The Fed is Starving Economy of Interest Income

By Warren Mosler

He left out the part about needing a fiscal adjustment to compensate but this is part one of a three part presentation of something I wrote.

51 Responses

  1. Warren, have you developed the thinking in this piece in a longer essay form? It seems to me that this concern with interest income has become a major new theme in your thinking.

      1. @beowulf, Sorry guys, but I don’t get this. In that paper, Warren argues that the government uses security sales mainly as a means of regulating reserve levels and short term interest rates, particularly the overnight Fed Funds rate. He draws on research from Scott Fullwiler and Randy Wray to support this view, and also the view that market lending rates are strongly correlated with the overnight rate. He argues that in a state currency system with floating exchange rates, the normal or base interest rate is zero, and cites Japan as an example of a country that has kept its overnight at close to zero for a decade.

        He contrasts the case of country’s like the US and Japan with countries operating a fixed exchange rate against a reserve currency who must use security sales to protect their central bank reserves against conversion into the reserve currency, and whose overnight rates are determined by market forces, not government decision.

        He argues that:

        The central bank clearly controls the short-term interest rates in a state currency with flexible exchange rates, and there are a number of good reasons for setting the overnight rate at its natural or normal rate of zero and allowing markets to factor in risk to determine subsequent credit spreads.

        and reiterates the point in the conclusion:

        Furthermore, there are a number of reasons why allowing the rate of interest to settle at its natural rate of zero makes good economic sense.

        So I see nothing in the paper suggesting that an important function of government security sales is to provide interest income to their purchasers. But now that seems to be a major concern for him

        And in the natural rate article Warren does nothing to suggest that keeping the overnight rate close to zero is harmful. In fact he asserts that there are a number of good reasons for it. But now he is saying that lowering rates is a fiscal drag with a contractionary and deflationary bias.

        This line of argument and concern has been emerging in some of Warren’s recent posts. But it seems to me like a new a angle that is a departure from, or at least novel extension of, the views expressed in the classic “mandatory readings.”

      2. @Dan Kervick,

        This isn’t new.

        I think the basic argument is that zero rates allow more constructive tax cuts elsewhere.

        Similarly, QE is a lousy policy, but that if done, should at least require additional tax cuts as “compensation” for its effect on income.

      3. i’ve always supported a 0 rate policy and the idea that for a given size govt it means lower taxes than otherwise.

        (also, my ideas came from logic and experience, vs ‘drawing’ on prior econ literature)

      4. @Dan Kervick,

        Agreed. I realize Warren has supported a 0 rate policy as he states and as described in mandatory readings, so the recent tone has been a bit confusing as well.

  2. Lowering interest rates and buying financial assets are indirect ways of investing. And investing adds to aggregate demand.

    Subsidizing consumption rather than investment would make sense if there are no good investments available. But that’s clearly not the present world.

  3. It is not evident to me that higher interest rates will help the economy. I would have thought that lower rates would help to stimulate this mess we have. I am thinking that the fed got those securities by buying and lowering the rate. That seems right, so what am I mossing here?

    1. @Jonf, There’s no point in lowering rates if the borrowing class is already maxed out, unemployed and broke. Businesses are not going to borrow more money to expand if the economy is awful and there are no consumers. Meanwhile, the savers lose income and have less money to spend in the economy.

    1. @Hoonose,
      with an interesting Beowulfian thought experiment.

      I do like how this guy thinks.
      Assuming an average coupon yield of 3% across this $18 trillion portfolio, we would calculate the Fed’s interest income to be about $540 billion per year. The Fed would then claim a profit close to this amount, pay the money to the U.S. Treasury, and the net effect would be a 50% reduction in our government’s annual budget deficit.

      However he loses the thread here:
      It’s easy for this sort of arrangement to confuse people, because most logical people recognize the obvious circularity of the money transfers. However, since we lack a real-world analogue to this arrangement, it can be hard to get our minds around all the implications the first time we think about it.

