Paradoxes of Paying Interest on Reserves
When the Federal Reserve began paying interest on bank reserves on October 9, the justification in its press release was to permit the Fed to hit its Federal funds target interest rate more reliably. But the full explanation is more complicated than that.
The Fed also serves as a clearinghouse for banks, and that function is in tension with monetary policy. When the Fed was first created in 1914, it provided clearing services to all member banks for free, driving out of business the various private clearinghouses that had arisen and were solving some of the liquidity problems associated with the destabilizing National Banking System. Then in 1980, the Depository Institutions Deregulation and Monetary Control Act required the Fed to offer its clearing services to all depository institutions--whether banks or not, and whether members of the Fed or not--but at a fee that allowed the reemergence of private alternatives.
There are two ways to run a clearinghouse. The first, net settlement, involves waiting until the end of the settlement period (traditionally a day) and then transferring only net amounts. The second, a real-time gross settlement (RTGS) system, settles each payment as it occurs. The private Clearing House Interbank Payments System (or CHIPS, created in 1970), which now handles more than one-quarter of bank clearings in the U.S., netted all settlements at the end of the business day until 2001, when it switched to intraday payments. The Fed's current system, Fedwire, in contrast, has always conducted real-time settlements. Because banks may therefore lose all their reserves to other banks before any offsetting receipts come in, the Fed provides banks with intraday overdrafts to assist with their clearings.
Before paying interest on reserves, the value of these overdrafts was climbing to an amount exceeding bank reserves. Thus since 1987, U.S. banks reserves (counting vault cash) have hovered around $65 billion, but the average daylight overdrafts outstanding at any minute during the day rose from around $15 billion to nearly $50 billion. The peak value of daylight overdrafts at any moment could rise even higher, to over $100 billion. Alex Tabarrok over at Marginal Revolution provides a colorfully apt description of this process:"in essence, the banks used to inhale credit during the day--puffing up like a bullfrog--only to exhale at night. (But note that our stats on the monetary base only measured the bullfrog at night.)"
A clearing system using net settlement leaves the potential losses from a bank's failure to pay on the bank(s) owed money. But Fedwire's RTGS system transfers that risk to the Fed itself. The Fed has consequently tried to limit bank use of daylight overdrafts, first imposing net debit caps in 1985 and then imposing minute-by-minute interest charges in 1994. Once the Fed began paying interest on reserves, the banks had an incentive to substitute excess reserves for now more costly Fed credit. A technical article that models this change, Ennis and Weinberg, reveals that the Fed expected and hoped for this result in order to reduce the Fedwire risk from daylight overdrafts.
Being able to earn on interest on reserves would have caused the banks to hold more of them anyway, but the fee on daylight overdrafts only augments that effect. Much of the Fed's recent, more than ten-fold increase in bank reserves, to a current total of about $675 billion, has so far caused banks primarily to increase their reserve ratios rather than expand their loans. Some, like Paul Krugman, have interpreted this as a huge, deflationary flight to liquidity. Others, like myself, contend that it is only a matter of time before this leads to inflation. But as Alex suggests, the payment of interest on reserves could render both predictions wrong. The increase in reserve ratios could simply be a one-shot response of banks, hiking ratios to a new level. No one knows for sure, including I would add, the Fed itself.
The European Central Bank (ECB), like the Fed, has been pumping up its monetary base with wild abandon. And as in the U.S., private European banks seem to be increasing their reserve ratios, at least in the short term. But the ECB has paid interest on reserves since introduction of the Euro in 1999. In fact, because interest on reserves reduces central bank seigniorage, confining it to currency alone, this feature may have eased the negotiations over the inevitable conflicts in creating a European monetary union. The ECB also oversees a real-time clearing system with intraday credit, known as TARGET (Trans-European Automated Real-Time Gross Settlement Express Transfer).
So again, the accumulation of excess reserves may reflect the perverse impact of central banks paying interest on them. The Fed started doing this, confident from the experience of the ECB, and other central banks, such as those of Canada, New Zealand, and Australia, that have been doing so for some time. But the policy had never been tested in a period of falling interest rates, rising risk premiums, and rising preferences for shorter maturities.
I predict that future economic historians will look back on this change as a major blunder during the current credit tightening, making traditional monetary policy less effective. True, the broader monetary aggregates are already beginning to respond to the Fed's base explosion, with M1 annual growth up from 0 to 20 percent over the last three months, and M2 annual growth up from 5 to 10 percent over the same period. Yet irrespective of whether the long run brings deflation, inflation, or neither, paying interest on reserves has certainly applied deflationary pressure in the short run. It may eventually rank with the Fed's doubling of reserve requirements in the 1930s and bringing on the recession of 1937 within the midst of the Great Depression.
