On Lowering Interest on Reserves….

There’s been a lot of chatter in recent months about the Fed potentially “stimulating the economy” through a reduction in the rate paid on reserves.  The idea is generally related to the myth of the money multiplier and the false thinking that reducing the IOER will then entice banks to “lend out” their reserves.  The NY Fed has finally put this myth to bed.  Their conclusion – lowering the IOER won’t do much, if anything at all:

“What determines the size of the monetary base? As with any other institution’s balance sheet, the Fed’s dictates that its liabilities (plus capital) equal its assets. The Fed’s assets are predominantly Treasury and mortgage-backed securities, most of which have been acquired as part of the large-scale asset purchase programs. In other words, the size of the monetary base is determined by the amount of assets held by the Fed, which is decided by the Federal Open Market Committee as part of its monetary policy.

It’s now becoming clear where our story’s going. Because lowering the interest rate paid on reserves wouldn’t change the quantity of assets held by the Fed, it must not change the total size of the monetary base either. Moreover, lowering this interest rate to zero (or even slightly below zero) is unlikely to induce banks, firms, or households to start holding large quantities of currency. It follows, therefore, that lowering the interest rate paid on excess reserves will not have any meaningful effect on the quantity of balances banks hold on deposit at the Fed.”

It’s even more basic than that though.  Banks are not reserve constrained.  That is, they make loans and find reserves afterwards if necessary.  There is no process by which banks check their reserve balances before they make loans in order to ensure they’re meeting some mythical money multiplier constraint.  Paying interest on reserves doesn’t constrain the bank from making new loans.  Ie, it doesn’t reduce the efficacy of monetary policy working through credit channels.  Banking is a business of spreads and since the spread on a creditworthy customer’s loan will almost always yield a better return than the IOER there’s nothing in the payment of IOER stopping banks from making loans just because they earn IOER.

So why pay interest on reserves at all?  Well, following the Fed’s expansion in their balance sheet the Fed Funds Rate became increasingly difficult to target because of the downward pressure from the surge in reserves.  So the Fed pays interest on reserves to keep the rate controlled within its corridor of 0-0.25%.  But more importantly, the IOER exists in order to allow the Fed to raise rates in the case of higher inflation (without having to reduce the size of their balance sheet).  That is, the IOER serves as a de facto FFR.

The FAQ on all of this at the NY Fed is very helpful.

* Updated from the comments with regards to negative interest rates:

“Banks cannot get rid of reserves. As the NY Fed mentioned in the quote, only the Fed can control the amount of reserves. So charging banks a negative interest rate is a tax that likely just gets passed on to customers in other various ways. It has no impact on whether the banks use these reserves (which they don’t for lending).”

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • Jason

    Cullen, suppose hypothetically that the fed started charging a negative 5% interest on excess reserves, could you explain what would happen to the excess reserves? Where would they go? Obviously, I presume, the banks wouldn’t want to keep that money there since they would be losing money for no reason.

  • freemarketeer

    I’ve never thought about it in terms of excess reserves. Rather, like legislating credit card fees, if you reduce the revenue potential of existing business, a bank will have to find a way to compensate for that relative shortfall.

    Naturally, this is dependent on interest from reserves being a significant form of revenue to warrant any action. I’m no expert here, anyone care to weigh in?

  • http://www.pragcap.com Cullen Roche

    Banks cannot get rid of reserves. As the NY Fed mentioned in the quote, only the Fed can control the amount of reserves. So charging banks a negative interest rate is a tax that likely just gets passed on to customers in other various ways. It has no impact on whether the banks use these reserves (which they don’t for lending).

  • Jason

    The NY Fed said that if it charges a rate sufficiently below zero, banks would change reserve balances into currency, but since these reserves are excess of requirements, why wouldn’t they instead store it in a place that earns an interest?

    I’ve never seen anyone ever talk about lowering IOER in terms of increasing the monetary base, I have only ever seen it mentioned in terms of increasing velocity, so I think this stuff about the monetary base is a non sequitur.

  • http://www.conventionalwisdumb.com Conventional Wisdumb

    Cullen,

    This may be obvious to you but I am not following the logic of “That is, the IOER serves as a de facto FFR”. Could you expand a little on that?

