Bernanke and Kohn defend interest on reserves

by on February 16, 2016 at 1:54 pm in Current Affairs, Economics, Uncategorized | Permalink

On the potential for a contractionary impact of IOR, they write:

This claim, made even by some good economists, is puzzling. Before December, the Fed paid banks one-quarter of one percent on their reserves. If the Fed had not paid interest, the return to reserves would have been zero. Accordingly, the only potential loans that would have been affected by the Fed’s payment of interest are those with risk-adjusted short-term returns between precisely zero and one-quarter percent—surely a tiny fraction of the total. In fact, over the last four years bank lending has increased at about a 5 percent annual pace (including around a 7 percent annual rate the past two years), with only residential mortgage lending lagging in the aftermath of the housing bust.

There is more here.  I cannot say I am convinced.  I would focus not on the interstices of lending, but rather on expansionary pressures from the banking system.  Without IOR, what do Fed models predict would have been the price level impact of those trillions of new reserves following 2008?  (Note that at some margin banks can just convert those new reserves into dividends, without any additional lending, if they are so satiated with trillions of unwanted liquidity. I’m not saying it would happen that way, but think of that as a limiting case.)  No, I’m not advocating hyperinflation, but less sterilization of those new reserves would have maintained aggregate demand at a higher level post-2008, boosting investment, output, and employment through a quite traditional channel, as advocated say by the market monetarists.

And note Bernanke and Kohn’s own argument, elsewhere in the post, that soaking up reserves by selling off the Fed’s portfolio may be impractical, disruptive, or too costly.  Let’s say that’s true.  By limiting its use of IOR, the Fed in essence would have made a more credible commitment that any increase in bank reserves is here to stay, rather than just sitting in a holding tank of sorts.  No?

Bernanke and Kohn also rebut the common charge that interest on reserves is a subsidy to banks.  They may be right, but they are arguing too hard for “it is not a subsidy at the current margin of further reserve extension,” and not sufficiently rebutting the possibility of an infra-marginal subsidy, initiated right after IOR.

So this is a very smart and well-argued post, as one would rationally expect, but I don’t quite think it lays one’s doubts to rest either.

1 Brian Donohue February 16, 2016 at 2:54 pm

That was good, interesting.

“The interest received by the Fed has thus far been much greater than the interest it has paid out. The difference between interest received by the Fed and the interest paid to banks—over $550 billion since 2009—is turned over to the US Treasury.”

As a taxpayer, I approve.

2 Willitts February 16, 2016 at 3:15 pm

You approve of the Fed paying interest on an asset with certainty and receiving interest from risky assets purchased with those loans?

When the Fed begins to sell its balance sheet, the IOR will be a 15 minute fire-rated door before the conflagration spreads. Economic growth will not be able to buoy fixed income assets as the Fed cycles through its junk.

Get a fixed rate mortgage now.

3 Heorogar February 16, 2016 at 3:43 pm

The purpose of the QE’s was to push down long-term rates.

We closed a 3.875%, 30 year fixed rate (purchase) home loan in August 2013. The other house only has a small-balance, amortizing prime rate HEL, which interest rose 0.25% last month.

4 Brian Donohue February 16, 2016 at 4:06 pm

I don’t think that’s right, other than 2011’s Operation Twist.

As an empirical matter, QE was associated with higher long-term interest rates, which have been moving mostly down since the 2013 taper.

5 Heorogar February 16, 2016 at 5:23 pm

I think I read in Bernanke’s book that the QE was intended to affect long-term rates. Maybe I’m wrong.

Aside from the Bernanke book, I would only guess at why. And, I’m not qualified for that.

6 Brian Donohue February 16, 2016 at 5:42 pm

@E Harding, No. Higher real real rates too (look at TIPS).

7 Brian Donohue February 16, 2016 at 6:59 pm

Good. Always happy to assist another’s misapprehension.

8 Brian Donohue February 16, 2016 at 4:04 pm

You sound like Krugman in 2003.

Sounds like you should load up on TIPs. Easy money.

9 Different T February 16, 2016 at 9:35 pm

When the Fed begins to sell its balance sheet, the IOR will be a 15 minute fire-rated door before the conflagration spreads.

Bernanke directly addressed your “concerns”:

“First, the Fed has already announced that, at some point, it will stop reinvesting the proceeds from maturing securities, thereby allowing its balance sheet to shrink to something approximating its pre-crisis size.”

10 Ray Lopez February 17, 2016 at 12:15 am

@Willitts – why must the Fed sell its junk paper ever? Just hold onto it.

11 Willitts February 16, 2016 at 3:09 pm

Then why do it?

12 mulp February 16, 2016 at 3:16 pm

Conservatives have argued for lower and lower labor costs to pump up profits on the theory that high profit drives greater consumption of gdp thus driving growth of gdp.

But lower labor costs means more and more individuals have less income to service debt or buy gdp, so the only way to use debt to increase gdp is to charge 35% to 500% interest rates to workers with too little income to service their debt used to fund their consumption.

