Last December, I participated in an AEI event where I made the case that the Fed’s current floor operating system could collapse into a corridor operating system fairly soon. My argument was that even without a significant reduction in the supply of reserves, a large shift in the demand for reserves could be sufficient to move the Fed off the perfectly elastic or ‘flat’ portion of the bank reserve demand curve. The Fed, in other words, could have a relatively large balance sheet and still end up in a corridor operating system.
Graphically, such a development is depicted in the figures below. The figure on the left shows a floor operating system with a large supply of reserves on the flat portion of demand curve. In this system, the IOER is both the target and overnight interest rate.Read More »