The limits of monetary policy
By Eileen M Debold
Published: June 12 2003 5:00
Sir, Alan Ruskin attempts to interpret the mechanics of the Federal Reserve Board ("Deflation holds unknown perils for the Fed", June 9) but the analysis is flawed. He argues that the Fed can "significantly" influence long-term yields but that the medium-term sector is where the Fed "most needs to manipulate yields". This ignores bank reserve accounting in a floating exchange rate world.
Having the Treasury issue bonds and then having the Fed buy them back is a highly inefficient operation. When the Fed buys long-term treasuries in the open market it creates excess reserves, which are credited to a member bank account. The Fed must then offset these excess reserves by selling short-term securities. If the Fed chooses not to drain the excess reserves they have created, the Fed funds rate will go to 0 per cent, since Fed funds traders will not pay a rate of interest for non-interest-bearing reserves.
Furthermore, as the Japanese experience has shown, there is no transmission mechanism between excess reserves and the real economy.
Citing the Fed's example of its 1940s treasury-buying operations to cap long-term yields is irrelevant. That example is a throwback to a time when the US was on a gold standard and member bank lending could still be controlled by reserve requirements and gold. Today monetary policy has no such power.
Mr. Ruskin throws out a few good questions for policymakers to answer. But he overlooks the most important one: since the Fed's buying of bonds is functionally equivalent to the Treasury's never having issued them, why should the Treasury issue bonds in the first place?
It is time for a new economic framework that acknowledges the limits of monetary policy in a floating exchange rate world. But, as Mr. Ruskin points out, "it is tough to teach an old dog new tricks".
Eileen M. Debold, Piscataway, NJ 08854, US