American financial markets went for an interesting ride last week. A particular market that specializes in providing banks and firms with short-term cash was hit by an unexpected squeeze last Monday. Interest rates in that market briefly quadrupled to 10 percent by Tuesday morning. That jump bled into the Federal Reserve's target interest rate, driving it up to the very top of the range the Fed is currently targeting.
It was an exceedingly weird momentary panic that's had Fed-watchers talking since. And it highlights how two basic trends in Federal Reserve monetary policy have evolved since the 2008 crisis — and how they just ran headlong into one another.
Before the Great Recession, the Fed relied on a "corridor system" to target interest rates. The central bank bought and sold U.S. Treasuries with the major banks, and those exchanges moved reserves — the foundational layer of money the Fed creates and pumps out to backstop the financial system — in and out of the banking system. By changing the overall supply of reserves in the banking system, the Fed could exert upward or downward pressure on the interest rate banks charged each other for reserves.
The thing is, for the corridor system to reliably function, the Fed had to keep the overall supply of reserves on a short leash. When the 2008 crisis hit, the Fed flooded the banks with reserves to shore them up; that increase drove the interbank lending rate to permanent zero, effectively wiping out the corridor system's functionality.
A pure corridor system works. Our corridor system worked fine until government debt threatened the Fed. To get back to pure corridor, the Fed needs a long term contract with Congress over the seigniorage issue so the liquidity state of federal programs can be exposed to the liquidity market.
The contradiction is deeper than stated, but solvable.
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