Can someone explain this to me?

Satures sent me this link from the New York Times:

Mr. Bernanke was also asked why the Fed does not lower or eliminate the interest rate — already at 0.25 percent — that it pays banks for excess reserves kept at the central bank to encourage more lending.

He said that Fed officials had not ruled out that idea but that so far it appeared the benefits would be very small and that there were concerns that eliminating the interest takes away a tool used to control broader interest rates.

That’s obviously false, so what is Bernanke’s point?


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45 Responses to “Can someone explain this to me?”

  1. Gravatar of Britonomist Britonomist
    21. November 2012 at 18:55

    This is a more detailed position on the issue put forward by the Fed http://libertystreeteconomics.newyorkfed.org/2012/08/if-interest-rates-go-negative-or-be-careful-what-you-wish-for.html

  2. Gravatar of Britonomist Britonomist
    21. November 2012 at 18:58

    Err, well researches at the Fed at least, though not explicitly endorsed by the institution itself.

  3. Gravatar of ssumner ssumner
    21. November 2012 at 19:42

    Britonomist, Yes, but Bernanke’s comment makes no sense, whatever one thinks of the virtues of IOR. I presume he was misquoted–I wish they had linked to the exact quotation.

  4. Gravatar of Major_Freedom Major_Freedom
    21. November 2012 at 19:45

    Bernanke probably believes that fed controlled interest rates (i.e. fed funds rate) themselves directly influence other interest rates.

    This is probably because the positivist minded Bernanke concludes that because the fed funds rate is positively correlated with other interest rates., there is a causal relationship.

  5. Gravatar of Bonnie Bonnie
    21. November 2012 at 20:18

    The question about IoR is at 40:18 on this c-span link. I’d put it here but am a lousy typist. So it’s better if you hear it with your own ears. :)

    http://www.c-span.org/Events/Ben-Bernanke-Addresses-Economic-Club-of-New-York/10737435976-1/

  6. Gravatar of Bob Murphy Bob Murphy
    21. November 2012 at 20:36

    Scott you’re right they slightly misquoted him. If you start listening at Bonnie’s link above you can hear what he actually said, and how the reporter understandably botched it a little bit.

  7. Gravatar of Major_Freedom Major_Freedom
    22. November 2012 at 00:18

    Bernanke said:

    “If there is no return on overnight money, that a variety of different institutions, money market funds, repo markets and so on, may become more illiquid, because there will be less…very little incentive for participants to transact in those markets when interest pays zero..why not just hold cash or hold fallow reserves? Um, and, so the concern is that perhaps the federal funds rate itself may become less informative, because it is being determined in a less liquid market.

    Reporter quoted him as saying:

    “there were concerns that eliminating the interest takes away a tool used to control broader interest rates.”

  8. Gravatar of Saturos Saturos
    22. November 2012 at 00:47

    Bernanke says CPI inflation has averaged 2% of the past 4 years, is that right?

  9. Gravatar of Saturos Saturos
    22. November 2012 at 00:48

    Also Scott, could you directly respond to Bernanke’s use of the “Recoveries following financial crises are always slow” meme?

  10. Gravatar of Saturos Saturos
    22. November 2012 at 01:01

    Scott, how do you explain Bernanke’s persistent presentation of the issue as being the Fed powerless to offest “headwinds” pressing down aggregate demand, at least without excessive cost?

  11. Gravatar of Saturos Saturos
    22. November 2012 at 01:13

    I find the argument from housing to be horribly circular. Suppose houses were abolished, and no one had any wealth in the form of houses. Why should that keep aggregate spending beneath the full employment level? Even if house prices were a cause and not an effect of demand, even a pathological housing market with prices unable to rise has little to with lack of spending money. Even Bernanke suffers from the notion that aggregate demand problems are a matter of “real” demands for goods and services being insufficient, with those demands being a function of real wealth-generators such as housing with exogenous fluctuations in value. But that’s stupid: a lack of real wealth available is simply incentive to produce more. Why should all the things that people can produce go unsold? It’s the medium of exchange, stupid. There’s no sane explanation for why a lack of willingness to buy houses should necessarily lead to mass unemployment. People need to think very hard about what it is that falsifies Say’s Law, otherwise you go on talking the nonsense which to this day is taught in our schools, and echoed by the Fed Chairman in the midst of a slump…

