The Fed Should Keep Looking Forward, Not Retreat to the Past

The past decade experienced a revolution in how the Federal Reserve conducts monetary policy. While new tools such as quantitative easing have received the most attention, just as significant have been the changes made in how the Federal Open Market Committee sets and controls the level of short-term interest rates.

Before the financial crisis, the Fed controlled short-term rates by engaging in open market operations. Each day, the Federal Reserve Bank of New York would assess whether to add or drain bank reserves from the financial system to balance the supply and demand to achieve the desired short-term interest rate. While straightforward in theory, the process was extremely complex to carry out. Each day the Fed had to forecast all the factors that were affecting the supply of reserves and then act to adjust that supply to equal what banks needed to meet their reserve requirements. In the same vein, banks had to buy and sell reserves to ensure that they had enough to meet their requirements but no excess because reserves earned no interest. To make this more tenable, reserve requirements were calculated over a two-week maintenance period and banks could carry forward small excesses or deficiencies into the subsequent two-week period.