Patrick Sullivan directed me to a very interesting essay by Ben Bernanke. As you’d expect, the article is well thought out and mostly accurate. But there is one issue on which I strongly disagree:
Prior to the crisis, the Fed set short-term interest rates through open-market operations that varied the quantity of bank reserves in the system, a technique which involved on average low levels of reserves—perhaps $10 billion or so. Today, the level of bank reserves is much higher, which makes it impossible to manage interest rates through small changes in the supply of reserves. Instead, the Fed manages short-term interest rates by setting certain key administered interest rates, such as the rate it pays bank on reserves held with the Fed. This “floor system” (called that because rates like the interest rate on bank reserves set a floor for the policy rate) was adopted out of necessity but seems to be gaining favor with the FOMC as a better way to manage monetary policy.
The phrase “adopted out of necessity” caught my attention. I think this is a very misleading way to describe what Ben Bernanke and I both think happened in October 2008. Presumably Bernanke means that given the Fed had decided to inject a large amount of reserves into the banking system in September 2008, and given the Fed had decided that it was unwise to reduce the interest rate target below 2% in September 2008, the IOR policy was necessary to keep the market fed funds rate close to the policy target. But I think the average reader would not understand this very restrictive meaning of “necessity”. The average reader might assume that Bernanke was saying something more like, “looking back on things, the imposition of IOR in October 2008 was necessary to meet the Fed’s policy mandate.” In fact, it was just the opposite. The decision to adopt IOR helped to prevent the Fed from achieving its policy goals, by making the Great Recession more severe than otherwise. That’s not just my opinion; unless I am mistaken that’s the implicit message of Bernanke’s memoir, where he indicated that, in retrospect, the Fed did not move quickly enough to cut rates in the fall of 2008.
The world would be a better place today if the Fed had never instituted its policy of IOR in 2008. I really don’t see how anyone can seriously dispute this claim. If you want to dispute the claim, what specific way did IOR make the world a better place? When the policy was adopted in 2008, the New York Fed explained it to the public as a contractionary policy. Can anyone seriously argue that the world would be worse off if monetary policy had been less contractionary in 2008-12? Why?
Now of course its possible that in the future a policy of IOR could be helpful, and Bernanke provides several reasons:
As I noted here, there are reasonable arguments for keeping the Fed’s balance sheet large indefinitely, including improving the transmission of monetary policy to money markets, increasing the supply of safe short-term assets available to market participants, and improving the central bank’s ability to provide liquidity during a crisis.
What Bernanke sees as an advantage, I see as a disadvantage. In a technical sense, the Fed actually has more ability to add liquidity in a world without IOR, because the balance sheet will be smaller at the onset of a crisis, and hence have more room to grow to its effective maximum size. Presumably Bernanke would respond that IOR allows the Fed almost unlimited ability to inject liquidity without sacrificing their other macroeconomic targets. In other words (a cynic might say), IOR will allow the Fed to make the same mistake in future crises that they made in October 2008—trying to rescue Wall Street without rescuing Main Street. OK, that’s probably too cynical, but I think it’s important for people to think about Bernanke’s argument in terms of what happened in the Great Recession. Bernanke may be 100% correct with regard to future crises, but it’s clear that his rationale for IOR was 100% wrong for 2008.
In my view the Fed should refrain from IOR, and I hope that causes the Fed to focus like a laser on macroeconomic stability. If the problem is solvency, then leave bailouts of banks to the Treasury or FDIC, or better yet, don’t bail out banks at all. There are some very promising proposals being developed that would allow for bondholders to be “bailed in” via debt to equity conversions during a crisis. If we move away from IOR, it’s more likely that the authorities will be forced to come up with an alternative method for dealing with large bank failures. As long as the Fed is supplying enough liquidity to keep expected NGDP growth at about 4%, I’m not at all worried about bank failures—let them fail.
If the banking system has a problem of liquidity but not solvency, then the usual Bagehot rules apply. IOR is not needed, as the size of base injections appropriate for meeting a surge in demand for liquidity is the same as the size of base injections needed to keep NGDP on track. If banks truly do “need” more liquidity, then injections of liquidity will not be inflationary. Let base supply grow as base demand grows.
My second reason for opposing IOR is that it moves us even further away from a quantity theoretic approach to monetary policy. The Fed already puts too much focus on nominal interest rates when considering the stance of monetary policy—IOR will make this problem even worse. One of the causes of the Great Recession was that low interest rates led the Fed (and almost everyone else) to falsely assume that policy was “accommodative” in 2008 and 2009, when it fact it was highly contractionary. With IOR, the quantity of money is even less informative. Let’s go back to the pre-2008 situation, where 98% of the base was currency.