The Fed Plan to Revive High-Powered Money

Don’t only drop the interest rate paid on banks’ excess reserves, charge them.

That would be a tax that reduces aggregate demand

By Alan S. Blinder

December 10 (WSJ) — Unless you are part of the tiny portion of humanity that dotes on every utterance of the Federal Open Market Committee, you probably missed an important statement regarding the arcane world of “excess reserves” buried deep in the minutes of its Oct. 29-30 policy meeting. It reads: “[M]ost participants thought that a reduction by the Board of Governors in the interest rate paid on excess reserves could be worth considering at some stage.”

They don’t realize paying interest on Fed liabilities is a subsidy to the economy any more than Professor Blinder does.

As perhaps the longest-running promoter of reducing the interest paid on excess reserves, even turning the rate negative, I can assure you that those buried words were momentous. The Fed is famously given to understatement. So when it says that “most” members of its policy committee think a change “could be worth considering,” that’s almost like saying they love the idea. That’s news because they haven’t loved it before.

So what exactly are excess reserves, and why should you care? Like most central banks, the Fed requires banks to hold reservesmainly deposits in their “checking accounts” at the Fedagainst transactions deposits. Any reserves held over and above these requirements are called excess reserves.

Not long agosay, until Lehman Brothers failed in September 2008banks held virtually no excess reserves because idle cash earned them nothing.

No, because Fed policy was to keep banks net borrowed, and then implement its policy rate via the Fed’s interest rate charges for the subsequent ‘reserve adds’ which were functionally loans from the Fed.

But today they hold a whopping $2.5 trillion in excess reserves, on which the Fed pays them an interest rate of 25 basis pointsfor an annual total of about $6.25 billion. That 25 basis points, what the Fed calls the IOER (interest on excess reserves), is the issue.

Yes, thereby supporting their policy rate decision, which happens to be a ‘range’ a bit above 0, which also happens to be a display of the Fed’s failure to understand monetary operations.

Unlike the Fed’s main policy tool, the federal-funds rate, the IOER is not market-determined. It’s completely controlled by the Fed. So instead of paying banks to hold all those excess reserves, it could charge banks a small fee, i.e., a negative interest rate, for the privilege.

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.

Reserves are assets. They can’t be ‘used’ to boost the economy. Banks can sell their reserves to other banks, but in any case the total persists as Fed liabilities. Nothing the banks can do will change that.

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.

When banks buy securities or lend, their reserve account is debited and the bank of the seller of the securities or of the borrower gets its reserve account credited. That is, the assets called reserves are merely shifted from one bank to another, with the quantity of reserves held by the banking system remaining unchanged.

A second reason for cutting the IOER answers some of the criticisms the Fed has taken for its asset-buying programs called quantitative-easing: Doing so would stimulate the economy without increasing the size of the Fed’s balance sheet. In fact, the Fed could probably shrink its balance sheet.

Why would charging banks a fee stimulate the economy?

And further note that, before the current budget agreement, these ‘fees’ were called taxes, and for a good reason! 😉

To understand why, 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.

I’ll give Professor Blinder the benefit of the doubt and assume the ‘good old days’ were the days of the gold standard, a fixed fx regime, where banking was continuously reserve constrained, interest rates were market determined, and bank lending was thereby constrained by the necessity to keep ‘real dollars’ on hand to meet depositors potential demands for withdrawals.

With today’s floating fx policy none of this is applicable.

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.

Here it seems he conflates the issue of liquidity and interbank lending with the issue of lending to the real economy, along with more inapplicable gold standard analysis.

Banking is always a case of loans creating deposits. And with today’s institutional structure, when deposits carry reserve requirements, in the first instance those requirements are functionally overdrafts in that bank’s reserve account at the Fed. And an overdraft is a loan, and booked as a loan from the Fed on statement day if it persists. So in fact loans create both deposits and any required reserves at the instant the loan is funded.

So rather than ‘high powered money’ as is the case with a gold standard, reserves today are best thought of as residual.

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.

As it always is due to ‘market forces’. The entire term structure of rates continuously adjusts to the Fed’s policy rate which generally imposed by targeting the Fed funds rate.

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.

I don’t follow this part at all. Banks always find holding reserves ‘unattractive’ as the Fed funds rate is likewise their marginal cost of funds. So reserves are, in general, never a profitable investment, and banks are always looking for investments that yield more, on a risk adjusted basis, than their cost of funds.

What are the arguments against turning the IOER negative? Over the years, Fed officials have made three, none of them cogent.

One is that cutting the IOER would have only modest stimulative effects. Well, probably. But are there more powerful tools sitting around unused? Besides, there is at least a chance that we’d get more new lending than the Fed thinks.

There’s a much larger chance that this new tax, though modest, will nonetheless reduce aggregate demand. With the economy a large net saver, and the govt a large net payer of interest, in general higher rates increase income and lower rates decrease income.

Second, there is a limit to how far negative the IOER can go. After all, banks can earn zero by keeping paper money in their vaults. So if the Fed charged a very high fee for holding excess reserves, bankers might find it worthwhile to pay the costs of bigger vaults and more security guards in order to keep huge stockpiles of cash. Sure. But a mere 25 basis point fee is not enough incentive for them to do so.

If it was realized negative rates are a tax, the argument would never get this far.

Third, a negative IOER could drive short-term interest rates even closer to zero, as banks moved balances from their reserve accounts into money market instruments. And that, we are told, would wreak havoc in the money markets. Really? Perhaps that was a legitimate concern three years ago, but we have now lived with money-market rates hugging zero for years, and capitalism has survived.

And if we eliminated the FDIC deposit insurance cap there would be no need for money market funds in the first place.

Besides, the Fed paid no interest on reserves for the first 94 years of its existence, the European Central Bank has been paying its banks nothing since July 2012, and the Danes have been charging a fee since then. In no case did anything terrible happen.

Instead the banking system was kept net short reserves, and the Fed- the monopoly supplier of net reserves- used the rate charged to cover that ‘overdraft’ to set its policy rate.

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 interesta swing of roughly $12.5 billion in the taxpayers’ favor. Some downside.

Like any other tax…

Mr. Blinder, a professor of economics and public affairs at Princeton University and former vice chairman of the Federal Reserve, is the author of “After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead” (Penguin, 2013).