Moreover, the paying of interest on reserves was motivated by the misguided focus on interest rates, rather than money supply measures, as an indicator and target of monetary policy, a focus that has dominated central bank operations worldwide for the last two decades. It is also a focus that seems sadly to have taken in many libertarian and free-market economists. Although done in the name of controlling inflation, this focus actually reflects a move toward centralized economic planning on the part of central banks, given that the interest rate is a relative price, with a significant real as well as a nominal component, compared with such purely nominal targets as the money supply or the price level.
The irony is that the Fed is now less able to hit its interest rate target than ever before. It first adopted the corridor or channel system of the ECB, setting the interest rate on reserves below its Federal funds target, as a lower bound, with the discount rate above the target as an upper bound. But as the effective Federal funds rate fell not only below target but below the interest rate on reserves, the Fed on November 5 moved to the New Zealand system, where the interest rate on both required and excess reserves is set right at the target Federal funds rate. So far, this hasn't worked either. (For accessible descriptions of these two systems, see an article by Keister, Martin, and McAndrews.)
Why does the effective Federal funds rate remain below the Fed's target rate of 1 percent, despite the fact that the Fed is now paying interest on both required reserves and excess reserves at that target rate? The best explanation for the anomaly has been offered by Jim Hamilton. Fannie, Freddie, the Federal Home Loan Banks, and other GSEs, plus some international institutions have deposits at the Fed, and these do not earn interest. These institutions are also players in the Fed funds market. So their Fed funds loans would not be affected by the interest paid on excess reserves.
William J. Stepp - 12/18/2008
The natural rate moves inversely with changes in the ratio of savings to income.
I don't think it would change much over time in a free market. Rothbard said something like this. It certainly wouldn't exhibit the sort of (government-induced) wild swings we've seen in interest rates the last year or so.
DeLong's post was the most bizarre thing I've read in a while. Why the natural rate should be 2% is anybody's guess, but, hey, he's in the know. Maybe he has a pipeline from God. I don't know what it should be; all I know is that the market would determine it.
(Why on earth should it be equal to the risk premium on equities?)
On the free market there can be no such thing as too little investment and mass unemployment, so his point about the natural rate being too high is beyond bizarre.
Interest rates were way too low the last few years in general; this fueled the untenable debt buildup.
While the Chinese and other countries did have high rates of savings, the U.S. had a very low rate, which offset the former effect on interest rates to some extent. China has a higher population, but the U.S. has higher incomes.
During the Scottish free banking period, Scottish banks were leveraged from 30:1 to 50:1 or more with no business cycle effects. Evidently the loan rate relected the natural rate.
Yet when U.S. banks were levered no higher than 35:1 (and most were lower), this was a problem. The boom was caused by rates that were submarket; there was a spread between the loan rate and the natural rate that wouldn't exist under free banking.
How's the bank coming along?
Bill Woolsey - 12/17/2008
A ceteris paribus analysis of what
would happen if the quantity of money
increases through a banking channel,
given the natural interest rate and
the demand for money is useful.
But if the natural interest rate is a
market price in reality, then interpreting the real world as if the
natural interest rate never changes is foolish. Perhaps I am missing something, but I can think of all sorts of things that "should" influence the natural interest rate and those things change frequently.
Why wouldn't a temporary decrease in the natural interest rate have the exact same impact as Mises' thought experiment?
At Cato Unbound, White said that changes in risk and the like should be reflected in changes in relative prices (or something sensible like that.) I took that to mean that,
among other things, the natural interest rate should change.
DeLong responded with a statement as to what real interest rates should be. Something like maximizing society's ability to bear risk. 2% productivity growth. Something about intertemporal elasticity. Risk premium on equities.
So, DeLong has some notion of what the natural interest rate is exactly. And it is a market failure if the market interest rate doesn't do this job. In fact, he has no hope that it can be done perfectly--but that hopefully we can aproxmate this.
DeLong also suggested that if interest rates are too high, that the result would be too little investment and mass unemployment. I will grant that if the alternative to having the market interest rate at the right level is mass unemployment (especially if it only can go away with the proper interest rate adjustment,) then it should count as a market failure.
I think Garrison once commented on Leijonhuvid regarding some kind of objective notion of the natural interest rate. The natural interest rate _is_ the interest rate that clears markets based upon actual market expectations. (according to
Isn't it obvious that _if_ investment is low because of a change in the willingness to bear risk, then today's resources "should" be used to produce consumer goods today, with a sacrifice of future production of consumer goods? While saving and investment might lead to more consumer goods in the future, it is just too chancy, so, we can't have them.
If there is an adjustment between investment and consumption in terms of resource allocation, then there would, presumably, be unemployment associated with the sectorial shift. There would be losses because of specific capital goods, etc. I certainly wouldn't count this sort of thing as "mass unemployment" caused by too little investmnet. But perhaps I misunderstood.