  12. Gravatar of Saturos Saturos
    22. November 2012 at 01:15

    There he goes about the credit channel again…

  13. Gravatar of Saturos Saturos
    22. November 2012 at 02:03

    He should stop conflating real growth and unemployment issues – it would help him see where he’s going wrong…

  14. Gravatar of Saturos Saturos
    22. November 2012 at 03:38

    Nominal Rigidities at the Twinkie Factory: http://www.businessinsider.com/twinkies-bakers-would-rather-lose-their-jobs-than-take-pay-cuts-2012-11

  15. Gravatar of Saturos Saturos
    22. November 2012 at 03:59

    Bill McBride is Optimistic: http://www.businessinsider.com/bill-mcbride-of-calculated-risk-2012-11

    But there is also this: http://www.businessinsider.com/initial-claims-year-over-year-jump-2012-11

  16. Gravatar of Saturos Saturos
    22. November 2012 at 04:00

    Funny state Europe is in right now:

    http://www.reuters.com/article/2012/11/22/us-eurozone-pmi-idUSBRE8AL08I20121122

    http://www.businessinsider.com/greek-10-year-bond-yield-drops-to-post-restructuring-low-2012-11

  17. Gravatar of Saturos Saturos
    22. November 2012 at 04:00

    (Yes, I have a fair amount of free time now.)

  18. Gravatar of Saturos Saturos
    22. November 2012 at 04:08

    Bonnie, thanks for the link!

  19. Gravatar of AldenPyle AldenPyle
    22. November 2012 at 05:22

    Bernanke said:

    “If there is no return on overnight money, that a variety of different institutions, money market funds, repo markets and so on, may become more illiquid, because there will be less…very little incentive for participants to transact in those markets when interest pays zero..why not just hold cash or hold fallow reserves? Um, and, so the concern is that perhaps the federal funds rate itself may become less informative, because it is being determined in a less liquid market.”

    This is so wrong-headed that it seems almost corrupt. T-bills are currently yielding 10 basis points. Why would money center banks lend in money markets if they could get 25 basis points from deposits. In fact, high yields on Fed deposits make money markets less liquid.

    Obviously, bank holding companies (including Morgan Stanley and Goldman Sachs who are already burnishing nameplates with the names Geithner and Bernanke) are making serious profits on their reserve deposits: 15 basis points on 1.5 trillion is 2.25 billion per year. I would like to deposit my money at that rate. I cannot, however, offer top people at the Fed and Treasury golden parachute jobs. GS and MS can do both. Coincidence?

  20. Gravatar of DOB DOB
    22. November 2012 at 05:41

    I think Bernanke interprets the question as “what would be the effect of lowering IOER from 25bps to 0bps”. To that, I think we can all agree it would be “very small”.

    The more interesting question is what happens when you lower IOER to -300bps :-D

    Not sure what he’s talking about regarding the fedfunds rate. The fedfunds market is already defunct precisely because IOER is higher than the target.

  21. Gravatar of Bill Woolsey Bill Woolsey
    22. November 2012 at 05:45

    I don’t think Bernanke’s argument makes much sense.

    The banks are more motivated to leave their funds “fallow” rather than lend them out if they are being paid interest on them.

    Of course, there are transactions generated by banks borrowing overnight funding to leave it in reserve deposits. In the federal funds market, the banks are borrowing from Fanny and Freddy. I suppose this allows Fanny and Freddy to make more money than they would otherwise.

    Of course, the rest of the private sector has a choice between holding funds in deposit accounts and lending it overnight using repos and the like. If the interest rate on deposits is assumed to be zero for these firms, then if the interest rate on overnight money is zero, then they just leave their money in checkable deposits.

