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The Red Toed Elephant: Interest on Reserves

June 8, 2012

There is a joke that goes:
Q: Why do elephants paint their toenails red?
A: So they can hide in strawberry patches. Have you ever seen an elephant in a strawberry patch?

The Fed’s interest on excess reserves policy (IOER) is the red toed elephant of macroeconomics. You would think that economists who are hyper-focused on the interest rate channel of monetary policy would pay attention to things which effectively turn reserves into bonds, but it is only ever mentioned by the occasional market monetarist. One of the defining features of high-powered money is that it doesn’t yield a return, so people who hold it want to get rid of it so that they can earn a return. Investors face a tradeoff between riskiness, liquidity, and yield for all of the investments they can choose from. Reserves, typically, have the highest liquidity and lowest nominal volatility, but the tradeoff to holding them is low returns. Currently, rates on government securities are very low, so the alternatives for those who want to buy safe assets are pretty poor, hence, banks are holding massive amounts of reserves, rather than lending.

I get frustrated when people talk about the liquidity trap, which is basically a situation where the central bank trades one asset yielding x% for another yielding x%, which does nothing to stimulate the economy. People usually talk about x = 0, but neither the fed funds nor the IOER rate is exactly 0, so there is still some wiggle room. The other point that almost never seems to be considered is that while the fed funds rate is practically limited to 0, the IOER rate is not. The Fed could easily make it -1%, or even -10%, which would make the reserves fly out the bank doors and be channeled toward productive investments. There are no legal limitations to this option, as Congress had no problem when the Fed did positive IOER.

Using IOER as a policy lever would also make monetary policy less unstable and prone to vicious cycles. This is a multiple equilibrium situation. In one equilibrium, NGDP growth is low, inflation is low, and investment opportunities are poor, leading banks to horde reserves. In another equilibrium, NGDP growth is rapid, inflation is high, and real investments yield more than government bonds, which causes banks to lend out their reserves at a very rapid rate. Interest on reserves acts like a monetary dam, preventing reserves from being lent. If that dam breaks, the central bank might not have the skill to stop the flood. Lowering the IOER while reducing the central bank’s balance sheet is like draining the reservoir before the hurricane hits. It would also make it easier for the central bank to communicate their intentions by making interest rate talk meaningful. The Fed is not out of ammunition, it just needs to switch guns.

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