Tuesday, December 9, 2008

Why exactly does the Fed pay interest on reserves?

The Fed’s paying interest on reserve balances has been bugging me lately. I simply don't understand why the Fed would initiate a policy shift desinged to "improve efficiency in the banking sector" when the banking sector is in the middle of a crisis. To me, all the policy shift has done is to pay banks not to lend.

Here is what Vice Chairman of the Federal Open Market Committee (FOMC) Donald Kohn had to say about bank lending: “In recent weeks, bank lending appears to have dropped back, consistent with the significant tightening of terms and standards reported by bank loan officers in recent quarters as well as the weakening of economic activity.”

When in fact, what he really meant to say wass this: “In recent weeks, bank lending appears to have dropped back, consistent with the significant tightening of terms and standards reported by bank loan officers in recent quarters, as well as the the weakening of economic activity, and since banks are now earning interest on reserve balances.

Apparently, the Fed deemed it urgent to pay interest on reserves (IOR) because they fast-tracked the authorization for IOR that was initially set to start in 2011. As part of the Economic Stabilization Act of 2008, the Fed was granted authorization to pay IOR three years early. Theoretically, IOR improves the Fed’s ability to conduce efficient monetary policy in a world where required reserves are falling (see this paper for a nice discussion of monetary policy without reserve requirements). The Bank of Canada, the Bank of England, and the Reserve Bank of New Zealand all conduct monetary policy without reserve requirements, so why not the Fed?

The Fed said that the IOR policy would help “eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector”. But why would a central bank try to improve efficiency smack dab in the middle of a banking crisis?

The most likey reason is that the Fed saw the IOR policy as an easy way to keep the effective federal funds rate close to its target as numerous $ billions in liquidity were added to the banking system. Well, that didn’t work. I bet that the Fed did not intend for excess reserve balances to balloon as they have.

The chart illustrates total and excess reserve balances as a share of total bank credit (on the H.4.1 statement). The Fed’s added liquidity (added bank credit) - $1.3 trillion over the last yearpromote bank lending – has ended right back at the Fed’s doorstep in the form excess reserves. Banks are hoarding the funds and getting paid to do it!

But don’t worry, the IOR policy can simply disappear. If the Fed cuts to zero, which I believe is a very distinct possibility in January (or even December, who knows), the interest rate paid on reserves will also fall to zero (equal to the FOMC target). Headache gone; then we will see what happens to excess reserve balances.

But now that I think of it, the Fed can always change its mind...and the formula used to calculate the IOR rate for the third time.

Rebecca Wilder


  1. This is one of the worst programs out there right now. I forget which blogger described it as "recapitalizing the banks by stealth", but I pretty much agree. In a risk-averse environment, banks are able to still make returns by hoarding money, instead of figuring out what ventures would be profitable to lend in going forward. Small returns are preferable in this environment when there's essentially no risk to hold capital.

    Unfortunately that doesn't do anything to restructure the credit market into a sustainable model going forward. The gov't is throwing money into a liquidity trap on the financial side while they're going to be simultaneously doing a helicopter drop directly onto the public via auto bailout, fiscal stimulus, etc.

    I know the US economy and gov't are relatively strong, but this whole fiasco seems like it's going to test the limits of what it can prop up.

  2. The Fed has created "The Fed Carries the Trade" (often wrongly said "carry trade" by the Japanese in broken English and parroted the world over).

    In short, the Fed lends cash to member banks, which in turn deposit such cash with the Fed for a return (IOR).

    As long as the IOR rate exceeds the the U.S. Treasury Tens rate, member banks have incentive to borrow free from the Fed and earn interest from the Fed.

    If the Fed stops paying IOR or if inversion happens between the IOR rate and the US Tens rate, a flood of cash into circulation shall happen.

    Once done, banks shall rent cash to debtors who shall bid up prices for things.

    This shall cause a Tsunami of rising prices.

    Bernanke might believe he can increase the Efficiency of Money (Money in Circulation to new Credit Growth) and inflate the economy this way.

    Yet, the net result shall be Now Cash bidded on existing things rising faster against Now Cash being used to buy new plant and equipment to build new things.

    This is another action setting up future disaster in America.

  3. Scott Fullwiler writes "With IBRBs (interest bearing reserve balances) eventually the entire national debt could be held exclusively as reserve balances"

    I.e., IBRBs have replaced open market operations of the selling type.

    The Keynesian training of the Feds' technical staff ("this world is not meant for ordinary mortals; it's for the merest few--men of occult knowledge and ethereal genius, mathematical logicians with no littler contempt for the crude statistics of that vulpine species, the businessman") advised them that interest was the price of money, not the price of loan-funds "the world's maelstrom reduced to a paradigm of Newtonian determinism".

    Keynes's "seductive Victorian gestalt" therefore decided that the money supply could be controlled through the manipulation of interest rates (i.e, the rate paid by banks to banks holding excess legal reserves in the Reserve Banks).

