A number of us have been warning since 2008 that the Fed’s decision to pay interest on reserves in early October 2008 was a dangerously deflationary decision, the post-Lehman financial crisis reaching its most acute stage only after the Fed announced that it would begin paying interest on reserves. Earl Thompson, whose untimely passing on July 29, 2010 is still mourned by his friends and students, immediately identified that decision as deflationary and warned that thenceforth the size of the monetary base (aka the size of the Fed’s balance sheet) would be a useless and misleading metric for gauging the stance of monetary policy. When Scott Sumner began blogging a short time thereafter, the deflationary consequences of paying interest on reserves was one of his chief complaints about Fed policy. Indeed, opposition to the payment of interest on reserves is one of the common positions uniting those of us who fly under the banner of “Market Monetarism.” But Market Monetarists are not the only ones who have identified and denounced the destructive effects of paying banks interest on reserves, perhaps the most notable critic being that arch-Keynesian Alan Blinder, Professor of Economics at Princeton, and a former Vice Chairman of the Federal Reserve Board.
Although Market Monetarists are all on record opposing the payment of interest on reserves, I don’t think that we have made a big enough deal about it, especially recently as NGDP level targeting has become the more lively policy issue. But allowing the payment of interest on reserves to drop from the radar screen was a mistake. Not only is it a bad policy in its own right, but even worse, it has fostered the dangerous illusion that monetary policy has been accommodative, when, in fact, paying interest on reserves has made monetary policy the opposite of accommodative, encouraging an unlimited demand to hoard reserves, thereby making monetary policy decidedly uneasy.
In a post earlier today I responded to Steve Horwitz’s argument that if a tripling of the Fed’s balance sheet had failed to provide an economic stimulus, there was no point in trying quantitative easing yet again. I pointed out that whether monetary policy has been simulative depends on whether the demand to hold the monetary base or the size of the monetary base has been increasing faster. I should have pointed out explicitly that the payment of interest on reserves has guaranteed that the demand to hold reserves would increase by at least as much as the quantity of reserves increased, thereby eliminating any possibility of monetary stimulus from the increase in bank reserves.
In Monday’s Wall Street Journal, Alan Blinder patiently explains why the most potent monetary tool in the Fed’s arsenal right now is to stop paying interest on reserves. The Fed apparently resists the idea, even though for almost a century it never paid interest on reserves, because not doing so would result in some inefficiencies in the operation of money market funds. Talk about tunnel vision.
Chairman Bernanke, listen to your former Princeton colleague Alan Blinder. He is older and wiser than you are, and knows what he is talking about; you should pay close attention to him.
If the FOMC does not stop its interest on reserves policy at its meeting next week, Chariman Bernanke should be asked explicitly to explain why he disagrees with Alan Blinder’s advice to stop paying interest on reserves. And he should be asked to justify that policy after every future meeting of the FOMC until the policy is finally reversed.
The payment of interest on reserves by the Fed must be stopped.
Uneasy Money 
David, Eloquent! As a “creditist” (it´s all in his “Nonmonetary effects of the financial crisis in the propagation of the Great Depression (1983)) Bernanke was terrified of a repeat of 1931/32, with banks falling dominoe fashion. I´ve called the “interest on reserves” policy B´s “neutron bomb”, the one that keeps “financial houses” intact but “kills” employment (the people).
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Marcus, That’s inspired. Bravo!
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The decision to begin paying interest on excess reserves in 2008 was reminiscent of the decision to increase the reserve requirement in 1936. Both were disastrous, in my opinion.
I have no objection, in principle, to central banks paying interest on reserves. In fact, it seems like a good idea. However, I would prefer the rate of interest to be pegged below the market rate on short-term government debt, like T-bills. If necessary, interest on reserves would go negative and thereby eliminate problems associated with the zero nominal bound. That is, reserves and short-term government debt would, by such a rule, never become near perfect substitutes.
Of course, the Fed did nothing of the sort. Ostensibly, the Fed began paying interest on excess reserves to retain control of the federal funds rate. However, it just seems to me the first round of quantitative easing in 2008 does not deserve the name. The Fed purposefully sterilised the expanding monetary base. Its goal was not to ease monetary policy at all, but rather to stabilise the financial system.
David Beckworth and Bill Woolsey tried to raise a stink about interest on excess reserves too, but it’s something that few people are very interested in discussing. Everyone seems to quietly acknowledge the point and then continue on as though it doesn’t mean anything.
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You’re right, I have only slowly become aware just how destructive interest on reserves actually is. Even late in 2011, I remember making some half hearted arguments for it. That’s the problem – where does one start to put it all into a perspective of ‘do that, then this’…and yet we have to make arguments from where circumstances actually are in the present.
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If it’s a big political scandal when the government carelessly loses $500 million (Solyndra), shouldn’t it be a much bigger scandal when the government intentionally loses billions of dollars per year?
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The FDIC charges a fee on the loans banks make. I am not sure how high this fee is, but in this low interest environment if the FDIC were to instead get its needed revenue by charging banks on excess reserves, you would have negative interest on ERs and no more fees on loans made. This approach to negative IOER would not take money out of the banking system.
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David,
Any comment on the ECB’s recent move to cut its deposit (IOR) rate to zero from 25bps? Will it have a big impact?
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BTW, unlike the Fed, Draghi and other ECB officials have acknowledged that a negative IOR is on the menu of options.
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Two weeks ago the ECB has stopped paying IOR. It helped, but only just a little bit…
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Blinder is ignorant. The credit crunch of 1966 is the precedent.
