A New Paper on the Fed's Floor System

The central idea behind this move was to remove the opportunity cost to banks of holding excess reserves by offering the banks a deposit rate at the Fed—the IOER rate—that was equal to or above short-term market interest rates. This favorable return was to sever banks’ incentive to rebalance their portfolios away from excess reserves toward other assets. The IOER rate was also to put a floor under short-term interest rates so as to align them with the Fed’s desired interest rate target. Together, these two facets of the floor system would allow the Fed to use its balance sheet as a tool of monetary policy while still maintaining interest rate control. 

In this new operating system, the stance of monetary policy was no longer set by a market interest rate but by an administrative interest rate: the IOER rate. The stance of monetary policy also was no longer tied to the supply of reserves. Instead, it was linked to the quantity of reserves demanded by banks, which the Fed influenced through changes to IOER. Specifically, the Fed set the IOER rate high enough that banks’ demand for reserves became perfectly elastic with respect to the federal funds rate. As a result, changes in the quantity of reserves supplied led to identical changes in the quantity demanded, other things being equal.  

The Federal Reserve, in short, went from an operating system in which monetary policy was transmitted through open market operations to one in which it is transmitted through the IOER rate. The Fed’s operating system changed from one in which money, in the form of reserves, mattered for monetary policy to one in which money has been “divorced” from monetary policy.

Okay, so why does this “divorce” matter? For advocates of a floor system the answer is simple:

This divorce from money is seen by many observers as the key advantage… because it gives the Fed the freedom to use its balance sheet independently of its desired interest rate target. The Fed, for example, can now sharply increase the supply of reserves in response to a liquidity crisis without causing a decline in its targeted interest rate.

Skeptics of the floor system, on the other hand, see this divorce as more problematic:

Others, however, see this divorce as creating an operating system that impairs the transmission mechanism of monetary policy… These observers’ understanding starts with the standard assumptions of a floor system. First, a floor system requires the IOER rate to be set at least equal to short-term interest rates. This removes the opportunity costs to banks of holding reserves and thereby keeps their demand perfectly elastic with respect to other short-term interest rates…  

[This] can lead to a rebalancing of bank portfolios that causes the supply of loans to be lower than it would have been otherwise. Banks lend as long as the marginal cost of funding is less than the risk-free marginal return on bank lending. In the Fed’s floor system, the IOER rate sets the marginal funding cost. Consequently, by setting the IOER rate higher than other short-term interest rates, the Fed has raised the marginal costs of funding and narrowed the gap between these costs and the risk-free marginal return on bank lending. All else being equal, the narrowing of this gap implies a relative reduction in the supply of loans and therefore a relative decline in the money supply.

If we zoom in and use two scales, this apparent structural change is even clearer.  Cash shares and loan shares become mirror images of each other:

Conversely, banks appear to have allocated more to cash assets with the IOER-Libor spread rose and vice versa:

Policy Implications