    Is it because banks will pass along the “rate” increase on new and existing loans?

    What if the banks have no “pricing power”?

    Thanks.

  • http://www.pragcap.com Cullen Roche

    If the Fed raises the IOER it sets a floor on the overnight rate. As the NY fed says:

    “With the payment of interest on excess balances, market participants will have little incentive for arranging federal funds transactions at rates below the rate paid on excess. By helping set a floor on market rates in this way, payment of interest on excess balances will enhance the Desk’s ability to keep the federal funds rate around the target for the federal funds rate.”

    So raising IOER is like raising the FFR. Hope that helps.

  • http://bubblesandbusts.blogspot.com Joshua Wojnilower

    Good post here clearing up misconceptions about IOER. The Federal Reserve’s Marvin Goodfriend has an informative paper on the subject which explains how IOER allows the CB to control FFR without worrying about controlling the MB (http://bubblesandbusts.blogspot.com/2012/08/interest-on-reserves-regime-will-rule.html). Unless you expect the Fed to undertake massive reverse QE before it ultimately raises rates, you should expect IOER to remain with us for the foreseeable future.

    One other reason for IOER currently is that it offers a subsidy to the financial sector of approximately $3-4 billion per year.

  • http://coppolacomment.blogspot.co.uk Frances Coppola

    Recent experimentation with negative IOER by the Danish CB suggests that banks respond by raising interest rates to borrowers. This is not surprising, since the effect of charging banks to deposit funds at the central bank is to squeeze their margins. Negative IOER is in principle contractionary monetary policy, because as Cullen points out above it is a tax. If the response from banks is to maintain their spreads by raising interest rates to borrowers then it is also contractionary in practice, too. Which is surely the last thing the Fed wants.

    Denmark’s reason for imposing negative IOER is to deflect excess capital inflows from investors looking for a safe place for Euro-denominated funds, and enable it to maintain its ERM II peg. Denmark is experiencing inflationary pressure due to capital flight from the Eurozone, so contractionary monetary policy is exactly what they want. Their banks are wailing, of course, but the Danish CB isn’t exactly sympathetic.

  • Jason

    I found the comment by ‘Ron M’ on that page compelling:

    “Kind of misses the point. Changing IOER of course doesn’t affect the size of the money base; it would, however, change the quantity of lending done by banks and therefore transfer some of the excess reserves to required reserves. That is, after all, the whole point of increasing the money base (or it used to be) – not to increase the quantity of sterile bank reserves, but to increase the quantity of transactional money, which is the “M” in MV=PQ. Anyone who is still focusing on the money base, assuming the multiplier will remain constant, is missing the point.

    Put another way, lowering IOER may not affect the base, but it will surely affect the economic impact of the money base. If not, why not crank the rate UP a whole lot, instead, and help out those money funds?”

  • http://www.pragcap.com Cullen Roche

    Ron M doesn’t explain the transmission mechanism by which changing reserve balances changes the quantity of lending. He just says it will happen as if it is a fact. He seems to think the money multiplier is a reality, which is wrong.

  • Jason

    Perhaps. I think the main point is that lending can increase without increasing the monetary base, so just because the monetary base must remain unchanged doesn’t mean lending must also. So arguments focusing on the monetary base isn’t a compelling argument against the idea that banks might lend more. It’s not an argument for it either, but the article itself doesn’t seem to provide evidence against.

  • Dunce Cap Aficionado

    So is your criticism that the article does not address, directly, how it is not possible for changes in IOER to affect net lending done by banks?
    Cullen’s always been very clear that (hope I’m not putting words in his mouth, I don’t think I am) banks make as many loans as they can (so the amount of willing borrowers also comes into play) to borrowers they deem creditworthy, then go get any reserves that they need (as they are never constrained in this capacity). So I guess my question to you is, why does changing IOER change the amount banks will lend?

  • http://www.conventionalwisdumb.com Conventional Wisdumb

    Cullen,

    Thanks that is helpful. Do you think this would squeeze the banks’ interest rate spread?

