Getting up from the floor

Summary

Focus

How do central banks set interest rates? While the techniques are appreciated only by experts, their implications for the financial system can be surprisingly wide-ranging. This paper examines the evolution of techniques since the Great Financial Crisis (GFC), evaluates their merits and proposes a way forward.

Contribution

Since the GFC, a growing number of central banks have adopted abundant reserves systems ("floors") to set the interest rate. How do these compare with the pre-GFC scarce reserve systems ("corridors")? The paper's contribution is to explore this question with fresh eyes and with reference to the broader question of the optimal size and composition of central bank balance sheets.

Findings

In contrast to a widely held view, there are good reasons for returning to scarce reserve systems ("corridors"). First, the costs of floor systems take considerable time to appear, are likely to grow and tend to be less visible. They can be attributed to features of the environment which, in fact, are to a large extent a consequence of the systems themselves. Second, for much the same reasons, there is a risk of grossly overestimating the implementation difficulties of corridor systems, in particular the instability of the demand for reserves. Third, there is no need to wait for the central bank balance sheet to shrink before moving in that direction: for a given size, the central bank can adjust the composition of its liabilities. Ultimately, the design of the implementation system should follow from a strategic view of the central bank's balance sheet. A useful guiding principle is that its size should be as small as possible, and its composition as riskless as possible, in a way that is compatible with the central bank fulfilling its mandate effectively.

Abstract

Since the Great Financial Crisis, a growing number of central banks have adopted abundant reserves systems ("floors") to set the interest rate. However, there are good grounds to return to scarce reserve systems ("corridors"). First, the costs of floor systems take considerable time to appear, are likely to grow and tend to be less visible. They can be attributed to independent features of the environment which, in fact, are to a significant extent a consequence of the systems themselves. Second, for much the same reasons, there is a risk of grossly overestimating the implementation difficulties of corridor systems, in particular the instability of the demand for reserves. Third, there is no need to wait for the central bank balance sheet to shrink before moving in that direction: for a given size, the central bank can adjust the composition of its liabilities. Ultimately, the design of the implementation system should follow from a strategic view of the central bank's balance sheet. A useful guiding principle is that its size should be as small as possible, and its composition as riskless as possible, in a way that is compatible with the central bank fulfilling its mandate effectively. 

JEL classification: E42, E43, E52, E58

Keywords: monetary policy operating procedures, central bank balance sheets, abundant vs scarce reserves systems