but less than IOR. In essence, the Fed was giving them a consolation prize.

Thenceforth the "effective" fed funds rate--still based entirely on bank-nonbank Fed rate arbitrage--could only vary between the lower ON-RRP rate and the upper IOR rate bounds. For some time the Fed defined the limits of its fed funds rate "target range" using these bounds.

As proof that the floor system worked well, many Fed apologists pointed to how well the Fed had succeeded in keeping the effective fed funds rate on target! But of course, given the way the funds market now worked, and how the target was defined, such "success" was nugatory!

Yet even judged by it's own easy criterion, the floor system's record was far from perfect. alt-m.org/2019/10/03/ref…

But to really gauge the system's success, one has to consider how well it succeeded in keeping some genuine, interbank lending rate--like the SOFR--within the Fed's target range: fred.stlouisfed.org/graph/fredgrap…

Although the administered IOR and ON-RRP rates originally defined the upper and lower limits of the fed funds rate target range, that's no longer true. Thanks to several "technical adjustments," the IOR rate is now below the upper limit, while the ON-RRP is above the lower limit.

In fact, the target limits are now nothing but numbers. Only the IOR and ON-RRP rates actually serve to push and pull market rates, ideally keeping them where the Fed wants them.

So, why does the Fed bother with this little bit of window dressing? There are, I believe, several reasons. First, to better maintain the fiction that it is still "targeting" a meaningfully market-determined fed funds rate, and doing so successfully.

(Among other things, the tweaks have served to keep the effective ffr closer to the middle of the announced target rate). Second, the window dressing allows the Fed to pretend that it is keeping its stance unchanged, when in fact it isn't. Finally,

...the set-up allows the Fed to maintain the fiction that the FOMC, which sets the target range limits, is regulating the stance of monetary policy, as the Federal Reserve Act requires it to do, when in fact...

...it is the Federal Reserve Board, which sets the IOR and ON-RRP rates, that's really calling the shots, albeit with the FOMC supplying its rubber stamp and (supposedly) making the actual decisions.

End

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