One of the livelier discussions following Federal Reserve Chairman Ben Bernanke’s testimony to Congress on monetary policy has revolved around the issue of the payment of interest on bank reserves. Here, for what it’s worth, are a few reactions to questions raised by that discussion:
Is interest paid on reserves (IOR) a free lunch?
Ken Houghton has the following objection:
“… in September of 2008, the Fed decides to pay interest on reserves—including Excess Reserves. The banks can now make 25 times what they pay in interest, risk-free, just by holding onto money. The Fed is, essentially, leaving $100 bills on the sidewalk.”
I’m not sure exactly where the “25 times” comes from, but it seems to me that the most obvious transaction would be to borrow in the overnight interbank lending market—the federal funds market—and then “lend” those funds to the Fed by placing them in the Fed’s deposit facility. The differential between the return on those options is a good deal lower than a multiple of 25.
In fact, as many have noted before, the puzzle is why the gap between the funds rate and the deposit rate exists at all. As explained on the New York Fed’s FAQ sheet:
“With the payment of interest on excess balances, market participants will have little incentive for arranging federal funds transactions at rates below the rate paid on excess. By helping set a floor on market rates in this way, payment of interest on excess balances will enhance the Desk’s ability to keep the federal funds rate around the target for the federal funds rate.”
It didn’t quite work out that way, so clearly there is a limit to arbitrage. But if you really think that an 8 basis point spread between the effective funds rate and the deposit rate is a problem, the best approach would be, in my opinion, to address the institutional arrangements that are limiting arbitrage in the funds market. (Some of those features are discussed here and here.)
What is the opportunity cost of not lending?
That said, certainly the real issue about the IOR policy concerns the presumed incentive for banks to sit on excess reserves rather than putting those reserves into use by creating loans. This, from Bruce Bartlett, is fairly representative of the view that IOR is, at least in part, to blame for the slow pace of credit expansion in the United States:
“… As I pointed out in my column last week, banks have more than $1 trillion of excess reserves—money that the Fed has created that banks could lend immediately but are just sitting on. It’s the economic equivalent of stuffing cash under one’s mattress.
“Economists are divided on why banks are not lending, but increasingly are focusing on a Fed policy of paying interest on reserves—a policy that began, interestingly enough, on October 9, 2008, at almost exactly the moment when the financial crisis became acute.”
OK, but the spread that really matters in the bank lending decision is surely the difference between the return on depositing excess reserves with the Fed versus the return on making loans. In fairness, it does appear that this spread dropped when the IOR was raised from its implicit prior setting of zero…
… but it’s also pretty clear that this development largely reflects a general fall in market yields post-October 2008 as much is it does the increase in IOR rate:
And here’s another thought: As of now, the IOR policy applies to all reserves, required or excess. Consider the textbook example of a bank that creates a loan. In the simple example, a bank creates a loan asset on its book by creating a checking account for a customer, which is the corresponding liability. It needs reserves to absorb this new liability, of course, so the process of creating a loan converts excess reserves into required reserves. But if the Fed pays the same rate on both required and excess reserves, the bank will have lost nothing in terms of what it collects from the Fed for its reserve deposits. In this simple case, the IOR plays no role in determining the opportunity cost of extending credit.
Of course, the funds created in making a loan may leave the originating bank. Though reserves don’t leave the banking system as a whole, they may certainly flow away from an individual institution. So things may not be as nice and neat as my simple example. But at worst, that just brings the question back to the original point: Is the 25 basis point return paid by the central bank creating a significant incentive for banks to sit on reserves rather than lend them out to consumers or businesses? At least some observers are skeptical:
“Barclays Capital’s Joseph Abate…noted much of the money that constitutes this giant pile of reserves is ‘precautionary liquidity.’ If banks didn’t get interest from the Fed they would shift those funds into short-term, low-risk markets such as the repo, Treasury bill and agency discount note markets, where the funds are readily accessible in case of need. Put another way, Abate doesn’t see this money getting tied up in bank loans or the other activities that would help increase credit, in turn boosting overall economic momentum.”
Are there good reasons for paying interest on reserves?
Even if we concede that there is some gain from eliminating or cutting the IOR rate, what of the costs? Tim Duy, quoting the Wall Street Journal, makes note (as does Steve Williamson) of the following comment from the Chairman:
“… Lowering the interest rate it pays on excess reserve—now at 0.25%—could create trouble in money markets, he said.
” ‘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,’ he said.
” ‘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 when the Federal Reserve begins to tighten policy at some point in the future.’ “
Professor Duy interprets this as aversion to the possibility that “the failure to meet expectations would be the real cost to the Federal Reserve,” but I would have taken the words for exactly what they seem to say—that the skills and infrastructure required to maintain a functioning federal funds rate might atrophy if cutting the rate to zero brings activity in the market to a trickle. And that observation is relevant because of the following, from the minutes of the April 27–28 meeting of the Federal Open Market Committee:
“Meeting participants agreed broadly on key objectives of a longer-run strategy for asset sales and redemptions. The strategy should be consistent with the achievement of the Committee’s objectives of maximum employment and price stability. In addition, the strategy should normalize the size and composition of the balance sheet over time. Reducing the size of the balance sheet would decrease the associated reserve balances to amounts consistent with more normal operations of money markets and monetary policy.”
“Normal” may not mean the exact status quo ante, but to the extent that federal funds targeting is a desirable part of the picture, it sure will be helpful if a federal funds market exists.
Even if you don’t buy that argument—and the point is debatable—it is useful to recall that the IOR policy has long been promoted on efficiency grounds. There is this argument for example, from a New York Fed article published just as the IOR policy was introduced:
“… reserve balances are used to make interbank payments; thus, they serve as the final form of settlement for a vast array of transactions. The quantity of reserves needed for payment purposes typically far exceeds the quantity consistent with the central bank’s desired interest rate. As a result, central banks must perform a balancing act, drastically increasing the supply of reserves during the day for payment purposes through the provision of daylight reserves (also called daylight credit) and then shrinking the supply back at the end of the day to be consistent with the desired market interest rate.
“… it is important to understand the tension between the daylight and overnight need for reserves and the potential problems that may arise. One concern is that central banks typically provide daylight reserves by lending directly to banks, which may expose the central bank to substantial credit risk. Such lending may also generate moral hazard problems and exacerbate the too-big-to-fail problem, whereby regulators would be reluctant to close a financially troubled bank.”
Put more simply, one broad justification for an IOR policy is precisely that it induces banks to hold quantities of excess reserves that are large enough to mitigate the need for central banks to extend the credit necessary to keep the payments system running efficiently. And, of course, mitigating those needs also means mitigating the attendant risks.
That is not to say that these risks or efficiency costs unambiguously dominate other considerations—for a much deeper discussion I refer you to a recent piece by Tom Sargent. But they should not be lost in the conversation.