By Dan Kervick
Alan Blinder, writing in the Wall Street Journal on Tuesday, expresses enthusiasm about some recent hints at a possible change in the Fed’s policy on interest paid on excess reserves. The hints were contained in the minutes of the Federal Open Market Committee’s last policy meeting, which included a passage indicating that most participants in the meeting “thought that a reduction by the Board of Governors in the interest rate paid on excess reserves could be worth considering at some stage.”
Blinder has been a strong proponent of changing the current policy, so he thinks the hinted changes are of the utmost importance. “As perhaps the longest-running promoter of reducing the interest paid on excess reserves, even turning the rate negative,” he says, “I can assure you that those buried words were momentous.”
But I have always found Blinder’s arguments about the importance of the rate of interest on excess reserves to be unpersuasive, and I continue to be puzzled by his reasoning. In the recent piece he again moots the possibility of imposing a negative rate of interest on excess reserves, thus charging banks money to hold them. He then says:
At this point, you’re probably thinking: “Wait. If the Fed charged banks rather than paid them, wouldn’t bankers shun excess reserves?” Yes, and that’s precisely the point. Excess reserves sitting idle in banks’ accounts at the Fed do nothing to boost the economy. We want banks to use the money.
If the Fed turned the IOER negative, banks would hold fewer excess reserves, maybe a lot fewer. They’d find other uses for the money. One such use would be buying short-term securities. Another would probably be lending more, which is what we want.
I am unclear as to how changing the rate of interest of excess reserves could succeed in changing the quantity of excess reserves banks are holding.
Consider an example: Suppose Maple Valley Bank is holding $1 billion in total reserves. Let’s say $750 million of those reserves are held in the form of a reserve account balance at the Fed, and the other $250 million are held as vault cash. Now let’s suppose that the bank lends Smith $1 million. What happens to the Maple Valley Bank’s total reserves?
Possibly nothing at first. Assuming Smith maintains a deposit account at Maple Valley Bank, the bank will credit $1 million to Smith’s account. At the same time, it has received Smith’s signed promissory note for $1 million, plus some interest. So Maple Valley Bank has a new liability for $1 million, and it has a new asset worth $1 million and change.
But fairly quickly, Smith will start to spend from the account. Suppose Smith writes a $10,000 check to Acme Dynamite for some explosives. Acme will deposit the check at its bank. Acme’s bank will credit $10,000 to Acme’s account, and settle with Maple Valley Bank, which will result in a $10,000 payment from Maple Valley Bank’s reserve account to the reserve account of Acme’s bank. So one bank now has $10,000 less in its reserve account and another bank has $10,000 more in its reserve account, but total bank reserves haven’t changed.
Smith might choose to make some payments in cash rather than via check or electronically. Suppose Smith takes $200 out of the bank using an ATM card. Maple Valley Bank’s cash reserves are thus reduced by $200. Over the next few days, Smith spends the $200 on sundry small items. The businesses at which the money is spent collect their cash receipts each day and deposit them in their bank, as a result of which the $200 goes right back into the cash reserves of the banking system, though perhaps at other banks.
I suppose Smith might decide to take some cash out of the bank and keep it under a mattress. In that case, cash withdrawn from the bank does not promptly return to the banking system. But equally, such cash has no stimulatory impact on the economy. And in any case, these kinds of changes in bank customer behavior are likely to be minimal.
So as we can see, apart from relatively insignificant fluctuations in the amount of physical cash held by the public, bank reserves don’t go anywhere when banks increase their lending. They just move in larger volumes from bank to bank. It’s also hard to see why banks would anticipate that they can get rid of their excess reserves by increasing lending, because whatever impact the policy has on a given bank, it will have on all of the bank’s competitors. If changes in economic conditions cause Maple Valley Bank’s reserve account payments to increase by some percentage, those same conditions will cause Maple Valley Bank’s reserve account receipts from other banks to increase by the same percentage. So it doesn’t appear that these changes in the rate of interest paid on reserves make bank lending any more profitable than it was before.
Blinder seems to be of the opinion that in the days before the Fed paid interest on reserves, the Fed stimulated or inhibited bank lending through quantitative operations, as represented by the textbook money-multiplier model, and that the combination of the financial crisis and the interest on reserves policy has undermined the old system:
… think back to the good old days, when excess reserves were zero. When the Fed injected reserves into the banking system, banks would use those funds to increase lending, thereby creating multiple expansions of the money supply and credit. Bank reserves were called “high-powered money” because each new dollar of reserves led to several additional dollars of money and credit.
The financial crisis short-circuited this process. As greed gave way to fear, bankers decided to store trillions of dollars safely at the Fed rather than lend them out. High-powered money became powerless money.