      Sure we do, its called a “trust fund”. Tsy is the settlor and the beneficiary, the Fed is the trustee. Tsy holds equitable title in Fed-held debt since it’s the beneficial owner.

      1. @beowulf, I like that line of thinking too.

        A lot of the commentary on Ben Bernanke seems to interpret him as a misguided classic monetarist with the same view of the money multiplier and reserve-driven lending as the Market Monetarists, but who just has colder feet than they do when it comes to risking inflation. They think QE was all about some attempted banking channel supply side stimulus that didn’t work, and they want him to push harder on the string. Then they get paranoid, and think Bernanke is a Republican hack who is trying to scuttle Obama’s administration by holding back on the monetary policy bonanza that could be reaped by flooding the system with even more excess reserves.

        I don’t think Bernanke believes any of that crap. After all, he defended the famous “helicopter drop” which is a fiscal operation. I think he, Geithner and Obama are three peas in a pod, and the point of QE was to assist the fiscal side of things by helping the treasury with some zero interest borrowing.

        People never seem to notice that Bernanke continues to call for more fiscal action.

      2. but he falls far short of letting congress know they can’t run out of dollars, they can’t be the next greece, the fed sets rates and not markets, that we are not dependent on funding from the likes of china, etc. etc. so if what you say is the case, it’s an even harsher criticism of the chairman

  4. “For example, the Fed turned over approximately $80 billion last year to the Treasury, and probably a lot more this year with its larger portfolio, with no mention that the same $80 billion would have otherwise added that much to the income of the rest of the economy.” -> What about the fact that due to QE and other fed operations, the remaining $12tn of Tsys floating around in the private sector gained about $2tn in value (200bps rally x 8 years duration x $12tn)? Doesn’t that trump a meager $80bn subtracted from income (25x less)?

    1. the pv of ‘savings’ lost that much. ask any pension fund manager what’s happened to the value of his contributions with regard to providing future income for retirees.

      think macro!!!


      1. @WARREN MOSLER,

        The PV of net savings gained that much.. Other than treasury bonds, all savings are someone else’s borrowing and therefore when thinking macro, doesn’t it all wash off?

        Defined benefits private pensions (I assume that’s what you meant by ‘pension fund’) are an asset to the pensioner and a liability to the corporate sponsor. How are they any more relevant than any other private sector arrangement from an MMT NFA basis?

      2. yes,
        at the instant of the rate cut interest paid by the tsy doesn’t change. It’s over time as securities roll off. including the short bills.

        pension fund contributions (unspent income) and other ‘savings’ has to rise to pay out the same income down the road.

        when I look around the world and back in time seems lower rates haven’t in fact been ‘accommodative’ and/or inflationary and when I look at the interest income
        effects it seems to at least partially explain why, etc.

      3. @WARREN MOSLER,

        at the instant of the rate cut interest paid by the tsy doesn’t change. It’s over time as securities roll off. including the short bills. -> yes but the PV moves instantly and by a much larger amount. By the time the roll off trickles in, the business cycle could be in a different stage or taxes could be adjusted..

        pension fund contributions (unspent income) and other ’savings’ has to rise to pay out the same income down the road. -> so you’re arguing that a lower real yield, folks save more because they need to in order to spend the same in the future? I think I might actually agree with this: when real yields go up, if I don’t change my savings amount, my future consumption goes up and my spot consumption does not change. Any utility function with diminishing returns would mandate saving a little less for tomorrow to consume a little more today. Will think about what this implies.

        when I look around the world and back in time seems lower rates haven’t in fact been ‘accommodative’ and/or inflationary and when I look at the interest income effects it seems to at least partially explain why, etc. -> Hard to establish causation here. Saying that countries with lower rates are doing worse is obviously misleading and the same thing could be said about countries with high deficits (Japan). In fact, they tend to be the same countries…

      4. yes, the pv moves instantly, but there is no evidence that this hikes aggregate demand. in fact, the investor now faces lower returns on his future cash flow.

        for example, my parents had a CD paying 5% and they were using the interest to go out to eat now and then. When rates dropped and they were faced with
        something under 1% when the old one came due, they stopped spending even with the 5% still coming in. (Yes, I know, that’s just anecdotal.)