My view is that, with hindsight, we can see that the market interest rate was too low. I believe White has provided some evidence to that effect--total spending was growing "too fast" for a couple of years.
I don't think that this was necessary or sufficient to cause the current crisis.
I think, with hindsight, we can see that interest rates have been too high in the recent past. That is because nominal expenditure is growing "too slowly" now.
Bill Woolsey - 12/17/2008
Why would banks make any loans if
the Fed pays interest on reserves?
This is one of those times where thinking about _the_ interest rate causes problems. There is a constellation of interest rates.
Banks will make loans to people willing to pay more than the Fed. Banks will not be inclined to make loans to people willing to pay less.
On the other hand, there is no doubt that paying interest on reserves should decrease bank lending. Just not to zero.
I think what has been happening is that the Federal Reserve is trying to counter act the market forces moving funds out of the shadow banking system back to the normal banking system. When the Fed explained why they were paying interest on reserves, they said they wanted to keep the Federal Funds rate from going below target. Why is that a problem in a period of credit stringency when supposedly no one will lend except at unacceptably high interest rates? How can it be anything other than the loans are going to the wrong people? But there is no need to draw this logical inference, because the Fed also said that they were doing this so that the Federal Reserve would have more funds to lend. Why does the Fed need to lend directly? Because if the banks lent the money, then they would lend the money to the wrong people.
At the same time, the Fed is trying to get nominal expenditure growing again. That the target for the Federal Funds rate is now a range going down to zero and that there is some vague committment to expanding the Fed's balance sheet means that they have adopted a monetarist approach for the duration. Which is the right thing to do. I presume they will seek to offset observed changes in the money muliplier and the income velocity of money.
RIchard Pointer - 12/17/2008
I have been wondering what this would do to incentives. Why would a bank lend in an environment where they are assured gains by holding reserves?
In a rising economy this would be less important, but in a crashing one it is suicide.
William J. Stepp - 12/11/2008
After the tech stock bust of 2000-2002, bearing in mind that 70% of loan volume originated in the shadow banking sector and not from commercial banks, did banks, builders, mortgage issuers, insurers, commodity producers, hedge funds, and LBO firms leverage their balance sheets like there was no tomorrow because real interest rates on their debts were high or low? (Not to mention Joe and Jane Plumber, who were treating their home equity as another ATM machine.) Presumably because it was low, relative not only to the cost of equity, but also in comparison to what the natural rate would have been in a free market banking system.
An analysis of the recent boom and bust cycle must account for this fact, whatever the money supply was doing.
To revisit Jeff’s post of Nov. 30, he said that the main cause of lower interest rates was the world-wide savings glut. While this was no doubt a factor, I’m skeptical that it was as important as he and David Henderson claim. China put all of its U.S. investments into treasuries, and little if any into U.S. housing, banks, or LBOs.
He also said that Fed policy after 2000 couldn’t have been solely responsible for the post-1997 world-wide housing boom. However, no one I know claimed this to have been the case. What he failed to note was that the central banks of other countries (and the ECB from 1999) also pushed interest rates lower than they would have been at least some of the time. The Economist and the FT attributed some of the UK housing boom to the Bank of England. Spain’s housing boom was also indirectly caused by this, as many denizens of the City of London, including a former co-worker of mine, bought second homes there.
The massive leveraging of America (and much of the world) that preceded the Great Deleveraging of 2007 to 2009 has to be explained in order to understand what happened to the economy. A monetarist focus on money supply measures is at once too empirical and not empirical enough. It is too empirical in that it focuses on aggregate measures that don’t necessarily affect how entrepreneurs make economic calculations, which are oriented toward profit and loss and cash flows from investments. Interest rates and changes in them are far more important in these regards than money supply measures. It is not empirical enough in that it fails to come to grips with how investors, firms, and capital markets functioned both in the most recent boom and bust. It doesn’t explain the overleveraging of balance sheets, the lengthening and discoordinating of structures of production, rising asset values in capital and real estate markets, the revelation of these malinvestments in capital losses, and their liquidation or restructuring, which were accompanied by declining asset values, and increasing unemployment in capital, labor, real estate, and consumers’ goods (RIP the Archway Cookie Company, and I shed a tear when I read its obituary in the WSJ a couple days ago).
While I agree that much work remains to be done to understand the working of the natural rate of interest, for example how to measure it, it seems to me that even for all its possible shortcomings, it’s still far better than the alternatives, in particular the Keynesian diversion.
The Austrian theory at least attempts to explain all this, unlike the monetarists, Keynesians, and other schools (e.g., the “greed” school). The Austrians have a good and tough-minded theoretical explanation that also comports with how investors and businesses actually operate.