    My thinking is that it would of course depend upon the demand for capital/loans more than anything else so I guess the scenario in which they raise rates in this way is a scenario in which the economy is a lot stronger and therefore longer term rates would be higher unless we get a strong whiff of inflation without commensurate growth.

    Raising the IOER would seem to be unlikely given the BSR so in theory this is still a bullish environment for income/bonds especially if they plan on REDUCING the rate.

  • http://www.pragcap.com Cullen Roche

    The whole point of this piece is to hammer home the point that changing the size of the base doesn’t change the amount of lending (either up or down).

  • http://www.pragcap.com Cullen Roche

    Right, that’s been my position. The time to get worried about your long bond position (in the long-term) is when the Fed starts hinting at a rate increase cycle. But yes, that would entail a much stronger economy than the one we’ve got.

  • Jason

    I’m not making an argument regarding whether IOER does or does not affect lending, I’m just saying the article doesn’t seem to kill the idea that loans, only that monetary base.

  • Johnny Evers

    Instead of the sleight of hand about Reserve rates and deficit spending and QE3, the Fed ought to just go ahead and send a check for $10k to every man, woman and child in the United States.
    If you believe the economy needs cash, that would put it out there the fastest.

  • SS

    The Fed can’t just print money into the economy. The fed increases the money supply by hoping banks will lend more. The Congress can increase private bank balances by not taxing them as much or by spending more.

  • SS

    Oops. That was for Johnny above.

  • Johnny Evers

    I’m cynical — I believe the Fed can do whatever it wants in a crisis.
    I’d also like to see some transperency here — if you buy into the idea that federal debt will be carried forever, then we are printing money. So why not do away with the fiction of paying down debt, which is what gets debt hawks all worked up.

  • Jason

    Errr, for some reason that comment didn’t come out right. It should say “kill the idea that less IOER equals more loans, only that less IOER equals more monetary base”

  • Dunce Cap Aficionado

    Ok, how does less IOeR equal more lending, what’s the transmission mechanism? The only argument that I’ve ever seen that it does, would be via the Money Multiplier, which is clearly not a viable transmission mechanism.

    So what’s the transmission mechanism? To kill the idea that IOeR won’t result in more bank loans, first you have to make a continuous chain of causality for it increase them. The only one I’ve seen is based on the idea that decreased IOeR creates increased MB which creates more loans and therefore Money Multipler is part of the transmission mechanism. We know this is false.

    What’s the transmission mechanism for decreased IOeR to affect bank lending postively that we’re missing? I like new ideas.

  • Jason

    Hi, literally I just said:

    “I’m not making an argument regarding whether IOER does or does not affect lending”

    When I say I’m not making an argument, I’m not making an argument.

    It’s like if someone says “the fact that Jeremy loves fish kills the idea that Jeremy loves chicken”, and then I said “no, it only kills the idea that Jeremy hates fish, it doesn’t kill the idea Jeremy loves chicken”, and then you said “but where is the evidence that Jeremy loves chicken?”, you saying that would totally miss the point.

    Incidentally, I have never in my entire life seen an argument revolving around decreased IOER creating increased MB, only that it increases velocity through an interest rate channel, while leaving the base constant.

  • http://www.pragcap.com Cullen Roche

    So how does decreasing IOER increase velocity?

  • http://bubblesandbusts.blogspot.com Joshua Wojnilower

    Here’s what I tried to post at the NY Fed page:

    The supply of loans is effectively unlimited at any interest rate, so changing the quantity of lending would require IOER to increase demand for loans. It could do this through slightly lower rates or altering expectations about future rates and asset prices, but those effects are likely small for 0.25%. There are also costs to this policy that probably outweigh those benefits.

  • http://www.pragcap.com Cullen Roche

    Nice. I agree Joshua. Thanks.

  • Jason

    Using a quick google search, one argument seems to be that if rates are sufficiently negative, any individual bank would want to move the money deposited at the fed and put it elsewhere, firs to federal funds market, which lower the rate to zero, then to treasuries, which would lower their rates, then perhaps corporate bonds, lowering their yield and so on. I am NOT saying this is true, I’m just saying that what is said in the article does not prevent this from happening because in sum it would not alter the size of the monetary base, so in order to argue against this happening you’d need an argument not present in the article. Again not saying such arguments don’t exist.