        Pension funds also see both an appreciation of existing bonds but face lower investment rates and therefore need larger contributions.

        Corporate america is earning near nothing on its 2 trillion or whatever it is in cash holdings.

        checking account balances are near worthless for banks.

        agreed the observations don’t prove anything. but they don’t disprove it either.
        so at least that evidence doesn’t contradict the ‘theory’

  5. Surely those selling bonds to the Fed take into account the fact that they’ll lose interest for a year – two years or whatever. So they’ll demand a price that compensates them for that loss. Ergo the net effect in “interest income” is arguably nothing or very little.

  6. President Obama last night: “Americans … understand that when I get a tax break I don’t need and the country can’t afford, it either adds to the deficit, or somebody else has to make up the difference — like a senior on a fixed income, or a student trying to get through school, or a family trying to make ends meet. That’s not right. Americans know that’s not right. [Raising taxes on the rich is] how we’ll reduce our deficit. That’s an America built to last.”

    No, that’s an America built to be last.

    1. @Tyler, The Pres just can’t seem to get it right. Is he really this ignorant or would you blame his advisors? He could say the same populist stuff perhaps with a better staff writer.

  7. Warren,
    How much of an effect does lower interst rates have on desired savings? If the private sector is receiving less net interest income due to lower rates, is the private sector going to increase its net savings in order to try to restore the lost interest income? Put another way, the Fed’s policy could be driving the budget deficit higher.

  8. Warren: It all seems more complicated. The Fed is removing the 80 billion in interest income, which I agree is a fiscal drag, but in order to buy the bonds in the open market it has also injected the 1.6T or whatever it cost in newly created money, which should be a bigger fiscal stimulus in the short-run. It also helps to lower the prime interest rate which lowers required the marginal productivity of capital necessary to service a new capital loan which may be a fiscal stimulus if it generates more credit money. Am I missing something?

    1. when it pays for the bonds that’s just an asset exchange that doesn’t add income or nominal savings to the economy.

      and it marginally lowers the term structure of rates which tends to hurt savers and help borrowers income wise.

    1. Seth Carpenter paper

      Posted by WARREN MOSLER on September 28th, 2010

      On Tue, Sep 28, 2010 at 12:36 PM, Eileen wrote:

      Did Hell freeze over and I missed it??

      Seth B. Carpenter and Selva Demiralp, recently posted a discussion paper on the Federal Reserve Board’s website, titled Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?

      The authors note that bank reserves increased dramatically since the start of the financial crisis. Reserves are up a staggering 2,173% from $47.3bn on September 10, 2008, just before the financial crisis began, to $1.1tn now. Yet M2 is up only 11.4% since September 10, 2008, and bank loans are down $140.2bn. The textbook money multiplier model predicts that money growth and bank lending should have soared along with reserves, stimulating economic activity and boosting inflation. The Fed study concluded that “if the level of reserves is expected to have an impact on the economy, it seems unlikely that a standard multiplier story will explain the effect.”

      That not only repudiates the textbook money multiplier model but also raises lots of questions about the goal of the Fed’s quantitative easing policies.

      The Carpenter/Demiralp study quotes former Fed Vice Chairman Donald Kohn saying the following about the money multiplier in a March 24, 2010 speech:

      “The huge quantity of bank reserves that were created has been seen largely as a byproduct of the purchases that would be unlikely to have a significant independent effect on financial markets and the economy. This view is not consistent with the simple models in many textbooks or the monetarist tradition in monetary policy, which emphasizes a line of causation from reserves to the money supply to economic activity and inflation. . . . We will need to watch and study this channel carefully.”

      Here are more shocking revelations from the study under review: “In the absence of a multiplier, open market operations, which simply change reserve balances, do not directly affect lending behavior at the aggregate level. Put differently, if the quantity of reserves is relevant for the transmission of monetary policy, a different mechanism must be found.

