It’s been fascinating to see the topic of interest on reserves (IOR) all over the news. I was watching a CNBC video sent to me by Mike Sandifer, and they discussed two interesting tidbits around the 5 minute mark. First, that rumors the Fed would eliminate IOR triggered a big stock market rally the day before. And second, they actually discussed the idea of negative interest rates on reserves. I was gratified by the stock market reaction to the rumor that IOR would be eliminated (assuming the market was in fact reacting to this rumor, and I don’t know if it was) because market responses to news are the gold standard of causality. Even if the stock market is wrong, it might nevertheless be right for the usual “Tinkerbell” reasons. (If I think I can fly, then I can fly.) If the stock market thinks a Fed action is very bullish, and rises sharply in response, that market reaction can trigger more investment even if based on an erroneous theory of monetary economics.
And finally, I few days ago I mentioned how Jim Hamilton and Robert Hall had noticed the contractionary nature of IOR quite early on. Yesterday I ran across a David Beckworth post that was one of the earliest and best posts on the subject. Not only did David notice the contractionary impact, but he also saw the analogy to 1937, at a time (October 2008) when the vast majority of macroeconomists were still completely oblivious to what was going on.
Monetary policy can affect either the supply or demand for money. In the short run, monetary policy tools are generally used to change the supply of base money. Indeed most textbooks are only able to come up with a single example of the Fed targeting the demand for base money in order to change the stance of monetary policy; the 1936-37 decision to double reserve requirements. Futures textbooks will almost certainly mention the October 6, 2008 IOR decision as a second, and even more foolish, example of raising the demand for base money at an inappropriate time. Shame on the economics profession for not calling out the Fed at the time.
I like to point out that 2009 saw the biggest drop in NGDP since 1938. But as of October 2008, the decline was still not expected to be that large. So David’s reference to the 1937 example proved to be not only accurate, but also prophetic. Here’s how he modestly concluded his post:
Pardon me for being skeptical, but from what I can see this approach has only encouraged banks to hoard more excess reserves. I may be missing something here–and please let me know if I am–but it seems like we are making the same policy mistakes that were made in 1936-1937.
No David, you didn’t miss anything, but the rest of the profession sure did.