  • Dunce Cap Aficionado

    Sorry if I’m annoying you, not my intention.

    “And if done right, this signal would have a huge impact because lowering the IOER is tantamount to saying the Fed is going to permanently increase the monetary base.” David Beckwith

    http://macromarketmusings.blogspot.com/2012/07/lowering-ioer-is-not-so-scary.html

    I’m not trying to be arugmentative, it is however in my nature and I at times do not ineract as politely as I could. So again, I’m sorry for being frustrating.

    As long as there is a school of thought out there saying that decreased IOeR is defacto increased MB, then arguing against the transmission they purport to affect this is valid, at least in my opinion. I get the feeling we will agree to disagree on this. To me, if no one can accurately describe or observe a transmission mechanism then the idea was never born in the first place and so no one would try to kill it.

  • http://www.pragcap.com Cullen Roche

    Banks can’t “move the money” at the Fed. Banks don’t control the amount of reserve balances in aggregate….Sure, the marginal decline in rates might help some, but we’re talking peanuts at this point….

  • Jason

    You’re talking about aggregate, I’m talking about individual banks. An individual bank can do whatever it wants with reserves in excess of requirements, it just so happens that when a bank makes a transaction that money moves to a different bank which is then deposited at the federal reserve, leaving the total stock of reserves in aggregate unchanged. So banks in sum cannot decrease or increase reserves, but an individual bank can increase or decrease its own reserves.

  • flow5

    The authors correctly point out that the volume of excess reserve balances doesn’t delimit the aggregate volume of the commercial banking system’s assets or liabilities. Lowering the remuneration rate though does increase the circuit income & transactions velocity of money (by stopping & even reversing dis-intermediation within the non-banks & shadow banks).

    Dis-intermediation is where the non-banks shrink in size (an outflow of voluntary savings), but the size of the commercial banking system remains the same (& the CBs never loan out existing deposits, saved or otherwise). Voluntary savings impounded within the CB system are lost to investment, indeed to any type of expenditure (and are a leakage in National Income Accounting). In other words contrary to Lord Keynes, savings do not always equal investments.

    Lowering the remuneration rate may not increase the ratio of loans to securities. But lowering the remuneration rate will force the member banks to acquire “close substitutes” (if they are to maintain or increase their profitability). And if the banks acquire these securities from the non-bank public, the money stock will increase pari passu.

  • flow5

    “changing the size of the base doesn’t change the amount of lending (either up or down).”

    This statement is actually a myth (demonstratably so).

  • David Beckworth

    Dunce Cap Aficionado:

    Since you quote me, let me explain what I meant by that statement. I did not mean that the act itself of lowering the IOER would lead to an increase of the monetary base. Rather, it would send a signal that the existing increase in the monetary base would be permanent. My view, and others like Michael Woodford, is that most observers don’t expect this increase in the monetary base to be permanent, just like Japan’s original QE was not permanent. This belief is implicit in the long-run forecasts of inflation.

    If the exiting increase or some portion of it suddenly was expected to be permanent it would change the expected path of the price level (and by implication expected future nominal spending and income)and positively affect investment and spending decisions today.

    Note that this is not a money multiplier story. Rather, it has the expectation of higher future price level and nominal economic activity changing current behavior. That is, portfolios are rebalanced and the demand for credit increases in anticipation of this new future. It is not happening because banks are pushing more loans. (Banks may be more eager to make loans in this environment, but they too are responding to change in economic outlook.)

    I do think the authors of NY Fed piece ignore this potential expectations channel. With that said, I don’t think that the most likely form of an IOER cut–some incremental, limited cut–would make all that much difference. The reason being is there would need to be a huge change in the public and market’s outlook for the the above scenario to unfold. The Fed has been too timid and not likely to do something bold enough to slap the market out of its funk.

    By the way, I recommend taking a look at this post on the topic: http://synthenomics.blogspot.com/2012/08/interest-on-excess-reserves-illustrated.html

  • Dunce Cap Aficionado

    David- much appreciated taking your time clearing up my misconception. And thanks for the link.