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Lee, I agree that paying interest on reserves is not intrinsically a bad idea, but it is a bad idea when nominal interest rates are close to zero and real interest rates are negative. And you are right that to start paying interest on reserves in 2008 was very much like doubling reserve requirements in 1936. Announcement of the policy had an immediate negative effect and dramatically worsened the financial crisis. It was only afterwards that the Fed finally reduced the federal funds rate from 2% to 1.5% and then reduced it further over the next few months. But the economy kept getting worse until the Fed announced an aggressive policy of buying securities in March 2009.
Max, Months ago I wrote a post asking whether the Fed was legally authorized to pay 0.25% interest on reserves when the authorizing legislation said that the Fed could not pay a higher interest rate than that paid on short-term securities. At the time, the yield on T-bills was less than .25% even for two-year maturities. Some of the more excitable members of the blogosphere picked up on this and suggested that there was a terrible scandal about to break. But pretty soon people realized that the Fed was interpreting “short-term securities” to mean the overnight rate on inter-bank loans, i.e., the Fed Funds rate, which is pegged at .25%. After that everyone seemed to calm down. Of course, because the Fed is paying .25% interest on reserves, the inter-bank overnight loan market has ceased to exist, so the .25% benchmark is purely conventional, not market-determined. So the payment of .25% interest on reserves still seems a bit edgy to me.
Richard, Interesting idea. Maybe others who know more about the nuts and bolts of bank regulation than I do can weigh in.
David, Well, it’s a positive step, but it’s not as if that were the only issue in the conduct of ECB policy. I hope that people will start confronting Bernanke about this and demand some explanation for this policy, which is both deflationary and pro-bank. One would think a deflationary, pro-bank policy would not be politically viable.
123, As I just observed, IOR is not the only problem with ECB policy.
flow5, Care to elaborate?
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David,
Using the markets’ non-reaction as an arbiter, it appears that the ECB 25bps IOR, in its own right, was thought to be rather insignificant aspect of monetary policy.
Further, there are increasing signals that the ECB may implement a negative deposit rate. One would think this signalling would be an important policy change. However, again, the markets have not reacted.
http://www.reuters.com/article/2012/07/24/us-ecb-rates-idUSBRE86N10D20120724
Perhaps its fair to say that a negative IOR would be meaningful with a higher inflation target, just as QE would be meaningful with a higher inflation target. It seems that this is the same as saying, “expectations matter, mechanisms don’t.”
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I agree with David Pearson. Everybody -firms, consumers and BANKS- are accumularing liquidity reserves. So, that is te problem, is not it? In Europe, the ECB measure has had no effect. Why not to penalise firms for their buffet líquidity? If banks need líquidity, they look for it ay any price (a quite exact indice of fear).
I think an inflationary policy would be much more compelling. BTW, I see that te TIPS of 5 years T Bond is less than… minus one%!
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David, Perhaps so, but I think that there are other problems associated with ECB policy. I don’t say that mechanisms don’t matter, but the lifting becomes much heavier when expectations are not operating in tandem with mechanisms but opposing them.
Luis, Yes, uncertainty about the fate of the euro is becoming so acute that there is a danger of breakdown. The yield on the 5-year TIPS has been less that 1% for quite some time. The yield on the 10-year TIPS was -0.68% yesterday.
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Could you explain why payment of interest on reserves is so harmful?
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Maybe I don’t get this, so someone explain it to me. Patience required.
If the Fed is paying .25% interest to banks that keep the “required” reserves and then another .25% to banks that keep “excess” reserves, isn’t the Fed in a crude sense just paying interest on money it ordered printed itself during QW 1 and QE 2? Didn’t banks just hoard the money they were given from the stimulus packages instead of loaning it out to people who needed it? QE 1 and QE 2 were supposed to keep credit flowing right? Did that happen?
Does this analogy in anyway hold water? Times are bad so I reach into my laser printer at home and handscribble out 300 $100 dollar bills. Since this is my fantasy why not put oh..say…Kim Kardashian in the portrait circle. Then, once I neatly scissor this money out, I give it to my 3 year old son who puts it in his piggy bank. He is thrilled to be so rich. But when I ask him for just $100 dollars back of what I gave him…he tells me…Sorry Daddy…that money is mine now. You can’t have it. Seems such a waste to keep Kim K’s cute face in a piggy bank.
So I dream up a neat solution. Since my son is so wealthy now, on money that I created out of thin air, I am now going to start paying him interest on it. So I collect bottlecaps and give him a quarter a day while his Kardashian notes sit cozily in his piggy bank.
I don’t mean to be so hostile about this, but from my limited understanding this seems like nothing but a shill game that aids the wealthy and makes the middle class and poor poorer.
Is the Fed only limited by the number of trees on the planet at its disposal for paper currency? I hope Ron Paul’s endless quest to finally find out what the Fed is really doing (from a Congressional Audit…not their own “independent audit) will result in something. I can’t see how a Fed, with no Constitutional mandate, has free reign to control the money supply.
I am not an economist (obviously), a student of economics, or even knowledgeable about economics. But I do know a good shell game when i see one. I guess the problem with this game is that all three shells will make you a winner.
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PeterP, Paying interest on reserves is not intrinsically harmful, but when the nominal interest rate is close to zero, paying interest on reserves creates an unlimited demand on the part of banks to hold reserves, which makes it impossible for the Fed to create an excess supply of base money with which to increase NGDP and prices except by increasing the quantity of currency. That is still possible to do, but people are so shocked by the tripling of the Fed’s balance sheet because of the increase in reserves, there is resistance to any further increase in the Fed’s balance sheet, so that monetary policy is paralyzed.
Mark, You obviously are spending too much time listening to Ron Paul.
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