DIVORCING MONEY FROM MONETARY POLICY

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

As a result, banks' overnight reserve holdings are too small to allow for the smooth functioning of the payments system during the day. When reserves are scarce or costly during the day, banks must expend resources in carefully coordinating the timing of their payments. If banks delay sending payments to economize on scarce reserves, the risk of an operational failure or gridlock in the payments system tends to increase. The combination of limited overnight reserve balances and the much larger daylight demand for reserves thus creates tension between a central bank's monetary policy and its payments policy. The central bank would like to increase the total supply of reserve balances for payment purposes, but doing so would interfere with its monetary policy objectives.

This tension has led to a common practice among central banks of supplying additional reserves to the banking system for a limited time during the day. These daylight reserves (also called daylight credit) are typically lent directly to banks. Many central banks provide daylight reserves against collateral at no cost to banks. The Federal Reserve currently supplies daylight credit to banks on an uncollateralized basis for a small fee.10 In providing daylight reserves, a central bank aims to allow banks to make their payments during the day smoothly and efficiently while limiting its own exposure to credit risk.

Under normal circumstances, this process of expanding the supply of reserves during the day and shrinking it back overnight works well; banks make payments smoothly and the central bank implements its target interest rate. However, this balancing act is not without costs. Lending large quantities of reserves to banks each day exposes the central bank to credit risk. While requiring collateral for these loans mitigates credit risk, it is an imperfect solution. If collateral is costly for banks to hold or create, the requirement imposes real costs. Moreover, collateralizing daylight loans simply moves the central bank's claims ahead of the deposit insurance fund in the event of a bank failure, without necessarily reducing the overall risk of the consolidated public sector.

Routine daylight lending by the central bank may also create moral hazard problems, leading banks to hold too little liquidity and, perhaps, take on too much risk. In addition, such lending might make regulators more reluctant to close a financially troubled bank promptly, exacerbating the wellknown too-big-to-fail problem. Even if each of these costs is relatively small in normal times, their sum should be considered part of the tension generated by the link between money and monetary policy.

3.2 Liquidity Policy

In times of stress or crisis in financial markets, the tension between monetary policy and central banks' other objectives can become acute. After the destructive events of September 11, 2001, the Federal Reserve recognized that the quantity of overnight reserves consistent with the target fed funds rate was too small to adequately address banks' reluctance to make payments in a timely manner. The FOMC released a statement on September 17, 2001, that, in addition to lowering the target fed funds rate, stated: