DIVORCING MONEY FROM MONETARY POLICY

Economic Policy Review - Federal Reserve Bank of New York, Sep 2008 by Keister, Todd, Martin, Antoine, McAndrews, James

The equilibrium interest rate is determined exactly as before, by the height of the demand curve at the level of reserve balances supplied by the central bank. Monetary policy is thus implemented in much the same way as it is in the United States. The target interest rate determines, through the demand curve, a target supply of reserves, and the central bank aims to change total reserve supply to bring it as close as possible to this target. Importantly, the link between money and monetary policy remains: the quantity of reserves is set in order to achieve the desired interest rate.

The symmetric channel systems used by various central banks differ in a variety of important details. The Bank of England and the ECB operate relatively wide channels, with the standing facility rates 100 basis points on either side of the target. Australia and Canada, in contrast, operate narrow channels, where this figure is only 25 basis points. Australia and Canada have no required reserves; in this case, the demand curve in Exhibit 2 shifts to the left so that the "required reserves" line lies on the vertical axis. The important point here, however, is that regardless of these operational details, a symmetric channel system links the quantity of reserves to the central bank's interest rate target, exactly as in the U.S. system.

3. PAYMENTS, LIQUIDITY SERVICES, AND RESERVES

The link between money and monetary policy described above can generate tension with central banks' other objectives, particularly those regarding the payments system and the provision of liquidity. Reserve balances are useful to banks, and to the financial system more generally, for purposes other than simply meeting reserve requirements. Banks use reserve balances to provide valuable payment services to depositors. In addition, these balances assist the financial sector in allocating other, less liquid assets. Since reserves are a universally accepted asset, they can be exchanged more easily for other assets than any substitute. Finally, reserve balances serve as a perfectly liquid, risk-free store of value, which is particularly useful during times of market turmoil. Because reserves play these other important roles, the quantity of reserve balances consistent with the central bank's monetary policy objective may at times come into conflict with the quantity that is desirable for other purposes. In this section, we describe some of the tensions that can arise.

3.1 Payments Policy

The value of the payments made during the day in a central bank's large-value payments system is typically far greater than the level of reserve balances held by banks overnight. (In the United States, for example, during the first quarter of 2008 the average daily value of transactions over the Fedwire Funds Service was approximately 185 times the value of banks' total balances on deposit at the Federal Reserve.) The discrepancy has widened in recent decades as most central banks have adopted a real-time gross settlement (RTGS) design for their large-value payments system, which requires substantially larger payment flows than earlier designs based on netting of payment values.9