    But what happens when the Fed pays interest on reserve balances, the banks who have access to these funds pay higher interest on deposits, which makes the private sector more likely to leave the funds “fallow” in bank deposit balances.

    Suppose that depositors pay charges on their deposits (negative interest rates on them.) Then they would be motivated to lend the money out overnight if the interest rate that could be earned was even slightly positive, zero, or must less negative than what is “earned” (charged) on deposit accounts at banks.

    Because banks have lots of regulatory costs, they can afford to pay less than those borrowing overnight (the shadow banking system.) And so, they pay less (charge more) than those borrowing overnight would pay (charge).

    Now, if interest rates get so low (so negative) that there is a currency drain, then holding currency in vaults is an option. The choice is no longer between holding funds in regulated banks or lending overnight, currency can be held instead of bearing the charges of holding funds in regulated banks. The overnight borrowers have to compete with holding currency now–something new. Less transactions in that market.

    What is clear is that by paying interest on reserve balances, everyone “lending” overnight money including banks holding reserves, depositors holding funds in banks, and those lending overnight, make a higher return.

    P.S. In all the other recessions, where the Fed left the interest rate on reserves at zero, the recoveries were weak and drawn out. The problem had to do with there being too little liquidity in the overnight market. The overnight interest rates weren’t providing enough information. This time, by paying interest on reserves, the Fed has been able to engineer a prompt and strong recovery. Right?

  22. Gravatar of DOB DOB
    22. November 2012 at 06:09

    Bill,

    Exactly! I’m not sure how transforming the fedfunds market into a one-way conduit between GSEs and banks has increased the amount of information interest rate markets provide..

  23. Gravatar of Saturos Saturos
    22. November 2012 at 06:33

    Tyler has his annual “favorite films” list out: http://marginalrevolution.com/marginalrevolution/2012/11/best-films-of-2012.html

  24. Gravatar of Steve Steve
    22. November 2012 at 06:46

    “I really can’t afford to not be working, but this is not worth it. I’d rather go work somewhere else or draw unemployment,” said Johnson, a worker at Hostess for 23 years.

    Would rather draw unemployment…

    “Workers had a laundry list of frustrations, from rising healthcare costs…”

    That’s what the state healthcare exchanges are for! Free care for the newly unemployed.

    High effective MTRs strike again!

  25. Gravatar of Steve Steve
    22. November 2012 at 06:47

    Saturos, you are on fire! Go have some fiscal stuffing and monetary cranberries!

  26. Gravatar of Major_Freedom Major_Freedom
    22. November 2012 at 06:48

    DOB:

    the amount of information interest rate markets provide..

    What market interest rates?

  27. Gravatar of DOB DOB
    22. November 2012 at 06:57

    Major_Freedom,

    I was just referring to Bill’s sentence: “The overnight interest rates weren’t providing enough information.”

    The fedfunds market is probably the most looked at, historically, but they more or less move in tandem..

  28. Gravatar of Saturos Saturos
    22. November 2012 at 07:02

    Steve, we don’t really do Thanksgiving down here in Australia, but I’m having a pre-Christmas brownie right now…

  29. Gravatar of Lars Christensen Lars Christensen
    22. November 2012 at 07:17

    Saturos, I will buy you a beer at the beach in Langkawi

  30. Gravatar of Major_Freedom Major_Freedom
    22. November 2012 at 07:36

    DOB:

    OK, fair enough. I wonder what did Bill meant by market interest rates. I have looked everywhere for them. Can’t say I found any.

  31. Gravatar of DOB DOB
    22. November 2012 at 07:40

    Major_Freedom,

    Is this your way of saying that the Fed sets interest rates and therefore they aren’t set by markets?

  32. Gravatar of Major_Freedom Major_Freedom
    22. November 2012 at 07:51

    DOB:

    Again this reference to market interest rates. Are you getting something in the mail that I am not? What’s your zip code?

