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.