  • http://www.pragcap.com Cullen Roche

    Of course. But I don’t see how this matters.

  • http://www.pragcap.com Cullen Roche

    Please demonstrate. Please try to avoid silly/unrealistic examples. And we live in a world of excess reserves so if you’re talking about the pre-2008 world then we probably agree….Which I presume is what you’re getting at.

  • http://www.pragcap.com Cullen Roche

    So we’re back to the old idea that changing a savings account for a checking account will have some grand economic effect….You claim so. The evidence is weak though.

  • http://www.pragcap.com Cullen Roche

    Yeah, David, thanks for the link. I’ll have to have a read and revisit. Best, Cullen.

  • jt26

    Couple comments:

    (1) “But more importantly, the IOER exists in order to allow the Fed to raise rates in the case of higher inflation (without having to reduce the size of their balance sheet). ”
    I’m a bit confused. Why does IOER/EFFR need to be >0 to allow the Fed to raise rates, is it technical? (I.e. if EFFR was -1% today and 1% tomorrow, why is that not as effective as from 0.25 to 2.25%?)

    (2) The debate on IOER (and especially the impact through the expectations channel) seems the same as the MR position that normal monetary policy as well as QE is not effective in the current BS recession. As Cullen says, you need some form of fiscal policy (true fiscal policy or monetary policy masquerading as fiscal policy).

  • Andrew P

    The current payment of 0.25% IOR is a bank bailout. It is risk-free cash to the banks, and barely covers the FDIC insurance rate. If the Fed lowered IOR to say -1%, the banks would want to dump any excess reserves like a hot potato. No bank would want any excess. They would lend the money to less creditworthy borrowers, put it into stocks, municipal bonds, whatever, just to stop losing money. They would also start charging negative interest rates to their depositors. It is the presence of IOR that prevents deposit rates from going negative.

    If banks charged negative interest rates, their customers would want to pull their money out and put it into bonds and money market funds. Is it any surprise that the SEC just tried to impose a regulation that would have effectively killed off the money market funds? The regulation (that would have trapped the money by preventing full withdrawals) was barely beaten back by 1 vote, and it will come back.

  • Jason
  • http://bubblesandbusts.blogspot.com Joshua Wojnilower

    I’ll be interested to see Cullen’s take on David and Yichuan’s posts, but here’s my take…

    While the reasoning is perfectly logical, I think both posts still presume existence of the money multiplier and that increasing the monetary base allows banks to extend more loans. In this manner, a permanent expansion of the monetary base will lead to nominally higher prices.

    The point I was trying to make above and have done many times previously, is that banks don’t lend reserves. Increases in the monetary base therefore don’t influence the supply of lending and only have an impact as much as it influences demand for loans. Although the Fed can control the monetary base, I would argue that it generally chooses to provide reserves in response to private bank lending (http://bubblesandbusts.blogspot.com/2012/08/markets-determine-interest-ratesuntil.html).

    Whether or not the monetary base expansion is temporary or permanent (I believe the latter), it will not alter the banks’ willingness to make loans.

  • http://bubblesandbusts.blogspot.com Joshua Wojnilower

    Responding to comment 1, IOER does not have to be positive if the Fed accepts a zero FF rate. The trouble arises when the Fed wants a positive FF rate because of the amount of excess reserves. If the Fed pays no IOER, than banks will try to rid themselves of individual excesses, driving the interbank FF rate down below the Fed’s target.

  • http://bubblesandbusts.blogspot.com Joshua Wojnilower

    As the NY Fed post shows, the banks can not rid themselves of excess reserves in the aggregate unless the public demands greater amounts of currency. Also, I’m not sure banks would charge negative rates on depositors because individuals would likely put cash under the mattress and deprive banks of the capital needed to make loans. A more likely outcome would appear to be banks charging higher rates on loans in order to preserve margins. In this sense, I think a negative IOER would actually hinder the extension of credit.

  • http://www.pragcap.com Cullen Roche

    David and Sumner (see here and here) are making a slightly different point. They’re saying it’s the portfolio rebalancing effect that will help drive the economy and NGDP. I’ve asked David what his exact thinking is there so hopefully he’ll respond.