  33. Gravatar of Orn Gudmundsson Jr Orn Gudmundsson Jr
    22. November 2012 at 07:55

    There are are two parts to this, the second one (about losing a tool) is obvious nonsense. The first is a bit more nuanced. Most commercial bankers will say that 25 basis points (even risk free) is simply not enough incentive to prevent them from making loans. Really, if they had good loans to make they would. They are beating themselves up right now on a handfull of borrowers and net interest margins are shrinking. What really explains the excess reserves is a combination of two things: lack of demand among qualified borrowers and the new definition of qualified borrowers. Lack of demand is a complex issue and the price of debt/money is not just interest, it is also bankruptcy risk. And, bankruptcy risk I think is a much bigger issue than rates at the moment.

    But, what is really interesting to me is how bank regulators have changed the way banks lend commercially. Sure, banks have tightened up, but they want to loan money, what is happening in the background with loan classification has more to do with the lack of lending than anything else. What is happening? Well, I know from a friend who is a regional head of a large commercial bank, that regulators are sitting in on some routine credit reviews/calls, something they never used to do. Regulators have tightened, to an extreme extent, how they classify loans, leading banks to be reluctant to make loans they think are safe simply because of how the loans will be classed later.

    It’s a giant wet blanket. This, in turn, is part of the reason for the lack of demand. All of us that own businesses have friends who’ve had credit lines pulled in seemingly arbitrary situations (of, course, we also know situations where the line needed to be pulled). But, knowing the difficult environment, it would be foolish to commit to any semi- permanent capital project through a loan no matter what the list price of the interest. Will the loan be hard to re-finance due to some new regulatory fetish? And let’s, face it, capital projects with a positive NPV that can be done out of cash are already happening, where it’s not happening enough is where bank dept is required, and this is not a function of price as much as it is some of these softer factors. It will take business borrowing to shrink excess reserves.

  34. Gravatar of DOB DOB
    22. November 2012 at 08:28

    @Major_Freedom,

    I still don’t understand what you’re trying to say. If this is a joke, I’m afraid I don’t get it..

    @Orn Gudmundsson Jr,

    At -4% interest rate, many more loans become viable: more borrowers can afford to repay their loans (even after term premium and credit spread are added).

    For instance, if you could borrow to setup a business at -1%, it stands to reason that you’d have a greater chance of remaining solvent than if you were borrowing at +3% (I’m assuming that term premium + credit spread = 3%).

  35. Gravatar of ssumner ssumner
    22. November 2012 at 09:43

    Thanks Bonnie.

    Bob, Understandably? Botched a “little bit?” This is the NYT for God’s sake. Are you crazy!

    Saturos, Nope, 1.37% on the PCE, which is the Fed’s favorite price index.

    Bernanke knows that growth was very fast from 1933-37, so I doubt he believes what he says.

    Lots of good points in your other posts.

    AldenPyle, That’s right.

    More to come . . .

  36. Gravatar of Siegfried Mayer Siegfried Mayer
    22. November 2012 at 09:46

    The FED is caught up in a Liquity Trap… nothing Uncle Ben does now will have little effect on the bank rates. At a zero rate there is no incentive “exercise” their money. The banks are waiting for market demand to appear out of thin air… it isn’t going to happen as long as the FED continues to suppress the Natural Interest Rate to zero.

    There are no more PRICE MECHANISM for housing to respond to. Housing is over built and there is still a massive shadow inventory of YET to be foreclosed homes which is not yet factored into a recovery. Commercial real property is also weak and getting worse.

    The FED’s artificially low nterest rates neutralizes the market forces of normal supply-demand and essentially eliminates the Price Mechanism.

    The US Government is going to have to bail out the Fanny and Freddy AGAIN, (another $300 Billion) and this will only make things worse.

    Bernanke could try a NEGATIVE -2% to -5% rate and see what that would do?
    My guess would be that Banks might start pushing their money out the door to higher risk deals just to avoid the capital errosion.

    What do you think??

  37. Gravatar of ssumner ssumner
    22. November 2012 at 11:48

    Bill and DOB, Good points.

