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July 30, 2010

Some observations regarding interest on reserves

One of the livelier discussions following Federal Reserve Chairman Ben Bernanke's testimony to Congress on monetary policy has revolved around the issue of the payment of interest on bank reserves. Here, for what it's worth, are a few reactions to questions raised by that discussion:

Is interest paid on reserves (IOR) a free lunch?

Ken Houghton has the following objection:

"… in September of 2008, the Fed decides to pay interest on reserves—including Excess Reserves. The banks can now make 25 times what they pay in interest, risk-free, just by holding onto money. The Fed is, essentially, leaving $100 bills on the sidewalk."

I'm not sure exactly where the "25 times" comes from, but it seems to me that the most obvious transaction would be to borrow in the overnight interbank lending market—the federal funds market—and then "lend" those funds to the Fed by placing them in the Fed's deposit facility. The differential between the return on those options is a good deal lower than a multiple of 25.

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In fact, as many have noted before, the puzzle is why the gap between the funds rate and the deposit rate exists at all. As explained on the New York Fed's FAQ sheet:

"With the payment of interest on excess balances, market participants will have little incentive for arranging federal funds transactions at rates below the rate paid on excess. By helping set a floor on market rates in this way, payment of interest on excess balances will enhance the Desk's ability to keep the federal funds rate around the target for the federal funds rate."

It didn't quite work out that way, so clearly there is a limit to arbitrage. But if you really think that an 8 basis point spread between the effective funds rate and the deposit rate is a problem, the best approach would be, in my opinion, to address the institutional arrangements that are limiting arbitrage in the funds market. (Some of those features are discussed here and here.)

 What is the opportunity cost of not lending?

That said, certainly the real issue about the IOR policy concerns the presumed incentive for banks to sit on excess reserves rather than putting those reserves into use by creating loans. This, from Bruce Bartlett, is fairly representative of the view that IOR is, at least in part, to blame for the slow pace of credit expansion in the United States:

"… As I pointed out in my column last week, banks have more than $1 trillion of excess reserves—money that the Fed has created that banks could lend immediately but are just sitting on. It's the economic equivalent of stuffing cash under one's mattress.

"Economists are divided on why banks are not lending, but increasingly are focusing on a Fed policy of paying interest on reserves—a policy that began, interestingly enough, on October 9, 2008, at almost exactly the moment when the financial crisis became acute."

OK, but the spread that really matters in the bank lending decision is surely the difference between the return on depositing excess reserves with the Fed versus the return on making loans. In fairness, it does appear that this spread dropped when the IOR was raised from its implicit prior setting of zero…

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… but it's also pretty clear that this development largely reflects a general fall in market yields post-October 2008 as much is it does the increase in IOR rate:


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And here's another thought: As of now, the IOR policy applies to all reserves, required or excess. Consider the textbook example of a bank that creates a loan. In the simple example, a bank creates a loan asset on its book by creating a checking account for a customer, which is the corresponding liability. It needs reserves to absorb this new liability, of course, so the process of creating a loan converts excess reserves into required reserves. But if the Fed pays the same rate on both required and excess reserves, the bank will have lost nothing in terms of what it collects from the Fed for its reserve deposits. In this simple case, the IOR plays no role in determining the opportunity cost of extending credit.

Of course, the funds created in making a loan may leave the originating bank. Though reserves don't leave the banking system as a whole, they may certainly flow away from an individual institution. So things may not be as nice and neat as my simple example.  But at worst, that just brings the question back to the original point: Is the 25 basis point return paid by the central bank creating a significant incentive for banks to sit on reserves rather than lend them out to consumers or businesses? At least some observers are skeptical:

"Barclays Capital's Joseph Abate…noted much of the money that constitutes this giant pile of reserves is 'precautionary liquidity.' If banks didn't get interest from the Fed they would shift those funds into short-term, low-risk markets such as the repo, Treasury bill and agency discount note markets, where the funds are readily accessible in case of need. Put another way, Abate doesn't see this money getting tied up in bank loans or the other activities that would help increase credit, in turn boosting overall economic momentum."

Are there good reasons for paying interest on reserves?

Even if we concede that there is some gain from eliminating or cutting the IOR rate, what of the costs? Tim Duy, quoting the Wall Street Journal, makes note (as does Steve Williamson) of the following comment from the Chairman:

"… Lowering the interest rate it pays on excess reserve—now at 0.25%—could create trouble in money markets, he said.

" 'The rationale for not going all the way to zero has been that we want the short-term money markets, like the federal funds market, to continue to function in a reasonable way,' he said.

" 'Because if rates go to zero, there will be no incentive for buying and selling federal funds—overnight money in the banking system—and if that market shuts down … it'll be more difficult to manage short-term interest rates when the Federal Reserve begins to tighten policy at some point in the future.' "

Professor Duy interprets this as aversion to the possibility that "the failure to meet expectations would be the real cost to the Federal Reserve," but I would  have taken the words for exactly what they seem to say—that the skills and infrastructure required to maintain a functioning federal funds rate might atrophy if cutting the rate to zero brings activity in the market to a trickle. And that observation is relevant because of the following, from the minutes of the April 27–28 meeting of the Federal Open Market Committee:

"Meeting participants agreed broadly on key objectives of a longer-run strategy for asset sales and redemptions. The strategy should be consistent with the achievement of the Committee's objectives of maximum employment and price stability. In addition, the strategy should normalize the size and composition of the balance sheet over time. Reducing the size of the balance sheet would decrease the associated reserve balances to amounts consistent with more normal operations of money markets and monetary policy."