  • http://bubblesandbusts.blogspot.com Joshua Wojnilower

    Thx for the clarification. I’m a bit more inclined to accept some rebalancing effect but will await a further response before making judgment.

    One aspect of Sumner’s claim which I don’t get is:
    “So what if the Fed increases the base, and we don’t want to hold any more money? What happens? The answer is that our attempt to get rid of this money causes a change in the macroeconomy (higher NGDP), which eventually causes us to want to hold on to the extra money created by the Fed.”
    I presume we refers to banks since the monetary base expansion alters bank balance sheets. My question is, if banks (we) know that it is impossible to get rid of this money, why do we attempt to do so? Doesn’t this infer that banks (we) will continue to act irrationally?

  • http://bubblesandbusts.blogspot.com Joshua Wojnilower

    Thanks for clarifying that point. I’m more inclined to accept some degree of rebalancing effect but will await further details before passing judgment.

    The aspect of Sumner’s post that through me off was the belief that we attempt to get rid of the excess money created by expansion of the monetary base. If I understand MR and the NY Fed post correctly, the “new” money is really just an asset swap with private banks and can only be removed from the system by the Fed. If that’s true, why would banks (or individuals) attempt to get rid of money they knowingly can’t? I could see how individually this might be true prior to IOER, but would that have altered a bank’s willingness to supply loans? Would that still hold in an IOER regime?

  • http://www.pragcap.com Cullen Roche

    I too will wait to hear from Beckworth on this. Regarding Sumner’s point – I am not even sure what he means precisely. Obviously, banks can’t “get rid” of reserves in the aggregate. The Fed’s portfolio rebalancing has the effect of eliminating some Tsy’s which causes other agents to drive up prices potentially which could be stimulative if it has a broad credit impact. But I am still missing the real transmission mechanism here that drives balance sheets to be materially changed….Hopefully David will provide some details.

  • http://www.pragcap.com Cullen Roche

    Here’s a quote from David on this:

    The ability of the Fed to influence total current dollar spending does not depend on banks creating more loans.  Rather, it depends on the Fed’s ability to change expectations so that the non-bank public rebalances their portfolios appropriately.  Recall that a nominal GDP level target means the Fed makes an unwavering commitment to buy up assets until some pre-crisis nominal GDP trend is hit.  As Nick Rowe notes, just the threat of the Fed doing this would cause the public to expect higher nominal spending growth and higher inflation.  This change in expectations, in turn, would cause investors to rebalance their portfolios away from liquid, lower-yielding assets (e.g. deposits, money market funds, and treasuries) toward higher-yielding assets (e.g. corprate bonds, stocks, and capital).  The shift into higher-yielding assets would directly affect nominal spending through purchases of capital assets and indirectly through the wealth effect and balance sheet channels.  The resulting increase in nominal spending would increase real economic activity, improve the economic outlook, and thus further reinforce the change in expectations.

  • Andrew P

    The public would demand greater amounts of currency if deposit rates were negative. But Gov’t regulations make having large amounts of currency extremely inconvenient. There is a $10K reporting requirement, and large amounts are seized by police at will on the grounds that it might possibly be for drug transactions. Deposit rates would have to be very very negative to overcome these regulatory hurdles and cause the public to put all their money in a home safe. If all banks were doing their best to dump excess reserves as fast as the deposits were flowing in, they wouldn’t be able to dump the reserves in aggregate (since recipients of the money would make deposits), but it would make money circulate faster.

  • jt26

    [Sorry if this got re-posted (web problems in the reply?) ...]

    @AndrewP/Joshua Wojnilower… Good point about the cash. Under negative IOER, for excess cash, I think the average person would pay off excess debt, and if they qualified, use a line of credit instead. For other Joe the Plumbers, the gov could introduce a new rule to not charge <0 IOER on FDIC insured balances although that could be an administrative nightmare.

    BTW, re:international banking, I'm wondering if this would force all dollars into international banks which I believe are exempt from Fed reserve requirements?