On the other hand, to get the increasingly wealthy due to profits that are increasingly trapped in tax havens to borrow their own money, interest rates on their debt must be extremely low, but they use the debt to invest, because they already consume all they can.

However, those getting richer from high profits understand that building new capital assets will drive down asset prices, thus destroying wealth, and worse, building new productive assets will generate too much supply driving down prices and profits which will drive down asset prices destroying wealth.

The Fed has been pushing get string. The velocity of all forms of money have been falling as high and higher profits from monopoly and rent seeking have put money in the hands of people wealthy due to high profits and scarcity inflating asset prices. Increasing the profits paid to workers will destroy wealth, but that is the only way to increase gdp and thus the velocity of money.

But it’s a prisoner’s dilemma: if you pay out profits in labor costs, either as lower higher wages or to build more productive assets, all producers benefit with higher production and higher accumulated profits and thus higher wealth while your lower profits will destroy your wealth. Potentially you gain in the long run by taking lots of market share.

China, Bezos, Musk have focused on paying every penny of profit to workers to build more productive assets that they own and control giving them bigger shares of the market in hopes of reaching monopoly power.

Apple has taken the opposite approach, relying on government to give it monopoly power profits, accumulating money that is effectively removed from the economy, thus requiring the Fed to print money to keep the pool of money from shrinking.

Alphabet is the means of taking the monopoly power of Google (from a decade of spending profits on building productive assets) to generate profits and then paying labor to build new productive assets.

Which model is best for “the economy”? Apple has created the greatest wealth, but the least growth in consumer spending because that’s driven by labor costs which Apple has focused on cutting.

13 JWatts February 16, 2016 at 4:22 pm

“Conservatives have argued for lower and lower labor costs …”

No they haven’t. And that’s where I stopped reading.

14 msgkings February 16, 2016 at 5:36 pm

I stopped at “mu…”

15 LonelyLibertarian February 16, 2016 at 6:23 pm

Why does this idiot keep showing up on this site. A few days ago Tyler suggested that David Brooks had a reasonable read on Obama – then we get this garbage. Time for me to find a site with some sanity – this sucks…

16 msgkings February 16, 2016 at 6:49 pm

K, bye!

17 Stillman Brown February 16, 2016 at 8:46 pm

The world awaits your book, dude.

18 Matt February 16, 2016 at 3:24 pm

I disagree. 0% and 0.25% are just two slightly different interest rates paid on reserves: what economic theory can account for such a stark discontinuity as the rate goes above 0%? You ask what the Fed’s models would have predicted – and while I’m not an expert on the inner workings of the models, it is hard for me to see where that kind of discontinuity would arise, and I strongly doubt that one emerges from the models.

This isn’t just a theoretical point: it’s an empirical one too. Remember that Japan had excess reserves starting in 2001, but only introduced interest on reserves starting in 2008. If we’d expect some kind of massive expansionary pressure working through the banking system from excess reserves combined with 0% IOR, surely we’d have seen it during that interval, right? What about Japan today, with -0.1% IOR and massive excess reserves? Or all the other countries with negative IOR and massive excess reserves? Is some other force intervening in each of these cases and preventing the usual effect? Zero and negative IOR have been beneficial, but they haven’t unleashed any kind of previously dormant excess reserve-driven boom.

19 Heorogar February 16, 2016 at 3:36 pm

Prior to 2008, no interest was paid on Fed reserves.

I agree with Ben et al. If the banks had better use (could earn interest above 0.25% or 0.5%) for their excess reserves, they would invest/lend them elsewhere. If anything is affected it’s inter-bank, overnight lending or possibly commercial paper that suffers. The authors assert that lending is growing at 5% annually (way faster than GDP). So, interest on reserves doesn’t seem to be a heavy factor in holding back bank lending.

The Fed “dividend” payout rate to the UST is 97.7% of 2013 Fed “net income.” From the 2013 Fed annual statements, total assets were $2.4 trillion and capital was $17.7 billion resulting in 135-times leverage. Having the ability to create reserves, the Fed doesn’t need much capital . . .

I pulled up the Fed January 2014 press release for the CY 2013 payment to the Fed.

“The Federal Reserve Board on Friday announced preliminary unaudited results indicating that the Reserve Banks provided for payments of approximately $77.7 billion of their estimated 2013 net income to the U.S. Treasury. Under the Board’s policy, the residual earnings of each Federal Reserve Bank are distributed to the U.S. Treasury, after providing for the costs of operations, payment of dividends, and the amount necessary to equate surplus with capital paid-in.

“The Federal Reserve Banks’ 2013 estimated net income of $79.5 billion was derived primarily from $90.4 billion in interest income on securities acquired through open market operations (U.S. Treasury securities, federal agency and government-sponsored enterprise (GSE) mortgage-backed securities (MBS), and GSE debt securities). […] The Reserve Banks had interest expense of $5.2 billion on depository institutions’ reserve balances, and recorded losses of $1.3 billion that result from the daily revaluation of foreign currency denominated asset holdings at current exchange rates.”

