"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008

Wednesday, August 4, 2010

Should Fed stop paying interest on reserves?

FT Alphaville asks:
Is the policy of continuing to pay interest on the bank reserves held at the Federal Reserve a good idea, a bad idea, or completely irrelevant?
The quick answer is that Fed should stop paying interest on reserves in the process of driving fed funds rate down closer to zero. But with many serious misconceptions about interest on reserves floating around a longer discussion is needed.

Paying interest on reserves is expansionary

Milton Friedman in 1959 advocated the policy of paying interest on reserves held at central bank. He was worried that if reserves earn no interest, this is equivalent to a distortionary tax on reserves. This distortionary tax harms the activities of banking sector and the whole economy.

Recent research by Vasco Curdia and Michael Woodford supports Milton Friedman's conclusion that paying interest on reserves is a good idea. Curdia and Woodford explain that there are three independent dimensions of monetary policy: target for the federal funds rate, credit policy (funds lent to the private sector by central bank) and interest rate paid on reserves. Curdia and Woodford show that if federal funds rate is held constant, higher levels of interest on reserves are associated with lower lending spreads and higher levels of economic activity. When central bank removes artificial scarcity of reserves that was caused by zero interest rates on reserves, the quantity of reserves increases and commercial banks can expand lending even though fed funds rate stays the same. This is why some countries like Canada and New Zealand have long ago started paying interest on reserves.

Credit crisis and the start of interest on reserves program in September/October 2008

If we return to the above-mentioned three independent dimensions of monetary policy, it is important to note that the only dimension of policy that Fed got right during the crisis was interest on reserves policy (IOR policy). Starting in October 2008, Fed began moving interest rate paid on reserves closer to fed funds rate. As recommended by Curdia and Woodford, eventually these two interest rates became equal. Alas, Fed has misjudged the severity of credit crisis and federal funds rate was not cut fast enough, and despite multitude of acronyms such as TALF, Bernanke's credit policy was too weak to save the economy.

Critics of the IOR policy

Fed's IOR policy was immediately criticized by James Hamilton and David Beckworth. But their criticism suffers from two shortcomings. First, they picked the wrong target by saying that interest rate paid on reserves is too high. Because the primary tool used by the Fed is fed funds rate, Hamilton and Beckworth should have argued instead that fed funds rate is too high. Second, it is not true that hoarding by banks of massive quantity of excess reserves under IOR regime is somehow more harmful than hoarding of a small quantity of required reserves under previous zero interest rate regime.

Scott Sumner, another famous critic of IOR, deserves a separate mention. He focuses on opportunity cost of reserves. He argues that interest paid on reserves discourages lending by providing alternative source of income to banks. This is not true. Under IOR policy the opportunity cost of reserves is IOR rate. However, under previous zero IOR policy regime opportunity cost of reserves was not zero, because quantity of reserves was artificially scarce, and banks were willing to hold reserves that pay zero interest, because they were earning liquidity related convenience yield. The size of such convenience yield is equal or greater than fed funds rate, so IOR policy does not reduce the willingness of banks to lend.

What the Fed can do?

Back in February we warned that "extended period of exceptionally low levels of the federal funds rate will last longer than many think." Developments since then have vindicated this forecast, as markets have postponed the date they think the Fed will start raising interest rates; in addition to that, TIPS market is indicating that inflation will be lower than Fed's implicit target of 2% during next five years, this means that aggregate demand is too low and monetary policy is too tight.

Current target of federal funds rate is the range of 0.00 - 0.25. The Fed should cut federal funds rate target to zero; and the Fed should stop paying interest on reserves while fed funds rate is zero. The primary benefit of such move is that a signal would be sent to markets that a majority of FOMC members believe they should combat deflationary shocks, thus providing at least a short term support to stock market. Direct benefits of 25bps reduction are not so large, as Stephen Williamson says:
"Now, what would be the effects of a decrease in IROR to zero? As Bernanke says, not much. Reserves would become slightly less attractive to banks, and in the course of trying to shed them, the price level would rise by a small amount, reserves would fall, and the quantity of currency (in nominal terms) would rise."
The most important steps that the Fed should take are different. First, the Fed should be more explicit about policy goals and should switch to explicit target of price level path, or even better, nominal income path. Second, the Fed should restart the support of private credit markets by purchasing commercial investment grade-bonds with maturities of up to three years.

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