A Powerful Federal Reserve Reform: Flexible Open Market Operations

By Norbert Michel, Director of the Center for Data Analysis at The Heritage Foundation

The Federal Reserve is spreading its wings.  Its latest book, “The Power of Regional Food System Investments to Transform Communities,” focuses on things like “food equity” and “Inclusion in Local and Regional Food System Efforts.” I suppose there’s really no major problem here, as long as the Fed is still willing to tackle monetary policy. I even have a suggestion for a new book: How to improve the way the Fed conducts open-market operations. At some point, the Fed will shrink its balance sheet and end the unconventional monetary policies it started during the 2008 crisis. But the central bank’s procedures for open-market operations will still need an overhaul. Traditionally, the Fed has conducted open-market operations via a limited number of financial firms known as primary dealers. This system broke down during the 2008 crisis. It’s no secret that the primary dealer system was a problem. Donald Kohn, former Vice Chairman of the Federal Reserve Board of Governors, notes that:

The fact that primary dealers rather than commercial banks were the regular counterparties of the Federal Reserve in its open market operations, together with the fact that the Federal Reserve ordinarily extended only modest amounts of funding through repo agreements, meant that open market operations were not particularly useful during the crisis for directing funding to where it was most critically needed in the financial system.

The current version of this system –roughly 20 large financial institutions – was created in the 1960s when there were clearer advantages to having a centralized open-market system in New York. In practice, when the Fed wants to expand the monetary base so that banks can make more loans, it directs its traders to buy Treasuries from the primary dealers. The Fed then electronically credits the reserve accounts of the dealers’ banks, thus leaving it to the primary dealers to distribute credit through the federal funds market. That was the bottleneck, and that’s also where the story gets interesting. Back in the late 1990s, the Fed actively explored ways to conduct open-market operations
without having to buy Treasuries, because it appeared that the level of outstanding government debt was going to shrink substantially. In 2002 it released a study titled

Alternative Instruments for Open Market and Discount Window Operations. The report discussed several alternative approaches, including an auction-based lending facility that could provide liquidity to the banking system. The Fed chose to maintain its traditional blend of policy tools rather than create such a facility, but the financial crisis forced its hand.

In December 2007, as the primary dealer system broke down, the Fed introduced the Term Auction Facility (TAF) to help provide system-wide liquidity. The TAF was a lending program that combined aspects of open-market operations and discount window lending. The experience during the crisis suggests a modified TAF program could improve the Fed’s ability to maintain system-wide liquidity, and ultimately replace both the discount window and the primary dealer system. In fact, such a facility could even eliminate the need for the separate emergency lending authority – Section 13(3) lending – that proved so controversial during the crisis. On the surface, replacing the primary dealer system with a broader liquidity facility, so that most financial firms could participate directly in open-market operations, makes perfect sense. By definition, such an approach would not have a bottleneck. It’s also the case that other central banks already use broader liquidity facilities. For instance, the European Central Bank (ECB) conducts its open-market operations with more than 500 bank counterparties in the Eurozone. The Bank of England uses a “product-mix auction” to provide broad-based liquidity in both normal and crisis conditions, thus mitigating the need for separate emergency lending authority. Surely the Fed would prefer to stay out of political squabbles by avoiding special loans to one or two large firms in a crisis? There’s certainly more than one way to pull this off, but George Selgin recently published a proposal that would, among other things:

  • Allow a single Fed standing (as opposed to temporary) facility to meet extraordinary as well as ordinary liquidity needs as they arise, with no need for ad hoc changes in the rules governing the facility, or for special Fed, Treasury, or congressional action;
  • Make Fed lending to insolvent, or potentially insolvent, institutions both unlikely and unnecessary, no matter how “systemically important” they may be, by allowing most financial enterprises to take part directly in the Fed’s ordinary credit auctions;
  • Dispense with any need for direct lending, including both discount window and 13(3) loans, whether aimed at particular institutions or at entire industries, and otherwise radically simplify existing emergency lending provisions of the Federal Reserve Act;
  • Eliminate any general risk of Fed mispricing or misallocation of credit, including such underpricing as might create a moral hazard;
  • Replace the ad hoc and arbitrary use of open-market operations to favor specific firms or security markets with a “neutral” approach to emergency liquidity provision, by making the same facility and terms available to a wide set of counterparties possessing different sorts of collateral;
  • Enhance the effectiveness of the Fed’s open-market purchases during periods of financial distress by automatically providing for extraordinary Fed purchases of less-liquid financial assets; and
  • Eliminate uncertainty regarding the availability of emergency credit and the rules governing its provision.

For decades, the Fed has used open-market operations as its main monetary policy tool, and the goal has always been to maintain system-wide liquidity. The Fed’s primary dealer system, with its reliance on a small number of firms, clearly hurt the Fed’s ability to maintain system-wide liquidity during the 2008 crisis. Yet, the Fed has thus far chosen to keep the primary dealer system intact. At the very least, the Fed should update its own 2002 study to elaborate on its own experiences during the 2008 crisis as well as the new auction approach started by the Bank of England. It appears the Fed has more than enough resources to devote to this study.

*Originally published in Forbes, click here.

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