    Orn, The goal is not to get banks to make loans, but rather to reduce their demand for ERs.

    DOB, You must be new here—pay no attention to Major Freeman.

    Saturos, Isn’t it a bit early for a best of 2012 list?

  38. Gravatar of DOB DOB
    22. November 2012 at 12:38

    Scott: understood. I am indeed new here ;)

  39. Gravatar of TheMoneyIllusion » The NYT misquotes Ben Bernanke TheMoneyIllusion » The NYT misquotes Ben Bernanke
    22. November 2012 at 15:21

    [...] I did a post pointing to a NYT report on a seemingly inexplicable comment by Ben Bernanke: Mr. Bernanke was also [...]

  40. Gravatar of John Greenwood John Greenwood
    23. November 2012 at 05:10

    The Bank of England’s latest minutes (released November 21) show that the MPC has also considered the question of whether further Bank Rate reductions are worthwhile (see para 37). Here is their rationale for not cutting rates further:
    “The Committee also discussed the likely effectiveness of reducing Bank Rate to below 0.5%. Over the past few months, Bank staff had consulted with the FSA and the Building Societies Association on the possible consequences. In the light of that, the Committee had re-examined in detail the desirability of such an option. While it would be beneficial for some existing borrowers, there were concerns that a cut in Bank Rate might prove counterproductive for aggregate demand as a whole. Staff analysis had concluded that a further cut in Bank Rate would be likely to cause a
    reduction in the profitability of some lenders, especially building societies, because of the prevalence of loans with interest terms contractually or closely linked to Bank Rate. That would weaken their balance sheets and they might have to respond by increasing other loan rates or restricting lending. Viewed against the backdrop of the Funding for Lending Scheme (FLS), and the potential for building
    societies to play a material role in increasing lending, the Committee judged that it was unlikely to
    wish to reduce Bank Rate in the foreseeable future.”

  41. Gravatar of Orn Gudmundsson Jr Orn Gudmundsson Jr
    23. November 2012 at 08:18

    DOB,

    Lower interest rates do make a difference on some existing loans, but, in terms of starting a new business or project, lower debt costs are already priced into the end products, so I’m not really sure it does anything to boost returns. My industry (lumber) suffered a price drop of 50% over 3 years, the nominal price of debt was not really an issue in any investment, as the swings in the assets that debt would be employed in are far greater. If a few percent makes a difference, the return is probably too skinny for a private company.

    I’m still thinking about the extreme case of negative rates, but most existing loan contracts have minimum rates, it would be highly disruptive. I’ve been doing business in Japan for years and I don’t really think low nominal rates have helped there. I joked with my customer who was bragging about his low mortgage rate and pointed out that the real cost of interest seemed similar to mine.

    Scott,

    Perhaps I’m missing something important, but I don’t think the return on excess reserves is why banks are holding them.

    In order to reduce demand for ERs, you have to change the relative apeal of other assets, you can do that be reducing the return, but you can also do that by increasing the appeal of other assets (loans, bonds etc.) On the surface, there are plenty of investments that hold out higher returns, even adjusted for risk. I think you would have to do something extreme to excess reserves, and even that may not help much, if, as I think, there are structural barriers that are preventing banks from investing in those assets now. I have yet to find a commercial banker who wants ER’s.

  42. Gravatar of ssumner ssumner
    23. November 2012 at 09:22

    John, I guess the BOE doesn’t understand the difference between monetary policy and credit policy.

    Orn, I certainly agree that the main goal should be to increase the expected return on other assets, not reduce the nominal return on cash. But it might help a bit.

  43. Gravatar of Saturos Saturos
    23. November 2012 at 09:39

    “This is the NYT for God’s sake.”

