Back in late 2008 a few money market funds got into trouble and were in danger of “breaking the buck.” That’s due to their policy of pricing each share at $1. The solution is to allow the price to fluctuate. The Fed should have given the industry 6 months to prepare for negative interest rates. Instead they bailed them out and propped up interest rates at 25 basis points, in order to insure they would never break the buck.
If not for the money market industry the Fed could have already cut the fed funds target to around negative 0.25%, and the same for the interest rate on reserves. In that case (and assuming the IOR also applied to vault cash) it’s likely that most of the ERs would exit the banking system and end up in safety deposit boxes. But three trillion dollars is a lot of Benjamins, and despite the cash hoards you observe in places like Japan, a more likely outcome would have been hyperinflation. Obviously that would not be allowed, so what this thought experiment really shows is that with that sort of negative IOR the Fed could have gotten the stimulus it wanted with much less QE.
The decision to pay interest on reserves is one of the great mysteries of the 2008 response to the financial crisis. In terms of monetary policy, it is clearly contractionary, and a financial crisis seems like an odd time to engage in a contractionary policy.
The Fed acts in mysterious ways. At the time, the Fed said,
Paying interest on excess balances will permit the Federal Reserve to provide sufficient liquidity to support financial stability while implementing the monetary policy that is appropriate in light of the System’s macroeconomic objectives of maximum employment and price stability.
Which to me says exactly nothing. It could be that the only way to find out the basis of the Fed decision is with an audit.
Academics had a view that monetary policy involved the fed buying tbills. This how it was done in other countries… But not the at the fed. The open market trading desk focused on notes when implementing the fomc policy rate. During the 80s when the fed saw increased activity at the discount window, they became concerned that they lack sufficient tbills to sterilize the discount window activity. So they changed the term structure and increases their holdings of bills to 50% while maintaining a four year average maturity to match the overall treasury debt outstanding.
Now when the crisis hit, the fed saw the discount window as a stigma and instead used the term auction facility for the same purpose.
So they sterilized by selling off their tbills, until they ran out of tbills. That is when IOR was requested and applied.
It seems likely that an initial motivation of the QE program was to bail out the banks, who in 2009 had a lot of risky underwater assets they wanted to unload. The government got rid of mark-to-market accounting to give them time without having to raise capital, and the Fed started QE to bring the junk assets onto its own balance sheet, giving excess reserves in return. So banks got a low-counterparty-risk, low yielding asset (excess reserves) to replace high-yielding but high default risk assets worth much less than what the Fed was paying for them.
But, a key element is that Bernanke viewed QE as a form of stimulus and a monetary policy instrument as well as a bank rescue tool. There must have been a private agreement of the Fed with the banks that the excess reserves could not be withdrawn for use as money or converted into securities, since drawing down reserves could force the Fed to reverse QE (ie, if another bank did not have demand for excess reserves, the Fed would have to sell assets to redeem the excess reserves — printing currency is not feasible, there is less than $1 trillion in currency outstanding and nobody wants to hold trillions of currency). Instead, the banks had to accept the excess reserves as a permanent item on their balance sheets.
From this perspective, a quarter-percent payment is minimal compensation for a long-term or permanent loan. It is far below long-term Treasury rates. Banks are loaning deposits to the Fed for an indefinite term for a miniscule amount. What they get in return is two things:
– They got to unload junk mortgage securities and other assets to the Fed for prices well above market value;
– They have been allowed to use excess reserves as collateral for other trades including highly levered derivatives. This enables banks to make large investments or generate trading profits from small interest differentials through high leverage.
This has all been highly profitable for the banks but it has driven asset prices to levels from which prospective returns are minimal. And now the Fed has realized it has painted itself into a corner. Derivatives leverage has radically increased as a result of these policies, and any halt to QE will bring about a deleveraging with risks to the financial system. That is why the impact on the markets of Bernanke’s taper talk last summer was so large, and why the Fed got worried and backed off the taper while it re-appraised its options. Apparently they had not planned ahead.
Had the Fed adopted negative IOR from the beginning, the motivation for banks to accept excess reserves would have been greatly reduced. Sure, if they could unload junk assets to the Fed at well above market value, it might make sense, but they certainly wouldn’t have traded trillions of dollars of Treasuries to the Fed for nothing but an obligation to pay further interest to the Fed indefinitely, with no right to exit the trade. The banks might well have chosen to sit on their junk mortgage securities and hope for an economic recovery, knowing that they are “too big to fail” and the government would bail them out push come to shove anyway. So, QE would have been a total failure if the Fed had tried to charge negative IOR.
Since the Fed wanted to bail out the banks and needed the banks as partners, it had to pay IOR. And now it has no choice but to continue.
This is what I believe.
http://www.zerohedge.com/news/2013-11-24/banks-warn-fed-they-may-have-start-charging-depositors
QE has already gone past the point where it is beneficial for the banks. Now they have already unloaded all the assets they want to unload and taking on permanent assets yielding 0.25% is not attractive. If the Fed went to -0.5% on excess reserves as some have advocated, it would cost the banks 0.75% * $2.2 trillion annually = $16.5 billion per year off an already bad deal. Even with the current deal, QE is taking an increasing fraction of deposits and crowding out lending. Bernanke has left Yellen with few options, as we head into the next recession.
Hyperinflation. That’s hilarious. I would assume it a joke except it comes from Scott. The Fed would have had an extremely difficult time finding anything other than junk to buy to create those reserves if they had, and there are plenty of places to place dollars other than in US banks.
IOR was just a stealthy way to socialize bank losses and pump up their balance sheets with taxpayer money. Exactly what any reasonable person would expect given they current profiles of our bipartisan elites.
Paying IOER prevents the fed funds rate from falling below zero. Scott Fullwiler explains here how IOER controls the fed funds rate, and why this is necessary:
http://neweconomicperspectives.org/2013/01/understanding-the-permanent-floor-an-important-inconsistency-in-neoclassical-monetary-economics.html
If Sumner actually understood how the monetary system works he would know this. But he doesn’t think he needs to understand the plumbing. I can see why – after all I can do the washing up without knowing how the water reaches the taps – but when the water won’t come out of the taps, you do really have to understand the plumbing to be able to identify what the problem is.
By the way, paying interest on IOER is NOT contractionary. It is a constant small increase in reserves, which is expansionary. However, negative IOER is “of itself” contractionary. It is a tax or charge on bank deposits, which is likely to be passed on in the form of higher rates to borrowers. There are of course offsetting effects such as Sumner’s “hot potato” which may make the overall impact of negative IOER expansionary, but intrinsically it is contractionary.
The payment of interest on excess reserve balances demonstrates that all economists don’t know the difference between money & liquid assets, between the money creating depository institutions & their customers: the financial intermediares (the truistic conduits between savers & borrowers – where savings are matched with investments). It is simple accounting. The source of all time/savings deposits to the CB system is other bank deposits, directly or indirectly via the currency route or thru the bank’s undivided profits accounts. I.e., money flowing through the NBs never leaves the CB system as anyone who has applied double-entry bookkeeping on a national scale should know.