    I.e., the monetary transmission instrument used by the FOMC has been switched. It's chief instrument is now IORs. I.e., the FF market has been replaced.

    And Keynesian exegesis wanes: i.e., the money supply hasn't ever, or can't ever, be managed by any attempt to control the cost of credit.

  4. Remember sterile reserves? I.e., legal reserves represented a "tax". This is the theoretical interpretation as advocated by the late Dr. Milton Friedman).

    Titanic mistake, there is no such thing as a reserve "tax".

    When CBs grant loans to, or purchase securities from, the non-bank public, (except the commercial and the Reserve Banks), they acquire title to earning assets by initially, the creation of an equal volume of new money- (dds) -- somewhere in the banking system. I.e., commercial bank deposits are the result of lending, not the other way around.

    The lending capacity of the member CBs of the Federal Reserve System is limited by the volume of free legal (excess) reserves put at their disposal by the Federal Reserve Banks in conjunction with the reserve ratios applicable to their deposit liabilities, as fixed by the Board of Governors of the Federal Reserve System.

    Never are the CBs intermediaries in the lending process. A member commercial bank (depository institutions) only becomes a financial intermediary when there is a 100% reserve ratio applied to all its deposit liabilities.

  5. Rebecca,

    Jim Hamilton thinks plan "B" was for the Fed to cushion deleveraging by borrowing idle funds from banks and buying risk-assets. They elected to pay interest on reserves to pursue this obstensibly non-inflationary strategy. The unintended consequence, unfortunately, is that while it did cushion deleveraging it also crashed velocity. Now, Hamilton suggests that the Fed abandon the "bank" strategy in favor of "Plan C", which is of course QE.

    The underlying problem is that the Fed wants to save the financial system AND stave off future inflation. It has to abandon the latter goal in favor of the former. If they do not adopt, in this upcoming meeting, a significant, long-term inflation target (say, 5%), then deflationary expectations will strengthen their hold on the markets.

  6. THE FORMULA???????

    It is impossible to calculate.

    But currently, it is obviously wrong.

  7. A brief “run down” will indicate just how costless, indeed how profitable – to the participants, is the creation of new money. If the Fed puts through buy orders in the open market, the Federal Reserve Banks acquire earning assets by initially creating new inter-bank demand deposits. The U.S. Treasury recaptures virtually all of the net income from these assets.

    The commercial banks acquire free legal reserves, yet the bankers complain that they are not earning any interest on their balances in the Federal Reserve Banks.

    On the basis of these newly acquired reserves, the commercial banks can, and do, create a multiple volume of credit and money. And, through this money, they acquire a concomitant volume of additional earnings assets.

    The supposition regarding the payment of interest on reserves is bogus.

  8. The larger the volume of idle excess bank reserves, the lower the expansion coefficient or "money multiplier".

    If the volume of excess reserves is in constant flux, it will require constant adjustments to this interest rate peg.

    This distortion is obviously higher because the policy was just introduced. But it has shown no sign of stabilizing.

  9. We are either headed for a financial collapse such as in 1932-33, or a government controlled system of money creation and credit allocation.

  10. "We are either headed for a financial collapse such as in 1932-33, or a government controlled system of money creation and credit allocation."

    My money is on a total currency collapse- ie worse than 1932-33. More like the 1860s. If you were a Confederate.

  11. Hi David,

    This is the way that I see it: They dumped plan B (putting a floor under the effective federal funds rate by paying interest on reserves), are sticking to plan C (QE), and will move on to plan D - declare ZIRP, which would negate the IOR policy (because the IOR rate would be zero if they keep to their current formula).


  12. "Reserve Bank of New Zealand"

    Why would you use this example???

    The Reserve Bank of New Zealand pioneered zero reserve requirements. That lead to suffocating interest rates (+8) and inflation.

    Countries without reserve requirements:

    New Zealand

    Each one of these countries publishes their own version of M3.

  13. http://woodwardhall.wordpress.com/2008/12/
    "For reasons we are unable to explain, the Fed raised the rate it pays on reserves recently. The standard analysis of the payment of interest on reserves by central banks makes it clear that increases in the attractiveness of reserves are contractionary"

  14. Rebecca,

    Is IOR a backdoor subsidy for banks from the taxpayer, since the Treasury is the ultimate source of the revenue?

  15. Hi Anonymous,

    Yes, the taxpayer is ultimately on the hook for IOR. The reason is that the Fed uses the reserve funds to buy debt from banks in the form of “collateral” when the Fed makes a loan through the TAF, PDCF, Discount Window, or any other lending program. I don’t know WHAT form of collateral the Fed is purchasing – it could be anything - and to be honest, I don’t think that anybody really does. The Fed has not disclosed this to the public, which is one of the reasons that Bloomberg brought up the lawsuit http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aKr.oY2YKc2g.