    Yes, and bear in mind that you are talking about the newspaper which famously saw fit to print the following correction last year:

    An article on Monday about Jack Robison and Kirsten Lindsmith, two college students with Asperger syndrome who are navigating the perils of an intimate relationship, misidentified the character from the animated children’s TV show “My Little Pony” that Ms. Lindsmith said she visualized to cheer herself up. It is Twilight Sparkle, the nerdy intellectual, not Fluttershy, the kind animal lover.

    http://www.nytimes.com/2011/12/30/pageoneplus/corrections-december-30.html

  44. Gravatar of flow5 flow5
    24. November 2012 at 08:52

    Savings are attracted from the non-banks (shadow banks or financial intermediaries). It’s called dis-intermediation (where the size of the non-banks shrink, but the size of the commercial banking system remains unaffected).

    Introducing the payment of interest on excess reserve balances on Oct 9, 2008 thwarted our recovery. Remunerated excess reserve balances alter the construction of a normal yield curve, they INVERT the short-end segment of the yield curve known as the money market (which funds the capital market, etc.)

    The lending capacity of financial intermediaries (non-banks) is almost exclusively dependent on the volume of voluntary savings placed at their disposal. However, the CBs could continue to lend if the public should cease to save altogether. The size of the CBs is determined by monetary policy – not the savings practices of the public.

    The non-banks are the CB’s customers. From the standpoint of the system, the non-banks do not compete with the CBs for savings. Savings flowing through the non-banks never leave the CB system in the first place.

    Unspent savings exert a depressing effect upon the economy. I.e, savings impounded within the CB system have a velocity of zero (because CBs create new money when they lend & invest, CBs do not loan out existing deposits, saved or otherwise).

    And lending by the non-banks is non-inflationary (ceteris paribus), whereas lending by the CBs is inflationary. I.e., CB lending expands both the volume & rate-of-turnover of money, whereas, lending by the non-banks affects only the turnover of existing money.

    The .25% remuneration rate sharply reduced the supply of loan-funds in both the money market & capital market. It necessitates that the Fed follow a much easier monetary policy in order to counteract the policies’ depressionary impact. Without extraordinary monetary intervention in 2013 there will be a recesssion.

    One of the principle reasons the Fed expanded its balance sheet was to offset the decline in the supply of loan-funds (increase the availability & decrease the cost of loan-funds). However in the process the Fed created a shortage of safe assets (reduced the supply of collateral in the repo market). And IBDDs aren’t close substitutes as they are only held within the CB system whereas lending by the non-banks required governments. This un-necessary competition has set up a “collateral squeeze”, reduced the “velocity of pledged collateral, & limited commercial bank credit expansion (investments).

    The upshot is that IOeR’s result in a cessation of the circuit income & transactions velocity of funds. And in the longer term, IOeR’s exacerbate stagflation.

  45. Gravatar of flow5 flow5
    25. November 2012 at 18:16

    For example: the 5 1/2 percent increase in REG Q ceilings on December 6, 1965 (applicable exclusively to the commercial banking system), is analogous to the .25% remuneration rate on excess reserves introduced on Oct 9, 2008 (i.e., the remuneration rate @ .25% is higher than daily Treasury yield curve rates almost 2 years out – .24% as of 11/15/12).

    In 1966, it was the lack of mortgage funds, rather than their cost that spawned the credit crisis & collapsed the housing industry. I.e., it was dis-intermediation (an outflow of funds, or negative cash flow), involving the non-banks – but not the CBs as a system.

    The fifth (in a series of rate increases), promulgated by the Board & the FDIC beginning in January 1957, was unique in that it was the first increase that permitted the commercial banks to pay higher rates on savings, than savings & loans & the mutual savings banks could competitively meet.

    Just as in 1966, during the Great Recession, the Shadow Banking System (non-banks) experienced dis-intermediation (like the CB’s, IOeR’s now compete with other financial assets [held by the non-banks], on the short-end of the INVERTED yield curve).

    Bankers, confronted with a remuneration rate that is higher (vis a’ vis), other competitive financial instruments, will hold a higher level of un-used excess reserves – i.e., will not invest in securities with comparable returns (stopping the flow of funds or the transactions velocity of money). Obviously the payment of interest on excess reserve balances killed the commercial paper market, etc., etc.

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