The Federal Reserve Replaced Open-Market Operations with a Floor-Type Operating System as Its Chief Instrument of Monetary Control

Federal Reserve authorities responded to the 2007-8 financial crisis with a sequence of controversial monetary policy experiments aimed at containing the crisis and, later on, at promoting recovery. One of those experiments consisted of the Fed's decision to start paying interest on depository institutions' balances with it, including both their legally required balances and any balances they held in excess of legal requirements. Because the interest rate on excess reserves was high relative to short-term market rates, the new policy led to the establishment of a "floor"-type operating system, meaning one in which changes in the rate of interest paid on excess reserves, rather than open-market operations, became the Fed's chief instrument of monetary control.

Although it has attracted less attention, and generated less controversy, than many of the Fed's other crisis-related innovations, the Fed's shift to a floor system has also had more profound and enduring consequences than many of them. And despite Fed officials' intentions, those consequences, including a radical change in the Fed's methods of monetary control, have mostly been regrettable. While Fed officials hoped that the new floor system would assist them in regulating the flow of private credit in the face of extremely low and falling interest rates, a close look at the workings of the system, and at its record, shows that those hopes have been disappointed.

--George Selgin, introduction to Floored! How a Misguided Fed Experiment Deepened and Prolonged the Great Recession, Cato Working Paper 50 (Washington, DC: Cato Institute, 2018), 1.