I want to thank all the commenters on my last post — at Angry Bear, at Asymptosis, and at Mike Norman’s blog. You’ve provided me with exactly the education I hoped to achieve. Here’s hoping others benefited similarly.
I asked: what would happen if the the Fed cut the interest rate on reserves from its current .25% to zero. I was not suggesting it should be done. I simply wanted to understand what would happen if that one variable changed.
I want to summarize the conclusions I’ve come to based on all the discussion.
This is me speaking, based on sifting and considering all the responses. I won’t link to all the excellent comments that brought me to this. (Though I do want to highlight the Angry Bear comment by Bad Tux beginning “At 0% IOR”. It arguably explains things better than I do here, and at significantly less length.)
First, the market monetarists responses. Scott Sumner said (in comments a while back on his blog, which I linked from my original post):
It could be slightly expansionary, or if accompanied by other moves, wildly expansionary.
I’m presuming he says “slightly expansionary” based on the theory Mark Thoma gives us in a November 17 post that Cameron was nice enough to link to on Angry Bear:
it would slightly lower the incentive for banks to hold cash rather than loaning it out, and more loans would help to spur the economy
So banks could lend a quarter point cheaper, or loosen their lending requirements slightly. Assuming there’s some decent amount of demand at lower rates (elasticity of demand is appreciably > 0), or that good borrowers are asking for loans but being turned down cause they’re too risky, this could have a small effect. Scott’s “other moves” presumably include NGDP level targeting by the Fed, but that’s all beyond the contained question I asked here.
James Oswald — who cites himself as a market monetarist but who seems to understand and adhere to much MMT thinking in his other comments and writings — said at Asymptosis:
There is no reason to think they [reserves] would not decrease back to the pre-IOR levels, at least over time, pushing around around 1.4 trillion dollars of high powered money into the economy and triggering significantly higher inflation.
This doesn’t seem to make any sense at all. (And I rather doubt that the Sumners and Beckworths of this world would agree with it.)
In (simplistic) theory, taking IOR nominally negative (the extreme case) would make banks want to instead hold physical currency, with its higher (zero) nominal return. Continuing the simplistic theory, that more-liquid money would be lent and spent more.
But:
1. There are significant costs and management headaches associated with holding currency — trucks, warehouses, security guards, all that rot.
2. It’s completely unclear why banks holding warehouses full of currency would have any incentive effects on borrowing and lending — hence real-economy purchases/velocity. Lenders and real-economy borrowers do their thing because they see valuable risk/return opportunities in the real economy. Changing the form of banks’ holdings will not affect that real-economy reality. Recent history: the QE trades — giving banks reserves in return for bonds — doesn’t seem to have had such an effect, if the massive runup in excess reserves is any testament.
3. Explaining #2: For banks, currency is (see #1) less liquid than reserves. They’re not carrying it in their pockets so they can buy gum at the corner store. They want to make loans; are they going to make them in cash?
4. Even if they did make the move to currency:
A) They couldn’t all do it; there’s not enough currency around.
B) The effect would be to reduce the amount of currency “in circulation” (it’s stuffed under banks’ mattresses), presumably prompting exactly the opposite of what market monetarists suggest:
a. Less real-economy spending/circulation/velocity and
b. Deflation — dollar bills would be harder to come by, so they’d be more valuable relative to real goods
At least in the discussions I’ve been perusing, this “currency” theory of “pushing” “more-liquid” money into circulation doesn’t make any sense. At all.
Market monetarists do seem to at least loosely and implicitly adhere to the (questionable) theory that people and businesses spend more because they hold money in more-liquid form — and they might even confute bank’s incentives and behavior with people’s incentives and behavior at times — but still this currency thinking is probably not a good or widely held market-monetarist theory. In any case it deserves unequivocal debunking.
So: Numerous cogent and convincing commenters agree that taking IOR to zero would have negligible first-order effects on lending and spending. And (invoking authority here) Mark Thoma agrees, in the post cited above:
It probably wouldn’t do much
But — considering the practical, workaday effects on the financial system such as those depicted in the currency fantasy above — Thoma links to an article by Todd Keister from the NY Fed. In short, IOR of zero would break a whole lot of financial entities’ business models. The gang at Mike Norman’s blog point to the problems already facing primary dealers, which could be (greatly?) exacerbated by a drop to zero. StreetEye on Angry Bear says that it would trash the main-street banking model. And etc. Various institutions would die or just withdraw their services/trades from the financial system.
The second- and third-order effects of such eventualities could have profound negative impacts on the real economy.
Which perhaps explains another thing I’ve been wondering about: why did the Fed institute IOR in the first place, and why did it do so when it did?
We can at least give the Fed credit for understanding the business models of various financial entities. When they saw interest rates heading toward zero, they instituted IOR to prevent the systemic lockup/breakdown described above.
IOW, nothing (much) to see here folks. Move along.
Sorry if I’m so dull that I had to go through all this to figure it out.
Make sense?
Cross-posted at Angry Bear.
