95 – George Selgin on Fed Floors, Corridors, and Interest on Excess Reserves

Episode Summary

Executive Summary: George Selgin argues the Fed’s post-crisis “floor system” is an inferior operating regime that keeps interest on reserves too high, distorts monetary transmission, and may prevent the balance sheet from shrinking much below $3 trillion. He says a corridor system would preserve rate control, better align with the Friedman rule, and avoid the legal and governance problems now embedded in IOER.

Main Topics: Fed balance sheet normalization and the likely terminal size (Priority: 5/5): Selgin says the Fed is shrinking slowly and likely will not return to a pre-crisis balance sheet; he expects a floor system to keep reserves high and the balance sheet above $3 trillion, with downside crisis expansions possibly to $6 trillion. Floor system vs. corridor system (Priority: 5/5): He explains that a corridor system uses open market operations to target the policy rate, while a floor system sets rates via interest on reserves; he argues the U.S. should return to a corridor setup even if IOER remains. Reserve scarcity, abundance, and demand (Priority: 4/5): Selgin rejects the idea that floor systems are about reserve abundance per se; he says scarcity is relative to demand, and IOER raises reserve demand so banks willingly hold large excess balances. Monetary policy transmission and quantitative easing (Priority: 5/5): He argues the floor system neutralizes the usual money multiplier, making QE resemble 'stepping on the gas in neutral' and leaving asset purchases reliant on weak portfolio-balance effects. Legal and governance issues with IOER (Priority: 5/5): Selgin contends the Fed stretched the 2006 statute beyond its intent by defining 'short-term rates' to include the discount rate, and that IOER now gives the Board of Governors legal control over the key policy rate. International practice and policy efficiency (Priority: 4/5): He notes most central banks use corridor systems and argues a properly applied Friedman rule would not imply a floor system; instead, reserve remuneration should be below market rates by a modest spread.

Key Arguments: The Fed’s balance sheet is unlikely to shrink much below $3 trillion because the Fed is committed to a floor system that requires large reserve balances. A floor system is not inherently about 'reserve abundance'; it works by raising reserve demand, making reserves attractive relative to other short-term assets. The floor system weakens the standard bank-lending transmission mechanism and makes large-scale asset purchases less effective. The Fed can still pay interest on reserves in a corridor system, so abandoning the floor system would not require reverting to zero IOER. IOER as implemented conflicts with the original statutory intent, which said the rate should not exceed general short-term rates. The current setup shifts meaningful rate-setting power from the FOMC to the Board of Governors because the board controls IOER. Maintaining a floor system may reflect institutional preference and public-choice incentives, not just macroeconomic efficiency. A corridor system could better approximate the Friedman rule by paying reserves somewhat below market short-term rates rather than above them.

Data Points: Treasury runoff pace: $6 billion per month, rising in three-month intervals to $30 billion - Planned monthly reduction in Treasury holdings under the Fed’s balance sheet runoff Agency/MBS runoff pace: $4 billion per month, rising to a $20 billion cap - Planned monthly reduction in agency securities under the Fed’s balance sheet runoff Fed reserves floor scenario: $100 billion - Lower-end scenario in a Fed staff note for possible reserve balances under a corridor-type regime Fed reserves high scenario: $1-2 trillion - Upper-end scenario in a Fed staff note for possible reserve balances Expected minimum balance sheet size: $3 trillion - Selgin’s estimate of the smallest likely Fed balance sheet under the current plan Possible crisis balance sheet size: $6 trillion - Selgin’s estimate if a major crisis forces new QE under Powell IOER introduction date: October 2008 - When the Fed’s floor system effectively began IOER rate at introduction: 75 basis points - Initial rate when IOER was introduced One-month Treasury yield: 0.05% - Around October 15, 2008 when IOER was 75 bps IOER increase: 1.15% - October 24, 2008 IOER setting mentioned in the discussion One-month Treasury yield at that time: 0.33% - Yield cited for October 24, 2008 comparison IOER vs Treasury spread: 70-95 basis points - Range of spreads cited across October-December 2008 comparisons Optimal reserve tax estimate: 20-40 basis points - Baseline result from a cited paper on the efficient spread between reserve remuneration and overnight rates Discount rate spread: 75 basis points above target - The Federal Reserve’s primary credit rate relative to the target rate in the discussion

Pivotal Quotes: "I’ve called what the Fed’s doing Operation Snail." — George Selgin: His characterization of the Fed’s slow balance-sheet runoff "A floor system is just an above-zero liquidity trap." — George Selgin: His critique of the floor system’s macroeconomic effects "What we did in 2008 was put it in neutral." — George Selgin: His car analogy for why QE under IOER did not translate into broad money growth

Implications: If Selgin is right, the Fed’s current framework will keep reserves elevated, weaken transmission, and create legal/governance tensions. A corridor system could preserve control while improving flexibility, efficiency, and accountability.