"Normal" may not mean the exact status quo ante, but to the extent that federal funds targeting is a desirable part of the picture, it sure will be helpful if a federal funds market exists.

Even if you don't buy that argument—and the point is debatable—it is useful to recall that the IOR policy has long been promoted on efficiency grounds. There is this argument for example, from a New York Fed article published just as the IOR policy was introduced:

"… reserve balances are used to make interbank payments; thus, they serve as the final form of settlement for a vast array of transactions. The quantity of reserves needed for payment purposes typically far exceeds the quantity consistent with the central bank's desired interest rate. As a result, central banks must perform a balancing act, drastically increasing the supply of reserves during the day for payment purposes through the provision of daylight reserves (also called daylight credit) and then shrinking the supply back at the end of the day to be consistent with the desired market interest rate.

"… it is important to understand the tension between the daylight and overnight need for reserves and the potential problems that may arise. One concern is that central banks typically provide daylight reserves by lending directly to banks, which may expose the central bank to substantial credit risk. Such lending may also generate moral hazard problems and exacerbate the too-big-to-fail problem, whereby regulators would be reluctant to close a financially troubled bank."

Put more simply, one broad justification for an IOR policy is precisely that it induces banks to hold quantities of excess reserves that are large enough to mitigate the need for central banks to extend the credit necessary to keep the payments system running efficiently. And, of course, mitigating those needs also means mitigating the attendant risks.

That is not to say that these risks or efficiency costs unambiguously dominate other considerations—for a much deeper discussion I refer you to a recent piece by Tom Sargent. But they should not be lost in the conversation.

By Dave Altig, senior vice president and research director at the Atlanta Fed

July 30, 2010 in Banking, Federal Reserve and Monetary Policy, Monetary Policy | Permalink

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Comments

Is there some institutional constraint the forces IOR to be a multiple of 25 bps? Are holding steady and going to zero the only options?

Posted by: Andy Harless | July 31, 2010 at 01:41 PM

You refer to “…the presumed incentive for banks to sit on excess reserves rather than putting those reserves into use by creating loans.” That statement is incompatible with the widely accepted view that banks just don’t lend reserves. That is, where a bank sees a profitable lending opportunity, it just creates money out of thin air, e.g. it credits the borrower’s account. And in the current “excess reserve” scenario, the bank presumably has more than enough reserves, thus the latter are irrelevant.

In more normal times, that is where the banking system does not have excess reserves, reserves are still irrelevant. That is, a bank which sees a profitable lending opportunity goes ahead (as above) and credits its customer’s account. If that leaves the banking system short of reserves, the FED is then forced to supply extra reserves to the system, else interest rates are forced up.

Posted by: Ralph Musgrave | August 01, 2010 at 01:58 PM

IORs were originated by the same people that think commercial banks are financial intermediaires (intermediary between saver and borrower). Never are the CBs intermediaries in the lending process.

The money supply historically has never been, and can never be, managed by any attempt to control the cost of credit.

IORs are a credit control device. They are the funcational equivalent to required reserves. I.e., the BOG determines when the member banks can lend and invest.

This discussion is complete nonsense. If the IORs don't serve a purpose, then save the taxpayers some money.

The evidence is extremely clearcut. Burns, Miller, Volcker, Greenspan, & Bernanke have all screwed up using interest rate targets.

(1) Paul Volcker won acclaim for taming the inflation that he alone created.

(2) Bernanke didn't "ease" monetary policy when Bear Sterns 2 hedge funds collapsed. He initiated "credit easing" while continuing with his 25 consecutive months of policy "tightening" that began in Feb 2006. Instead Bernanke waited until Lehman Brothers failed. Bernanke drove this country into a deep depression by himself.

(3) Greenspan never "tightened" monetary policy towards the end of his term. Despite raising the FFR 17 times, Greenspan maintained his "loose" money policy, i.e., for the last 41 consecutive months of his term.

By using the wrong criteria (interest rates, rather than member bank reserves) in formulating and executing monetary policy, the Federal Reserve became an engine of inflation and a doomsday machine.

Posted by: flow5 | August 01, 2010 at 04:07 PM

I'm curious how a comparison of US spreads and Swedish spreads would look, given that the Swedish central bank has introduced a penalty on reserves. If I follow the arguments your presenting, the Swedish policy should not have had much effect on spreads, but would be driving liquidity into non-reserve forms, potentially undermining money market institutions. Can any of these expected outcomes actually be observed?

Posted by: Rich C | August 02, 2010 at 03:36 PM

The reason the fed funds rate can be below the IROR is that insurance companies and GSEs have access to the fed funds market but are not holders of deposits at the Fed. Hence they are willing lenders in the fed funds market at a rate below IROR, whereas the banks are the borrowers who then deposit these funds as reserves on which the Fed pays interest.

Posted by: emsoly | August 04, 2010 at 07:39 AM

Why wouldn't the FED charge negative interest on these reserves to spur lending? Thanks.

Posted by: Jonathan Herbert | August 06, 2010 at 02:56 AM

Even Dave Altig is too harsh on IOR here:
"OK, but the spread that really matters in the bank lending decision is surely the difference between the return on depositing excess reserves with the Fed versus the return on making loans."
This ignores the fact that before the IOR policy reserves were artificially scarce, and this scarcity yield was approximately equal to fed funds rate, so net spreads were actually narrower before October 2008.

More here:
http://themoneydemand.blogspot.com/2010/08/should-fed-stop-paying-interest-on.html

Posted by: The Money Demand Blog | August 06, 2010 at 05:35 AM

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