Hume and Hall call out the Fed

“If the coin be locked up in chests, it is the same thing with regard to prices, as if it were annihilated.” David Hume — Of Money

Consider the following: For the first time in its 95 year history, the Fed begins paying interest on bank reserves on October 6, 2008. The U.S. stock market falls roughly 40% in 2008, with over one half of the decline occurring in the first ten days of October. Much as I’d like to draw a connection, I know of no evidence linking these two events. Even so, Susan Woodward and Robert Hall found this policy just as puzzling as I did:

“Oddly, he [Bernanke] explained the new policy of paying 1 percent interest on reserves as a way of elevating short-term rates up to the Fed’s target level of 1 percent. This amounts to a confession of the contractionary effect of the reserve interest policy.”

Almost every money and banking textbook mentions the infamous Fed decision to double reserve requirements in 1936-37. We teach our students that the last thing a central bank would want to do is to reduce the money multiplier in a depression. So is the current Fed policy as bad as it looks? I honestly have no idea, it’s quite possible that without the interest payments the fed funds rate would have fallen to zero, and banks would still have hoarded lots of excess reserves. But why even think of paying interest on reserves? Do they fear that otherwise the fed funds rate would fall below their target? And why would that be so bad?

In 1983 Hall advocated paying interest on bank reserves, at rates that varied in such a way as to stabilize the price level. Under Hall’s proposal, the Fed would now be paying a negative rate (i.e. charging a penalty rate) on excess reserves. Were they to do so, banks would replace excess reserves with T-bills, and the bloated monetary base would be pushed out into “cash held by the public.” From there it would be much easier to boost AD, as (unlike in the pre-FDIC era) demand for cash balances has not been dramatically enlarged by fears of bank failures.

This probably isn’t the best way out of a liquidity trap (I’ll look at much more effective solutions later), but it is one of many missed opportunities.



6 Responses to “Hume and Hall call out the Fed”

  1. Gravatar of travis travis
    25. February 2009 at 11:09

    The reason is that the Fed doesn’t want to ask the Treasury to borrow money by issuing debt and deposit the money with the Fed so that the Fed can then buy various securities. With the new policy of paying interest on reserves, the Fed buys the securities directly and the cash is held as reserves because interest is paid on the reserves.

    This way, the purchases are essentially sterilized and prevents massive inflation. The Fed achieves its goal of lowering the risk premium.

  2. Gravatar of ssumner ssumner
    25. February 2009 at 19:19

    Travis, You may be right about how it prevents massive inflation. But the Fed says it wants more inflation. So why don’t they use the interest rate as a policy tool–gradually lowering it until they get a bit of inflation? And all this assumes that their broader goals of affecting the risk premium makes sense. In, Hamilton argues that the Fed’s attempt to affect spreads doesn’t work very well, and that they should concentrate on boosting aggregate demand. But their interest rate policy makes it harder to do monetary policy. They have already cut the fed funds target to near zero, and the interest rate on reserves policy makes quantitative easing mostly ineffective.

  3. Gravatar of Jordan Jordan
    29. March 2009 at 14:02

    Hello. pretty good job with your site! I did not expect this while stumbling around lol. If you could visit my blog and give me some feedback Id really appreciate it!

  4. Gravatar of ヒュームとホールがFedに提言 by Scott Sumner – 道草 ヒュームとホールがFedに提言 by Scott Sumner – 道草
    27. December 2010 at 07:37

    […] ヒュームとホールがFedに提言 by Scott Sumner // 引き続き、スコット・サムナーのブログ、TheMoneyIllusion の初期(2009å¹´2月くらい)のエントリご紹介。今回は、Hume and Hall call out the Fed(2/2/2009)。日付にご注意ください。ところで日銀は超過準備に付利してますよね!   “たんすにしまわれたコインは消滅しているようなもの”ã€€ãƒ‡ã‚¤ãƒ“ッド・ヒューム-貨幣について[1]     […]

  5. Gravatar of Ray Lopez Ray Lopez
    11. April 2015 at 18:28

    Sumner (2009): “But why even think of paying interest on reserves?” – I guess nobody in 2009 thought of “Open Mouth (sic) Operations”? The Fed pays interest so that banks can repair their finances by making a little easy profit holding cash, and it is not being lent because there’s no demand. This is not complicated folks.

  6. Gravatar of Second Thoughts On Negative IORC4X Investments | C4X Investments Second Thoughts On Negative IORC4X Investments | C4X Investments
    12. April 2015 at 00:37

    […] very first blog post after the intro discussed negative IOR. I also published a couple short articles discussing the […]

Leave a Reply