Interest on Bank Reserves and the Recent Crisis
One frequently overlooked provision of the Bailout Act is that it gave the Federal Reserve permission to pay interest on bank reserves immediately, rather than in 2011. The Fed therefore announced last Monday, October 6, that it would begin doing so this past Thursday, October 9. Here is the Fed press release.
The long-run rationale for this change is to permit the Fed to hit its target Federal funds interest rate more reliably, and other central banks throughout the world have already implemented this reform. The short-run rationale is that troubled banks will now be earning interest on their reserve assets, which previously earned no interest.
But I am concerned that in the midst of a potential liquidity crisis, this change can have unintended negative consequences. I can think of four:
1. During a liquidity crisis, banks tend to increase their reserves and thereby decrease their lending to the general public. On top of reducing the flow of savings, this puts deflationary pressure on the money stock. Because banks now receive interest on reserves, they have an incentive to do more of this, accelerating the scramble for liquidity. Indeed, bank anticipation of this change may have been a factor in the tightening of U.S. credit markets last week, after passage of the Bailout Bill.
2. Any particular day, the interest rates on actual Federal funds loans between banks are distributed all round the Fed's target, above and below, with the average not even being on target sometimes. Paying interest on reserves eliminates the lower tail of this distribution, so now banks will no longer lend on the Federal funds market at any rate below what they receive on their reserves. This may be good for the flush banks lending reserves but possibly not so good for the cash-starved banks borrowing reserves, some of which will now end up paying a higher interest rate on the Federal funds market, or curtailing their own lending. Both of these results seem to be the opposite of what the Fed would want in this situation and again could have contributed to last week's credit tightening.
3. Paying interest in effect converts bank reserves into Treasury securities. Any interest the Fed pays will reduce the seigniorage it earns, which by itself is good. But since there is no overall change in total federal expenditures, the reduction in seigniorage also increases the government debt by an equivalent amount. The present value of future tax payments therefore undergoes a one-shot increase by the total amount of reserves receiving interest, which is now approaching $150 billion (not counting banks' vault cash, for which the Fed will not pay interest). If Ricardian equivalence holds, meaning investors correctly anticipate future tax liabilities, this increase could have been one factor helping to initiate last week's stock market decline.
4. Although paying interest on reserves leaves the entire size of the monetary base unchanged, it also at one fell swoop reduces how much of the base qualifies as true outside money that is an asset only, paying no interest. (This is the flip side of point 3.) And it is the supply and demand of outside money ALONE that anchors the price level. (A point that Don Patinkin taught economists years ago.) Of course, paying interest on reserves simultaneously reduces bank demand for outside money by an equal amount, so the immediate effect should be entirely neutral. But at a time when regulators are worried about deflation and a flight into outside money, does it seem wise to hit the economy with a sudden shock, reducing the quantity of outside money by 15 percent, even with a hopefully offsetting 15 percent fall in demand? Could this sudden fall in the quantity of outside money at a period when otherwise demand is rising have been another factor contributing to the events of last week? That is a very complicated question, and I don't pretend to know the answer.
If the current liquidity scramble warranted accelerating any future change, you would have thought that the Bailout would instead have permitted the Fed to eliminate all reserve requirements, something it can do beginning in 2011. Perhaps that might have appeared too much like deregulation at a politically inopportune moment. Perhaps the Fed is more interested in centrally planning interest rates. Or perhaps it felt such a change unnecessary since it can under current law eliminate reserve requirements on a temporary emergency basis.
Hat tip to my former student, Christian Warden, for calling this provision of the act to my attention.
Bill Woolsey - 10/14/2008
We had a faculty round table on the issue. I presented the evidence showing expanded bank credit, deposits, etc.
Several professors insisted that business cannot borrow. The banks are cutting them off.
Someone said that it was on the "margin." Outstanding loans haven't disappared, but new loans aren't being made. I didn't understand how that is possible with total bank credit expanding.
Perhaps there is some credit market that is shrinking and those people are shifting to banks and the banks are cutting out people who have borrowed from them in the past.
Of course, it is possible that people get cut off all the time, and they are just complaining more. The new poeple getting loans and those who continue to borrow as before don't complain.
Robert Higgs - 10/14/2008
You refer twice in this post to a tightening of credit last week. I am wondering about what evidence of such tightening you have in mind. One of the few lending volumes systematically reported on a quickly updated basis is sales of commercial paper. Consulting the Fed's website (http://www.federalreserve.gov/releases/cp/volumestats.htm), I see that issuances of commercial paper increased last week from roughly $179 billion on Monday and Tuesday to roughly $205 billion on Thursday and Friday. This 14 percent increase would not seem to comport with a situation of "credit tightening."
As of Friday, discount rates on this paper varied, depending on the term to maturity and the risk rating, from less than 1 percent to somewhat above 6 percent for A2/P2 nonfinancial paper. Doesn't seem very pricey to me. Considering the present rate of inflation, some of these nominal discount rates certainly qualify as negative real rates of interest.
What am I missing? For weeks, I've been searching for solid evidence (no anecdotes, please) that well qualified borrowers cannot borrow--that is, "credit markets are frozen," etc., etc. I'm still searching; I'm still not finding.
When I discover that very risky borrowers can no longer borrow readily at low rates of interest, I can only say: so what? Such borrowers ought to have been pushed aside a long time ago. If they are being pushed aside now, it's high time.
Bill Woolsey - 10/14/2008
The payment of interest on reserve balances is important, but I disagree with most of the points you made.
If the quantity of base money is fixed, then paying interest on deposits increases demand and is deflationary.
If the quantity of base money is fixed, then paying interest on it reduces bank lending. (That would be a very plausible avenue through which the deflationary consequence would be arrive.)
However, base money isn't fixed with interest rate targeting. When banks fail to lend funds overnight (because they hold them to earn interest,) the Fed will expand the supply of reserves and the monetary base to keep the Federal Funds rate on target.
This increases the Fed's balance sheet. In the past, that would mean holding more government bonds. But now, it means more Federal Reserve lending to banks, former investment banks, issuers of commercial paper.. etc.
So, rather than banks lending money to who they think is best, they are effectively lending them to the Fed (that is, holding them) and allowing the Fed to choose where the funds should be lent.
I think it is about the Fed seeking to continue to funnel credit to (and through) Wall Street.
I don't agree with your usnderstanding of outside money. Outside money isn't debt to anyone in the system. That doesn't mean that it can't pay interest. As long as the supply is controlled, then all that paying interest does is raise the demand. The equilibrium price level would be lower.
With inside money, changes in the price level transfer money between the issuers and holders. (Because it is an asset to the holders and a liability to the issuers.) While inside money can pay interest, banknotes don't.
With outside money, changes in price level change the wealth of the holders and with, say, gold, there is no issuer. And with fiat money, we don't count the issuer. (That is, no Ricardian equivalence.) Nothing is effected by paying interest. Well, I don't think.