Comments
18 responses to “Answers: Taking IOR to Zero”
I’m not sure if there was a true consensus among Market Monetarists as to the desirability of IOR. That could also be why Sumner’s response to you was a bit vague, in that I remember discussions on The Money Illusion whether IOR was actually of use. There’s still some mystery in the whole situation that I wish the Fed would further clarify.
@Becky Hargrove
The breakdown/lockup of financial entities’ business models as described in the NY Fed paper is a pretty satisfying explanation to me. You? Though yes, I wish that straightforward explanation had come from the top of the Fed.
I went back and read the NY Fed paper from Liberty Street…will have to remember their site because as a non-economist some of the Fed sites don’t help that much. Perhaps it would have been easier to learn monetary economics in times not so close to the zero bound!
@Becky Hargrove “Perhaps it would have been easier to learn monetary economics in times not so close to the zero bound!”
Yeah ain’t it so. I keep having to remind myself that stuff that seems kind of clear and obvious now might not be so in a few years.
Sorry for the delay in responding. I was busy all weekend, but I’ve responded here.
[…] here and here. Recently, I commented on Steve Roth’s post on interest on reserves. He then responded, and I would like to as […]
I didn’t realize other central banks were using IOR prior to 2008. You might find this post by Timothy Taylor (The Conversable Economist) interesting, from 1-13-2012: “New Fed Nominee Jeremy Stein, Rethinking Monetary Policy”
@Becky Hargrove
Great article, Becky. Thanks.
Lowering the remuneration rate to zero would revive short-term borrowing & lending in the money market including interbank lending. I.e, it would encourage the CBs to buy governments (“near perfect substitutes”). The CBs are only encumbered by Basel II bank capital adequacy ratios and eligible securities (not by credit worthy borrowers as commonly pontificated). It would match savings with investments in the non-banks thereby increasing the transactions velocity of money. It would be highly inflationary.
@flow5 “It would be highly inflationary.”
I think everybody involved in this discussion thinks otherwise. Have you read through the comments linked above? (Including James Oswald’s latest, linked three comments up here)?
I’m undeterred.
THE SAVINGS-INVESTMENT PROCESS OF THE COMMERCIAL BANKS CONTRASTED TO THAT OF FINANCIAL INTERMEDIARIES:
(A) The commercial banks create new money (in the form of demand deposits) when making loans to, or buying securities from the non-bank public; whereas lending by financial intermediaries simply activates existing money.
(B) Bank lending expands the volume of money & directly affects the velocity of money, while intermediary lending directly affects only the velocity.
(C) The lending capacity of the commercial banks is determined by monetary policy, not the savings practices of the public.
(D) The lending capacity of financial intermediaries is almost exclusively dependent on the volume of monetary savings placed at their disposal. The commercial banks, on the other hand, could continue to lend if the public should cease to save altogether.
(E) Financial intermediaries lend existing money which has been saved, and all of these savings originate outside the intermediaries; whereas the commercial banks lend no existing deposits or savings: they always, create new money in the lending & investing process.
(F) Whereas monetary savings received by financial intermediaries originate outside the intermediaries, monetary savings held in the commercial banks (time deposits & the saved portion of demand deposits) originate, with immaterial exceptions, within he commercial banking system. This is demand deposits constitute almost the exclusive net source of item deposits.
(G) The financial intermediaries can lend no more (and in practice they lend less) than the volume of savings placed at their disposal; whereas the commercial banks, as a system, can bank loans (if monetary policy permits & the opportunity is present ) which amount to several times the initial excess reserves held.
(H) Monetary savings are never transferred from the commercial banks to the intermediaries; rather are monetary savings always transferred through the intermediaries. The funds do not leave the banking system.
Dr. Leland James Pritchard, Ph.D, Chicago 1933, MS, Statistics Syracuse
There’s a 1966 precedent on the flow of funds:
The increase to 5 1/2 percent in REG Q ceilings on December 6, 1965 (applicable only to the commercial banking system), is analogous to the .25% remuneration rate on excess reserves today (i.e., IOeRs @ .25% is higher than the daily Treasury yield curve 2 years out – .25% on 1/6/2012).
The liquidity preference curve is a false doctrine. There is no liquidity trap. Lowering the remuneration rate will incent the banks to acquire assets other than by making loans in the private sector, i.e., they will invest in governments in the public sector. The FED cannot be “pushing on a string” otherwise neither accelerating inflation, nor even hyperinflation is a possibility.
@flow5 “The FED cannot be “pushing on a string†otherwise neither accelerating inflation, nor even hyperinflation is a possibility.”
?? All current indications suggest that given current economic conditions, it would take some extraordinary actions/events for either of those to arise any time soon. Far more extraordinary than a quarter-point drop in IORs, for instance.
This does not, of course, indicate that they could never arise in the future, under different conditions. But that other-condition possibility does not prove that we’re not currently pushing on a string.
@Flow5
Also: “nor even hyperinflation”? That wording suggests you think hyperinflation is *more* likely than accelerating inflation? Maybe just misworded?
@flow5 If you’re still around, I’m wondering if this passage is being attributed to/quoted from Pritchard here.
Also I really like your summation elsewhere:
“I.e., IOeRs cause a cessation of circuit income & the transactions velocity of funds. IOeRs absorb savings and reduce real-output.”
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