  9. Warren – I admire your work and agree with most of your arguments however I believe this article is not your best. Specifically, you seem to contradict yourself when you make the following two points:

    “all the evidence so far indicates this source of fiscal drag may be at least offsetting any positive effects of lower interest rates on aggregate demand.”

    You clearly suggest that the fiscal drag from the interest income channel is being offset by effects that are working in opposite (positive) direction. I agree with this, but then you say:

    “The only way a rate cut could add to aggregate demand would be if, in aggregate, the propensities to consume of borrowers was higher than savers.”

    This suggests that the only effect on the real economy is the interest income channel and therefore that there is no other channel working in the opposite direction.
    In my opinion your first point is correct – the interest channel is working against two other channels of interest rate policy – the effect on investment decisions and the effect on inter-temporal spending decisions. Now I’m not a regular neo-classical economist who would argue that these two effects are large, but I think your failure to mention them at all makes your argument weak. I believe that – ceteris paribus – the other channels do have effects on the real economy, but much less than neoclassicals believe. In brief, I see the impact of lower interest rates on investment decisions being the biggest effect of all. Sure, the effects of this channel can be exaggerated, and that the current environment makes it particularly weak, but to claim it doesn’t exist at all is not correct. Heck, my boss would not be building his $2 million dollar house if interest rates were just 100 basis points higher. Lastly, like many who reject neoclassical behavioral assumptions I believe the inter-temporal consumption decision channel is very weak because people do not make consumption vs. saving decisions based on the perceived cost of delayed consumption versus the compensation for delayed consumption (interest rate income). However, with that said do you believe that savings desires are not influenced at all by interest rates? If the current problem is too much savings in relation to investment desires how would increasing the returns to savings (higher interest rates) not magnify the problem to some degree?

      1. @CDNDC,

        If Warren doesn’t answer, my guess would be that he’d mostly agree with you. But I’ve read him say that his real world experience tells him that those other two channels do not manifest significantly. In general, I am sure we’d all be interested in better empirical research on the matter.

  10. Refuting Mosler again.
    Posted by ducati998 under theory of money

    Mosler, the guru of MMT.

    The Fed again deserves low marks for another year of being part of the problem rather than part of the answer.

    Well I can certainly agree with that statement. The expansion of money and credit underwritten by the Federal Reserve, the whipping boy of Federal Government, via the massive expansion of credit via fractional reserve lending through commercial banks and the government entities led to the huge property bubble and financial over-leveraging that created this crisis. The Fed’s answer, more of the same.

    For 2011 the Fed has again failed to address the interest income side of its policies.

    Oh. That’s what you’re talking about. Well no. The ‘interest income’ is really a minor unimportant point in the scheme of things when talking about the Fed…

    …When the Federal Reserve monetizes the governments debt, and that includes government entities like Fannie Mae and Freddie Mac, the interest paid comes from the government, and is then simply returned to it as ‘profit’ via the Federal Reserve. Certainly the reduction of a ‘real interest cost’ is valuable to government, but they are only stealing it from you the taxpayer.

    It would serve public purpose if the Fed made it clear that in today’s rate environment, what’s called ‘quantitative easing’ in fact removes interest income from the private sector, thereby functioning much like a tax and a source of what’s called fiscal drag, as it takes net dollars out of the economy as it reduces the federal deficit.

    Partly true. It is a tax on the private sector. It does not however reduce net dollars in the economy, far from it, it expands the money supply, it is inherently inflationary, that’s why it is a tax on the private sector.

    Furthermore, all the evidence so far indicates this source of fiscal drag may be at least offsetting any positive effects of lower interest rates on aggregate demand.

    Mosler simply is ignorant of the difference between the market rate of interest and the natural rate of interest, which is driven by the time preferences of individuals. In an increasing tax environment, time preferences move higher, thus natural rates of interest rise, productivity falls. This is the current reality…

    Full article:

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