The Federal Reserve held interest rates steady and released a statement on 1 August that made only minor changes to reflect the more upbeat U.S. economy since the Fed’s June meeting. Despite the lack of surprises, however, we don’t think investors should write off the meeting just yet: The more interesting aspect may well come later ‒ when the meeting minutes are revealed in a few weeks.

There is a strong chance that at this meeting the Federal Open Markets Committee (FOMC) began more formal discussions of its longer-term monetary policy implementation framework, specifically whether to continue to implement monetary policy through the “floor” system, which uses the interest that the Fed pays on bank’s excess reserve balances (IOER) to control the fed funds rate. This is important because maintaining the floor system would require the Fed to maintain a bigger balance sheet than it otherwise would have.

Decision pending: “Floor” or “corridor”

Although the FOMC has discussed its longer-run strategy for monetary policy implementation in the past, it has yet to make a formal decision regarding the continued use of IOER when reserve balances normalize. However, the recent increase of the fed funds rate into the higher end of the target range has likely accelerated the need for a more formal decision. Indeed, in his semiannual testimony to Congress in mid-July, Fed Chairman Jerome Powell said the committee was planning to return to this question “fairly soon.”

Amid the Fed’s quantitative easing programs, which greatly increased the level of excess reserves in the banking system, IOER has been a more effective tool to manage interest rates. However, when reserves return to more normal levels, the Fed must decide whether to maintain the current system, or return to a “corridor” approach, whereby the open market operations desk would run daily reserve management operations to change the supply of reserves so that the market interest rate is as close as possible to the target.