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?
This question has been the source of ongoing debate among economists. Sadly, FT Alphaville does not have the answer, but we can at least trace the contours of the debate and look into some recent developments.
The original purpose of paying interest on excess reserves, which started in October 2008, was to “give the Federal Reserve greater scope to use its lending programs to address conditions in credit markets while also maintaining the federal funds rate close to the target established by the Federal Open Market Committee.” Also from the 2008 press release:
Paying interest on excess balances should help to establish a lower bound on the federal funds rate.
Ben Bernanke told Congress in February that paying interest on reserves would be one of the most important ways of tightening monetary policy when the time comes. Said Bernanke:
By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates. Actual and prospective increases in short-term interest rates will be reflected in turn in longer-term interest rates and in financial conditions more generally.
But with the economy now sputtering, the question is no longer about how the Fed can tighten policy, but whether the Fed should loosen it further— and therefore whether the 0.25 per cent being paid on the roughly $1,000bn in reserves should be eliminated. Using interest on reserves to establish a “lower bound” would seem to make less sense in a world where a second round of quantitative easing is being considered.
Asked to justify the continuation of the policy, here is what Bernanke told Congress on July 22:
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 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, for the Federal Reserve to tighten policy sometime in the future. So there’s really a technical reason having to do with market function that motivated the 25 basis points interest on reserves.
But in a Q&A following that same testimony, when asked what other options he had to stimulate the economy if things got worse, Bernanke added:
But broadly speaking, there are a number of things we could consider and look at; one would be further changes or modifications of our language or our framework describing how we intend to change interest rates over time — giving more information about that, that’s certainly one approach. We could lower the interest rate we pay on reserves, which is currently one-fourth of 1%.
So there are “technical” reasons for continuing to pay the interest, but if the economy declines further, Bernanke would still be willing to lower the rate.
Critics of the policy–which include Bruce Bartlett, Scott Sumner, and James Hamilton–argue that the continued payment of IORs amounts to contractionary monetary policy, and they can point to the declining spread between the rate paid on reserves and general borrowing rates.
Supporters of continuing the policy, such as Dave Altig of the Atlanta Fed, respond that the decline in spreads “reflects a general fall in market yields post-October 2008 as much is it does the increase in the IOR rate.” Altig also highlights the technical reasons mentioned by Bernanke, and says that paying interest makes the interbank payment system function more efficiently.
Joseph Abate of BarCap adds that if interest on reserves gets taken away, the money will be transferred to short-term markets like those for repos and t-bills (but NOT to increased lending) according to Real Time Economics. (James Hamilton, in the same link as above, disputes this.)
FT Alphaville’s head is spinning, and it is above our pay grade to adjudicate this fight, but we’d love to hear your thoughts. You know where to leave them.
Some observations regarding interest on reserves – Macroblog
Ending interest on reserves won’t help – Real Time Economics
QE II, or ‘standing up to free markets’ – FT Alphaville
There’s a reason it’s called ‘Monetary Policy’ – Scott Sumner
Options for Monetary Stimulus – James Hamilton