Mark Thoma recently made the following comments on the Fed’s interest on reserve program:
There’s been a lot of talk lately about the Fed’s policy of paying interest on reserves with many claiming that this has caused banks to retain reserves that might have otherwise been turned into loans, and thus the policy has depressed aggregate activity. However, paying interest on reserves is a safety net for the Fed that allowed them to do QEI and QEII. If the Fed wasn’t paying interest on reserves, QEI would have likely been smaller, and QEII may not have happened at all.
First, on whether paying interest on reserves is a constraint on loan activity, the supply of loans is not the constraining factor, it’s the demand. Increasing the supply of loans won’t have much of an impact if firms aren’t interested in making new investments. Businesses are already sitting on mountains of cash they could use for this purpose, but they aren’t using the accumulated funds to make new investments and it’s not clear how making more cash available will change that.
Second, I doubt very much that a quarter of a percentage interest — the amount the Fed pays on reserves — is much of a disincentive to lending (market rates have fluctuated by more than a quarter of a percent without a having much of an impact on investment and consumption).
Third, this a safety net for the Fed with respect to inflation. Paying interest on reserves gives the Fed control over reserves they wouldn’t have otherwise, and control of reserves is essential in keeping inflation under control. If, as the economy begins to recover, the Fed loses control of reserves and they begin to leave the banks and turn into investment and consumption at too fast a rate, then inflation could become a problem.
But by changing the interest rate on reserves, the Fed can control the rate at which reserves exit banks.
I agree with much of what Thoma has to say, but would add a few comments. Let’s start with the fact that without IOR a massive increase in the monetary base would eventually lead to high inflation. I think that’s right, but it’s not really a reason for having a positive IOR right now, rather it’s a reason for having an IOR program in place. (Indeed later in the post Thoma indicates that he holds the same view.)
In January and March 2009 I published a couple papers that suggested the Fed might want to implement a negative IOR. The plan was adopted just a few months later. Unfortunately, it was adopted by Sweden, not the US. (And the Swedish plan had some loopholes.)
I agree that the existence of IOR made QE1 and QE2 more likely, but I wonder whether Thoma realizes the implication of the argument. I’ve tirelessly argued that fiscal stimulus was unlikely to be very effective because the Fed probably would have mostly neutralized the effects by doing less QE (and other forms of monetary stimulus such as negative IOR, level targeting, etc.) So if the Congress had done the $1.3 trillion stimulus that many liberals recommended it seems unlikely that the Fed would have done QE1. And if they had done no fiscal stimulus, QE1 would almost certainly have been much bigger. The Fed may be a bit slow on the uptake, but they do eventually notice inflation falling below their target, and take corrective actions.
I’ve never rigidly argued that fiscal policy can’t work, or didn’t have any stimulative effect in 2009, just that the monetary reaction problem made multiplier estimates highly unreliable. Now Thoma says we also can’t rely on estimates of the impact of having no IOR, because without IOR there might have been no monetary stimulus. And he may well be right–it’s essentially the same argument I use against fiscal stimulus. The difference is that fiscal stimulus is quite costly, so the stakes are much higher.
I’d also point out that my monetary reaction argument is actually stronger for fiscal stimulus, than his argument is for QE1. That’s because fiscal stimulus was done to boost the economy, precisely the same motivation as monetary stimulus. On the other hand the original increase in the monetary base (which occurred in the fall of 2008) was aimed not at economic stimulus, but rather at rescuing the banking system by injecting liquidity. Recall that the Fed decided against cutting the fed funds target on September 16, 2008, because they viewed the risks of recession and inflation as equally balanced. But they might well have felt a need to rescue the banking system with some liquidity injections even if Congress had not given them authorization for IOR.
Sometimes I like to daydream and imagine a scenario where Congress refuses to authorize IOR, TARP, and all the other initiatives used to bail out the banking industry. Bernanke would have had to go to the Fed and deliver the awful news:
Ladies and gentlemen, Congress won’t let us bail out the banks by any means other than good old-fashioned monetary stimulus. We tried hard to get authorization for a program that would rescue banks without also boosting AD, but those morons on Capital Hill won’t go along. I am afraid we have no choice but to do massive monetary stimulus, which unfortunately will boost NGDP growth.
Yes, they might have found that the only way to bail out the banks was to bail out the economy. Wouldn’t that have been awful!
PS. Whenever an economist thinks they’ve discovered a new idea, you can be sure someone else got there first. I thought I was the first to discuss negative IOR, but Rodney Everson sent me the following quotation for an unpublished monograph written in 2001.
In essence, Japan will begin to immediately recover if its monetary authority charges each bank an interest penalty each week based on the amount of excess reserves reflected on its books at that time, assuming, of course, that they are farsighted enough to then provide the excess reserves. This will make the potato “hot” once again, and excess reserves will no longer be held in hand.
Alternatively, they could raise the rate of overnight money to 1 or 2 percent which, of course, is impossible under current theory because it would be considered a “tightening.” If you, the reader, now understand why such a “tightening” is necessary before an “easing” can be effected, then you have grasped the essence of this monograph. You also should then understand the immediate danger we face under the current Federal Reserve policy of steadily driving the federal funds rate lower.
The quotation is from the monograph mentioned in this blog post. BTW, I think the second paragraph is wrong, but would be interested in what others think.
Tags: QE 2