  • flow5

    “changing a savings account for a checking account will have some grand economic effect”

    That’s exactly how the credit crisis in 1966 was turned around. And the source of all time/savings deposits to the commercial banking system are demand deposits, directly via the currency route or thru the banks undivided profits account. And why should the banks pay for what they already own?

    As an FDIC fee is assessed on CB assets (including excess reserves) of US banks, but is not assessed on foreign-owned bank subsidiaries which operate in the US. This gives foreign-related US banks a 15-basis-point cost advantage over a US based banks. That explains why excess reserves held at foreign-related subsidiaries are disproportionately larger than those held by domestic banks. It also shows that lowering the remuneration rate (by lowering costs) will drive money to higher yielding assets.

  • http://market-thots.blogspot.sg/ kt

    i wrote a post on this back in july – http://market-thots.blogspot.sg/2012/07/central-bank-balance-sheets-in-focus.html

    yes the reserves are created unilateraly by the fed – it’s not a function of the banks not lending. there’s nothing stopping them from converting excess reserves to required reserves.

  • http://market-thots.blogspot.sg/ kt

    i wrote a post on this back in july – http://market-thots.blogspot.sg/2012/07/central-bank-balance-sheets-in-focus.html

    yes the reserves are created unilaterally by the fed – it’s not a function of the banks not lending. there’s nothing stopping them from converting excess reserves to required reserves.

  • Johnny Evers

    Why do we have the conventional wisdom that consumers need to borrow more money?
    How does that help the economy grow (past a short period)?
    That just moves future spending into the present, but how does it help future spending? If I buy an IPhone today with borrowed money and Apple expands it business, aren’t we right back in a worse spot next year when I have to pay down my loan and not only won’t be able to buy another IPhone but will have to reduce other spending.
    This seems like a failed paradim at work.
    Or, is this just an effort to drive up asset prices, so we can continue to spend the gains from our assets (except most Americans don’t have any assets).

  • Tom

    Because lowering the interest rate paid on reserves wouldn’t change the quantity of assets held by the Fed

    Where is the evidence for the claims? Where are the graphs on IOER compared to assets held?

    I flatly do not believe that a difference in interest rate will result in NO difference in reserves. And in the current deflationary / low velocity time we have now, 0 or even negative % (how can it be a tax? The Fed is “private”, isn’t it?) would certainly be an incentive for banks to do something else.
    Maybe not enough of an incentive to take out all excess reserves (beyond the minimum required), but some.

    Why is there no brief history of IOER rates and amounts?

  • Tom

    OK, so I looked a bit, at the Fed site, in 2008:
    http://www.federalreserve.gov/monetarypolicy/20081006a.htm

    Interest on Reserves
    The Financial Services Regulatory Relief Act of 2006 originally authorized the Federal Reserve to begin paying interest on balances held by or on behalf of depository institutions beginning October 1, 2011. The recently enacted Emergency Economic Stabilization Act of 2008 accelerated the effective date to October 1, 2008.

    IOER was needed before 2006 and the bubble pop. It is now counter productive — mostly a subsidy to big banks to guarantee that get no-risk interest so they don’t have to do the work of evaluating risk and loaning to risky entrepreneurs (who might offer some people jobs).

    Bah.

  • http://bubblesandbusts.blogspot.com Joshua Wojnilower

    Again, the logic makes sense but I have questions regarding the effectiveness on various levels. As the recent BoE report highlighted, most of the benefits accrue to the very wealthy. If an expectations based policy hurts the distribution of wealth, can it really be politically sustainable? Also, what about households and corporations that are heavily indebted already. If they further invert their balance sheets, doesn’t the overall economy become more fragile? Lastly, if money is largely shifted in stocks or commodities (non-productive assets), isn’t there a risk to vast mis-allocation of capital?

  • http://www.pragcap.com Cullen Roche

    I wish that sustainable economic growth was as easy as a wealth effect and pushing up stock prices. If it were that simple the govt would just buy stocks every time the economy began to dip. But stocks are nominal wealth. They are priced off of underlying assets in the real economy. Spending nominal wealth or relying on economic growth via nominal wealth is putting the cart before the horse. For instance, a company shouldn’t buy back stock to generate sustained growth. It should reinvest in its own cash flow generating business. To me, it’s just silly to think that these wealth effects result in sustained economic growth….