The Fed compounded the problem in October 2008 by starting to pay interest on reserves. And these days, the 25-basis-point IOER looks pretty good compared with most short-term money rates. If banks were charged rather than paid 25 basis points, they would find holding excess reserves a lot less attractive. As some of this excess central-bank money became “high-powered” again, the Fed would want less of it. So its balance sheet could shrink.
But as we have seen, banks never loaned reserves “out”. Reserves do not leave or enter the banking system in any significant amount when banks increase their lending in the aggregate, so there is no sense in which higher reserve balances resulted from banks “storing” money that otherwise would have gone “out” of the banking system.
Also, the Fed never really managed the pace of lending, to the extent that it was capable of doing so, via quantitative policies – at least not since some failed experiments along those lines in the late 70’s and early 80’s – but by adjusting its target policy rate. The Fed can manage the quantity of reserves or it can manage the rate at which banks lend reserves to one another. But it can’t manage both at the same time. Once it chooses a policy rate and targets it, then its quantitative decisions are forced by the need to maintain the policy rate.
In the end, Blinder’s message seems to be something along the lines of, “Why not experiment? What do we have to lose?” And perhaps he is right about that. I have no reason to think that the exact rate of interest paid on reserves is any big deal. But some of the points he makes along these lines undermine his argument. He says:
That said, suppose the policy failed. Suppose the Fed cut the IOER from 25 basis points to minus 25 basis points, and banks didn’t react at all; they just held on to all their excess reserves. In that unlikely event, cutting the IOER would neither provide stimulus nor enable the Fed to shrink its balance sheet. However, the Fed would start collecting about $6.25 billion per year in fees from banks instead of paying them $6.25 billion in interest—a swing of roughly $12.5 billion in the taxpayers’ favor. Some downside.
This is a really puzzling comment. It is especially puzzling from an economist who has been a backer of central bank monetary stimulus, since a contraction of the Fed’s balance sheet is effectively the dreaded “taper” that Blinder has seemed to oppose elsewhere. The Fed is not a private business whose service to the public consists in its success in making profits in the form of positive dollar balances on its balance sheet. As the branch of the government charged with emitting those dollar balances in the first place, the Fed does not need to “earn” them from some other source. Nor is it clear that doing so carries a public benefit. Note that if the Fed is earning a net profit, then it is extracting more from the non-government sector than it is injecting into the non-government sector.
This is in fact what has been going on recently. Since the start of the quantitative easing programs, the Fed’s SOMA portfolio has filled up with purchased assets and has grown very profitable. The Fed remitted close to $90 billion to the US Treasury last year, which represents its net earnings after paying its own expenses and making its statutorily required dividend payments to member banks. For all the ballyhoo about the money that QE has been “pouring into the economy” in recent years, QE asset purchases also result in the removal of financial assets from private sector balance sheets, which means those assets stop earning money for the private sector and start earning money for the Fed (which doesn’t need the money). Given that the Fed’s annual earnings have continued to be positive, and are actually now much larger than they were before, we can conclude that the total Fed contribution to the recovery has been a growing net tax on the non-government sector. I don’t know why people are so quick to regard this as a stimulatory policy.
It is true that the Fed’s net earnings are turned over to the US Treasury. But these remittances have not been accompanied by an expansionary policy, since the Treasury has been reducing its spending, and the remitted earnings have thus merely reduced the government deficit. As emphasized once again yesterday by Scott Fullwiler and Stephanie Kelton, seconding a recent piece by Paul Krugman, the Fed is a part of the US government. As a result, the Fed’s balance sheet and the Treasury’s balance sheet should be viewed in a consolidated manner when analyzing the total impact of government financial transactions on the non-government sector. Similarly, I would argue, the Fed’s income statement and the Treasury’s income statement should be seen as part of a single consolidated income statement. If the Fed is runs a $100 billion surplus (i.e. it has net positive earnings of $100 billion), while the Treasury runs a $1 trillion dollar deficit prior to Fed remittances, then the consolidated government deficit following Fed remittances is $900 biillion. By generating positive earnings, the Fed is effectively collecting a net tax haul for the government and giving it to the Treasury. So if the Fed increases its earnings by some number of dollars in a given year and the Treasury does not increase its spending by at least the same amount, but instead reduces its deficit, then the net financial result is a fiscal/monetary contraction by the government. I don’t know why Blinder regards that as a good thing, unless what he is really after is deficit reduction, not economic expansion.
One final consideration: It should be observed that a negative rate of interest on reserves appears, in its most direct and immediate effect, to be a slightly deflationary policy. Suppose total reserve balances at the Fed are $1 trillion, and the Fed imposes a negative 1% rate of interest on reserves. At that point the Fed is then draining $10 billion at an aggregate annual rate from bank reserve accounts. Given the high current level of excess reserves this drain probably wouldn’t inhibit lending in the near term, but by the same token, I don’t see why Blinder would expect it to stimulate lending – especially since he thinks monetary policy impacts the banking sector via quantitative means.
Cross-posted from Rugged Egalitarianism