Fed debating policy normalization methods

New York Fed says that policy makers are debating the best possible ways to normalize monetary policy when “the economy strengthens” and are considering either a corridor-type system or a floor-type system.

Corridor system refers to setting the target interest rate below the discount but above the interest rate banks get on their reserves at the Fed.

The floor approach sets the interest on reserves at the same level as the target rates.

“Each of these approaches offers some advantages. Central banks have much more experience with corridor-type systems, in part because it is possible to operate one without paying interest on reserves,” writes Todd Keister at the NY Fed.

In the corridor system “the supply of balances … falls in the inelastic region of the demand curve” while in the floor system the reserve balances fall in the “the elastic region of the demand curve”.

There are 3 regions in the graph of the demand of reserve balances. Flat one just above the discount rate where lot of banks have a problem meeting their reserve requirement so they bid up the rate to get the cash.

The middle downward sloping portion is where banks can meet their requirements but use portions of the reserves to payoff their cash obligations and may need some borrowing so as not to fall below required reserves. The rate they pay in this region is not very important.

The flat or the elastic portion is when banks have abundance of cash so small changes in rates influences whether that abundance would become larger or smaller.

“In a corridor-type system, the interest-on-reserves rate is lower than the market interest rate. Banks thus have an incentive to invest time and effort trying to economize on the quantity of balances they hold by lending extra funds to other banks or by purchasing other assets… A floor-type system
removes the incentive for banks to undertake such efforts.”

Full discussion available here.