The Fed Has No Control Over Bank Reserves or the Money Supply
23 November 2016 | Pago Pago, American Samoa
Why? Because it has decided instead to peg the only interest rate it can - the federal funds rate which is the rate at which banks can borrow from the Fed. Now the federal funds rate (FFR) is a truly big deal. Some days a big bank will borrow more from the Fed than its entire reserve requirement. Huge dollars are involved here.
The federal funds rate determines one half of the spread on which banks determine whether to borrow from the Fed and lend. A proposed loan with a rate discernibly greater than the federal funds rate will get done and the bank will pocket the difference after borrowing the loan money from the Fed. Banks have to account on meeting their reserve requirements only periodically and with a lag.
What this means is the Fed losses control over the amount of reserves and of the money supply. Consider the purchase of securities at the NY open window. Conventional wisdom is that this increases reserves in the banking system in like amount and the money supply. But that is not true. The increase in reserves depresses the FFR very fast (it is hyper-sensitive and very quick to adjust) and in order to maintain the peg on the FFR, the Fed has to sell securities in like amount quickly, in effect neutralizing the early increase in reserves and the money supply.
The rate is constantly monitored to maintain the peg. Alternatively, if the Fed sells securities to reduce reserves and the money supply, that pushes the FFR up it will have to turn around and put reserves back in the system by buying securities so banks are not caught short on their reserve requirement. Banks almost always walk the edge.
That is how tight, sensitive and fast that funds market is.
To maintain the peg, the Fed has to give up control of reserves and the money supply. The Fed's earlier effort to control reserves and derivatively the money supply, in turn meant, it had no direct control over any interest rate. That effort proved too problematic for reasons I don't discuss here.