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Interest on Reserves

January 9, 2012

My previous posts on the topic of the Fed’s interest on reserves policy are here and here. Recently, I commented on Steve Roth’s post on interest on reserves. He then responded, and I would like to as well.

Market Monetarists do not focus on inputs to policy – the money supply, the interest rate, the government deficit, etc. They focus on outputs, mostly NGDP, but also unemployment and RGDP. A central bank should do whatever it takes to hit the target. If printing $100 billion does not produce enough spending, print $200 billion. If lowering interest 0.25% does not reduce unemployment to the target, cut it by 0.5%. When people drive, they don’t talk about how they turn the steering wheel, they say where they want to go. It’s implied that you did exactly enough steering to get you there. Ben Bernanke saying “we printed $x” is like a driver saying “I rotated the steering wheel by pi/2 radians”. It does not matter. What matters is the target and did you hit it.

So, when asked “what happens when the Fed does policy x?”, a market monetarist should say, “Did their target change?”. If not, then there are no consequences for NGDP. Scott Sumner gave the right answer. I did not. I tried to answer the question ceteris paribus, but my answer was not as a market monetarist, it was as me.

Banks are forever faced with a decision: what do we do with the money we have? They continually try to get the highest return they can, adjusting for risk. Whatever is the best option, that’s what they do. For Diversification is very common, because banks face diminishing returns on many margins. When the Fed began IOR, they offered banks a risk free way to earn a tiny profit. Normally, with 3% inflation and good business opportunities elsewhere, banks would have ignored this insignificant return. They did not, and based on revealed preference, we can infer that depositing their money at the Fed was the best option many banks faced.

So, what’re the opportunity costs/alternatives? If bank did not deposit the money at the Fed, what would they have done instead? Banks just don’t have that option to hold more currency as a whole. If one bank holds more currency, another bank must hold less. I don’t think the Treasury would accomodate all the banks asking them to print up a trillion dollars worth of hard currency. Banks would need to buy other assets. They could buy stocks or bonds, or they could lend to individuals, driving down interest rates and increasing investment. While interest on government bonds is extremely low, interest on loans to individuals and businesses has a long way to go before it gets close to 0. Thoma recognizes this marginal effect when he says “it would slightly lower the incentive for banks to hold cash rather than loaning it out”.

In the short run, banks would probably act pretty slowly. They’d make a couple more loans when they would not otherwise. So, in this sense, I agree with most commenters in that “it wouldn’t do much”, but the reason why it wouldn’t do much is that it is presumed that the central bank won’t change its target. Mark Thoma isn’t answering ceteris paribus; he’s answering in a world with a sane central bank. Given a stable NGDP, getting rid of IOR would increase loans by a bit, but reduce other forms of spending by a bit.

Without a stable target, the whole thing could unravel quickly. If I am a bank and I know that other banks are increasing lending by 10%, that will increase spending, which will increase inflation, suddenly sitting on reserves doesn’t look so good anymore. You might still hold 90% of the excess reserves you did when inflation is 2%, but what if inflation is 10%? You’re going to reduce your reserve holdings (by lending) to the bare minimum and so is everyone else. That’s why I implied that getting rid of IOR could have profound implications for spending.

IOR of zero would break a whole lot of financial entities’ business models
That is precisely the idea. Their business model is “collect government subsidies for doing nothing”. If getting rid of IOR drives banks who weren’t lending anyway out of business, there will be no negative macroeconomic repercussions. The money multiplier only happens when the banks actually lend. There could be some margin at which IOR keeps a semi-lending bank alive and that getting rid of it could cause debt-deflation, but if that is really the case, the Fed should come up with some form of subsidy which does not reduce a bank’s incentive to lend at the margin.

As a final note, when IOR was first started, most people thought that it wouldn’t have a big impact because the interest rate was so small. They were wrong. NGDP collapsed, and that’s even with a huge fiscal stimulus and QE1.

6 Comments leave one →
  1. January 9, 2012 1:07 pm

    James, perfect, thanks. We’re in total agreement (now that I know what I think), except I’m confused by the last paragraph.

    Are you suggesting that IOR *caused* the drop in NGDP? That’s the impression I get. So lower IOR would have little effect, but instituting it had a huge effect?

    • January 9, 2012 1:32 pm

      I’m saying that the central bank underestimated the power of IOR and so they missed their target. The Fed could undo IOR without affecting NGDP, but they would have to be very careful.

  2. flow5 permalink
    January 10, 2012 10:53 am

    The 4th qtr 2008 & the 1st qtr 2009 were already set in stone when the IOeR was introduced. Thereafter it has retarded and will continue to restrain economic growth. Unbeknownst to the Keynesian economists (those that don’t know the difference between liquid assets and money), IOeRs induce dis-intermediation within the money market. IOeRs have altered the construction of a normal yield curve, they have INVERTED the short-end segment (i.e., the remuneration rate @ .25% is higher than the daily Treasury yield curve 2 years out – .26% on 01/09/12).

    IOeRs’ are the functional equivalent of required reserves. They are a credit control device. IOeRs’ are used to offset Bernanke’s liquidity funding programs (expansions), on the asset side of the FED’s balance sheet. I.e., quantitative easing, or the FED’s POMOs, were sterilized by adjusting the remuneration rate which restricts bank lending & investment. For the sterilization process to work, IOeRs by definition, must be contractive. I.e., the bank’s cash assets were transformed into earning assets, If the BOG raised the remuneration rate on excess reserves (vis a’ vis other competitive financial instruments, yields, & returns ), the VOLUME of IBDDs will increase and during this process IOeRs will also absorb savings.

  3. January 10, 2012 11:43 am

    Good points.

    “4th qtr 2008 & the 1st qtr 2009 were already set in stone when the IOeR was introduced”
    IOR was started on October 6, 2008. QE1 was started shortly thereafter, presumably when the Fed realized how contractionary IOR was. My mini-conspiracy theory is that the Fed did IOR to offset the inflationary effects of ARRA 2009 and all the bailouts.


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