David Beckworth on the floor vs. corridor system

David Beckworth has a new Mercatus paper that examines the Fed’s decision to adopt a “floor” system for interest rates.  Beginning in October 2008, the Fed began paying interest on bank reserves.  This effectively created a floor on market interest rates, as banks would have no incentive to lend money at rates lower than they could receive on reserves held on deposit at the Fed. Prior to 2008, the Fed controlled short-term interest rates by adjusting the supply of base money, a “corridor system”.  Now they have two independent policy tools, changes in the money supply (open market operations), and changes in money demand (done via interest on reserves.)

David sees several flaws in this new system:

The Fed’s floor system, then, may be a drag on economic growth for two reasons. First, it may weaken aggregate demand growth by setting the target interest rate above the natural interest rate. Second, it may inhibit credit and money creation by removing banks’ incentives to rebalance their portfolios away from excess reserves. If so, the critics are right to be worried about the Fed’s floor system, because it would constitute a Great Divorce for monetary policy.

I worry that deposit insurance biases banks toward too much lending, so at the moment I’m most worried about the first issue.  In monetary history, one recurring theme is central banks misjudging the stance of monetary policy because they focused too much on interest rates and not enough on the money supply.  Thus during late 2007 and early 2008, the Fed wrongly assumed that it was “easing” monetary policy, even as the growth in the monetary base came to a halt.

Admittedly, this excessive focus on interest rates can occur even without IOR.  But the system of interest on bank reserves makes the mistake even more likely to occur, as the quantity of money becomes even less informative.  Monetary policy is seen as being all about changes in interest rates, not changes in the supply and demand for base money.  The Fed’s monetary policy stance during the fall of 2008 would have almost certainly been less contractionary if Congress had not authorized the Fed to pay interest on reserves.



12 Responses to “David Beckworth on the floor vs. corridor system”

  1. Gravatar of Cloud Cloud
    13. November 2018 at 18:08

    Have read the previous version of Beckworth’s paper, it is a very good read!

    I think the floor system issue still need more mainstream discussion. And Prof. Sumner, you should write more about it also!! 😂😂

  2. Gravatar of Benjamin Cole Benjamin Cole
    13. November 2018 at 21:27


    The Divisia figures show US money supply growing at about 5% steadily of late, a little less.

    Like everything in macroeconomics, I am not sure what this means, but if money supply is key, then I guess the Fed is doing okay in maintaining an economy a little blue in the face from lack of oxygen (money).

    A Professor Richard Werner says look a credit creation as the key. How much in loans are banks extending? That tells you how much money is created.

    Maybe Werner is right.

  3. Gravatar of Brian Donohue Brian Donohue
    14. November 2018 at 06:59

    IOER is a straightforward subsidy to banks and needs to be ended. Is too much lending the problem right now? Everything Kevin Erdmann says about the mortgage market sounds like the opposite.

    Can we unwind QE and end IOER simultaneously in a monetarily-neutral way?

  4. Gravatar of rayward rayward
    14. November 2018 at 07:44

    Does history repeat so soon? In 2007-08, many worried about asset bubbles (Larry Summers described it as “inflation lurking in the background” in his Okun Lecture given as the financial crisis was unfolding), so it’s not surprising that the Fed was leaning contractionary even as the economy was headed to a financial crisis and great recession. Today, the Fed is leaning contractionary because, well, why? Is “inflation”, as it’s commonly defined, an imminent problem? Or is the Fed concerned about asset bubbles? How do we get ourselves out of relying on rising asset prices for prosperity without creating bubbles, that in turn motivate the Fed to adopt contractionary policies that cause, well, contractions?

  5. Gravatar of George Selgin George Selgin
    14. November 2018 at 11:12

    By a strange coincidence (since we’ve both been working on our respective projects for many months) David’s excellent paper came out on the very same day that my own book on the same subject came back from the printers. I hope the one-two punch, if not a knock-out blow, will at least get some policymakers’ attention!

  6. Gravatar of Matthew Waters Matthew Waters
    14. November 2018 at 12:07

    90% of reason shadow banking system existed was due to lack of IOR. OCC charters should be opened up for 100% reserve banks. Only IT security and anti-money-laundering needs regulatory attention.

    The ideas of “floor” and “corridor” is neither here nor there. Instead of IOR, pre-2008 monetary policy used reverse repos to set a floor in much the same way as IOR.

  7. Gravatar of bill bill
    14. November 2018 at 12:41

    @Brian Donohue, I think the answer is very much “yes”.
    And I agree with the rest of your comment too.

  8. Gravatar of Matthew Waters Matthew Waters
    14. November 2018 at 13:33

    “Second, it may inhibit credit and money creation by removing banks’ incentives to rebalance their portfolios away from excess reserves.”

    I wanted to give a more specific criticism of this point. Let’s first say the Fed lowers IOR and prints enough reserves to meet NGDP level target. So this sentence really says: If GDP=C+I+G, IOR hinders economic growth by having less I more C.

    Banks hold on to more reserves and so the Fed has to induce more demand through other channels to meet NGDP targets. The upshot is less I and more C.

    IMO, I’m not sure that is true. A lot of I is through non-bank conduits today. Second, is more C and less I really a bad thing? Much of the investment through banks has been malinvestment.

  9. Gravatar of Matthias Goergens Matthias Goergens
    14. November 2018 at 18:11

    Not only the FDIC biases, but also the preferential tax treatment for interest payments vs dividends.

  10. Gravatar of Tom Brown Tom Brown
    15. November 2018 at 10:13

    O/T: Katie Porter up 1.6% according to the NYT. That’s a surprise. Race still hasn’t been called though. If it does go to Porter that’ll be 5 flips to blue in CA, making it the most of any state. ME2 called for the Dem today (Golden is his name)? NYT doesn’t reflect that yet. ME2 had been leaning GOP since the election. “Ranked Choice” ballots took time to evaluate? Not sure. Wow, look at that. In the time it took me to write this the NYT colored ME2 dark blue. So that’s 35 flips now. If Porter, Utah and NY go blue (they’re leaning that way now) that’ll be 38 net flips, for a final House of 233 to 202

  11. Gravatar of Tom Brown Tom Brown
    15. November 2018 at 10:16

    … and if Duncan Hunter goes to jail, what happens then?

  12. Gravatar of Benjamin Cole Benjamin Cole
    16. November 2018 at 19:49

    OT but interesting. Recently both Moody’s and Pimco (world’s largest bond manager) have warned the Fed against being too tight.

    This is anecdotal, but I think 10-15 years ago it was a requirement that anybody in Financial America had to call for tighter money always and everywhere. It was just a thing, to call for balancing the federal budget and tighter money. If you had no material for an op-ed, you repeated a warning against inflation, and against easy money. A sermon from the very pinnacle of moral righteousness and probity.

    In fact, Scott Sumner was something of a “radical” back in the day for proposing a Fed that targeted NGDP growth (well, macroeconomics is a craft of totems, fables, hagiographies, but it makes up for that by being hidebound and clunky).

    But! This go ’round we are seeing “establishment” financial shops advocate for an easier Fed.


    See section on industrial commodities especially


    I notice it is private-sector economists who are migrating to the “Fed is too tight” commentary, and not so much the academics. I do not know if this means the commercial economists are “bought off” or the academic economists are cloistered theologians.

    But anyway, a few wisps of fresh air in the room.

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