20 Unanimous February 16, 2016 at 4:11 pm

Reserves are a bank asset that helps balance their balance sheets. They have counterbalancing liabilities and can not pay large reserves to shareholders without becoming insolvent.

Large reserves are a byproduct of central bank balance sheet expansion. While individual banks can engage in transactions that reduce their reserves, they have to do so by finding another bank to be the counter party to those transactions, and the net reserves of all banks is unaffected.

Interest paid or charged on reserves has second order effects only.

21 GT February 16, 2016 at 5:25 pm

Hi Tyler,

Please could you expand on what you mean by this:
“and not sufficiently rebutting the possibility of an infra-marginal subsidy, initiated right after IOR. ”

Many thanks.

22 Bill Conerly February 16, 2016 at 5:40 pm

Lots of mistakes.

On loans not made: remember that decision-making is at the margin. If loans are earning 3% and reserves (as well as fed funds) pay 0%, then the loan adds 3% income, which is balanced against risk and the cost of servicing the loan. If reserves pay 0.25%, then there is 2.75% to balance against risk and servicing. Every quarter point difference matters at least a little.

Growth of total loan volume tells us nothing, by itself, about whether more loans would have been made with 0% reserve payments.

Tyler, your comment about paying dividends is mistaken, as anonymous pointed out. Reserves are different from capital. Start a bank with $1 of capital. Take in $9 of deposits, but make no loans the first day. You now have $10 of reserves, but your capital is just $1. You could not dividend out $2 of reserves. You couldn’t even dividend out $1 and meet regulatory capital requirements.

Bottom line: bank have been as aggressive as regulators allowed them to be at originating new loans, as shown by the surveys of bank lending officers. The zero interest rate environment is very hard on banks, which used to earn 5% on fed funds, which covered the cost of “free checking” accounts. Now even at 0.25% or 0.50% it’s almost impossible to cover the cost of mailing paper statements to deposit account holders.

23 Different T February 16, 2016 at 9:32 pm

“Tyler, your comment about paying dividends is mistaken, as anonymous pointed out. Reserves are different from capital.”

Hugely important. Should be re-read again and again.

24 El Gabo Gringo February 16, 2016 at 9:58 pm

Please comment more often. Thanks.

25 Benjamin Cole February 16, 2016 at 7:37 pm

Good post by Tyler Cowen.

I think it is legitimate to look at the Federal Reserve as a regulatory agency, and to wonder if regulatory capture is going on.

I suspect the real thrust of QE was simply money printing and monetizing federal debt. It worked. The Fed never wanted to say so, and so instead focused public discussion on lowering interest rates.

Oddly enough, it is never discussed why the arrangement is that when the Fed buys bonds it must create reserves in the commercial bank accounts of the 22 primary dealers.

Why not the Fed has its own money desk? And buys Treasuries and simply retires the debt?

Or, the Fed could buy Treasuries and place them into the Social Security trust fund offsetting FICA tax cuts.

The current arrangement, that is the Fed creates reserves when it buys bonds, is not a law of physics. It is a fiction created by man.

26 Unanimous February 17, 2016 at 3:54 am

The Fed creating reserves when it buys bonds is a result of correct acounting, not a fiction. To do anything else iwould be a fiction.

27 Different T February 17, 2016 at 1:01 pm

To make this more clear; if a particular bank was feeling especially masochistic, they could take some of their excess reserves and purchase T-bills at a rate lower than the Fed pays on reserves. The corresponding reserve account of the T-bills seller would then have more sitting in the higher yielding reserve account. Correct?

Bernanke kind of addressed the issue in an unofficial way, so here’s an attempted re-phrase: “To carry out our mandate, we followed a path of purchasing large amounts of MBS and Treasuries. To finance this, the Fed credited bank reserve accounts. To partially offset the opportunity cost to banks, we have IOR.”

It’s usually helpful to remember the Fed’s mandate when looking at what they do.

28 Unanimous February 17, 2016 at 4:23 pm

Yes correct. And good summary of interest on reserves policy.

29 Jacob A. Geller February 17, 2016 at 12:46 am

Bernanke and Kohn don’t even seem to be arguing that IOR is not contractionary; their argument, at best, is that it’s not *that* contractionary.

30 TallDave February 17, 2016 at 9:57 am

Incentives matter.

31 George H. Blackford February 17, 2016 at 3:27 pm

I have never understood the rationale for IOR, and I have never been impressed with the arguments by banks that because reserves limit their ability to make money banks should not have to be limited by reserve requirements.

Reserve requirements are essential to providing stability to the system, and the cost of reserves are no different than any other cost of doing business. I don’t see any reason why the Fed should subsidize those costs any more than it should subsidize any other cost banks may face.

When it comes to the arguments with regard to increasing the effectiveness of monetary policy, I’m not impressed with them, but then I have never been in the trenches, as it were, so I really can’t go beyond the fact that they don’t make much sense to me.

I have never seen monetary policy as being all that effective when it comes to fine tuning except when it comes to short-term speculative behavior, and that, I would think, could be dealt with more effectively through a small transactions tax than with a monetary policy that included IOR

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