High inflation rates have been making headlines since the beginning of the year. Inflation seems to have caught even investors by surprise. While I’m optimistic that inflation will fall over the next year, this belief is formed with the expectation that the stance of monetary policy should and will remain tight. The effective Federal funds rate is currently 0.83% after spending nearly two years under 0.1%. The logic behind the increases in the Federal funds rate, driven by simultaneous increases in the rate paid on reserves held at the Fed, is that higher interest rates indicate tighter monetary policy. This is an age-old wisdom inherited most plainly from Paul Volcker’s tenure at the Fed. 

But monetary policy no longer works the way it did under Volcker and Greenspan. In the Volcker-Greenspan era, when the Federal Reserve raised the Federal funds rate, the Federal Open Market Committee (FOMC) would slow the rate of expansion of currency circulating in the financial system by slowing its purchases of US Treasuries. The slowing of monetary expansion translated to an increase in interest rates. As financial activity would begin to falter in response to higher rates, the FOMC would reverse course, lowering the Federal fund target and increasing the rate of expansion of currency. 

Since the Volcker-Greenspan era, it has become common to interpret the stance of monetary policy by the level of interest rates. This age-old wisdom, however, is misapplied. It fails to account for the disconnect between interest rates and the quantity of money allowed to circulate in the economy. The FOMC no longer needs to support the Federal funds rate target by changing the rate of expansion of circulating currency. The old mechanism used by Volcker and Greenspan still operates. It’s just not as important. Instead, the Federal Reserve simply changes the rate it pays on deposits. Currently the rate paid on reserve balances is 10 basis points (0.10 percentage points) below the upper limit of the Federal funds target range. When member banks choose where to invest funds, the rate paid on reserves held at the Fed represents a zero-risk option. Competing investment opportunities must offer a higher rate of return to offset risk of investment in the market. By its payment of interest on reserves, the FOMC sets the base of the yield curve. 

This, of course, requires that the Federal Reserve is able to manage interest payments. At low interest rates, this isn’t a major problem. The Federal Reserve currently holds $3.315tr in deposits. At the current interest rate of 0.9%, this means that it must pay out $30bn in interest each year to maintain this balance. The Fed currently borrows $2.26tr from the overnight lending market. With the effective Federal funds rate at 0.83%t, this amounts to $19bn in interest payments over the year. This borrowing from the overnight lending market puts upward pressure on the Federal funds rate, but apparently not enough for the rate to rise above the floor set by the rate paid on reserves held at the Fed. 

At current rates, the Federal Reserve must pay out $49bn in interest each year to maintain the current level of deposits and loans from the overnight lending market that enable it to borrow these funds. In 2021, the Federal Reserve earned $122.4bn in revenue, which is obviously more than enough to offset these costs. And as interest rates rise, newly purchased financial instruments will also yield higher rates of interest. At present, 31% of the Fed’s purchases of US Treasuries mature within 2.25 years (this excludes Treasury Inflation-Protected Securities, or TIPS, held by the Fed). These securities must be replaced as they mature. We can expect, then, that as interest rates rise, so too will revenues earned by the Federal Reserve as it rolls over maturing investments. 

In the past few weeks, the Federal Reserve has modestly begun to reduce its balance sheet. As rising rates increase interest payments by the Federal Reserve, a reduction of the level of deposits held at the Federal Reserve will help reduce the burden of these payments. As long as the Fed’s revenues exceed its expenditures, it can continue to set the Federal funds target without relying on expansion of circulating currency through traditional open-market purchases.