  • http://bubblesandbusts.blogspot.com Joshua Wojnilower

    Who would be buying the excess reserves? Unless banks paid others to take their reserves, isn’t it likely the market would be small and banks would be left with most of their current excess? Remember, paying -1% would cost the financial sector ~$14 billion/yr. Due to that expected loss banks may actually attempt to shore up capital by restricting credit and trying to sell assets. Broad money supply could actually contract and offset any increased circulation that occurs.

  • http://bubblesandbusts.blogspot.com Joshua Wojnilower

    Currently reserve ratios only apply to net transaction accounts (http://www.federalreserve.gov/monetarypolicy/reservereq.htm), so a large sum of dollars are not subject to those rules. Given the issues with using an international bank, I think the cost of depositing money in a US bank would have to be pretty high to create that shift.

  • http://bubblesandbusts.blogspot.com Joshua Wojnilower

    How would a bank convert the reserves? To my knowldge, the manner by which that would occur is if banks were able to attract enough deposits to increase their required amount. For the entire banking sector that would be equivalent to ~14 trillion in new deposits.

  • http://bubblesandbusts.blogspot.com Joshua Wojnilower

    Where would the change in reserves come from based on altering IOER? I agree with you that reducing the subsidy would create different incentives for banks, the question is how. It’s possible the banks would either raise fees or loan rates in order to offset declining margins, which would be counterproductive.

    As for the tax aspect, the Fed is “private” but all of its profits are transferred to the Treasury. Therefore if the Fed increases its earnings, it shows up as higher corporate tax revenue for the govt.

  • flow5

    It’s proprietary – but it has been affirmed by a phd in economics (VP) at the Fed & statistically ascertained by a phd in statistics.

  • flow5

    You’re a hypocrite. You pontificate that “loans create deposits”. So from the standpoint of the entire system, the CBs don’t loan out savings. When CBs grant loans to, or purchase securities from, the non-bank public, they acquire title to earning assets by initially, the creation of an equal volume of new money: (transaction accounts) – somewhere in the banking system. I.e., commercial bank deposits are the result of lending, not the other way around. Loans & deposits originate simultaneously.

    Since the source of time/savings deposits to the CB system are transaction accounts, directly via the currency route or thru the banks undivided profits accounts, why then should the CBs pay for something that they (as a system) already own? The lending capacity of the CB system is determined by monetary policy, not the savings practices of the public.

    As a consequence of the virtual stoppage in any net inflow of funds into the non-banks & shadow banks (because of the introduction of the payment of interest on the member bank’s excess reserve balances), the impact of the Fed’s new policy tool on the economy is decidedly negative. Monetary savings involve a prior cost of production to business and when the funds are not returned to the marketplace a depressing effect is exerted on the economy.

    The fact that the earning assets held by the commercial banks are approximately equal to their demand and time deposits liabilities is often cited to prove that demand and time deposits are actually being invested. It bears reiteration that no investment can take place unless money is turning over. The turnover of money involves the transfer in the ownership of demand deposits and this is the exclusive prerogative of the nonbank owners of these deposits.

    The earning assets held by the commercial banks are not therefore investment or even evidence of consumption. Their existence provides only presumptive evidence that investment (or consumption) has taken place; on the assumption that the recipients of the banks newly created demand deposits have transferred the ownership of these deposits to the producers of goods and services.

    In contrast to the commercial banks the earning assets held by the non-banks & shadow banks (the true financial intermediaries), are positive proof that expenditures have been made, that money “changed hands” – for it is impossible for the financial intermediaries to acquire earning assets without expending the money balances put at their disposal by savers, or acquired through the retention of earnings.

  • flow5

    The non-banks & shadow banks do not compete with the commercial banks. Money flowing thru the thrifts actually never leaves the CB

    The 5 1/2 percent increase in REG Q ceilings on December 6, 1965 (applicable only to the commercial banking system), is analogous (in the current period of historically low interest rates), to the .25% remuneration rate on excess reserves today (i.e., the remuneration rate @ .25% is higher than the daily Treasury yield curve 2 years out).

    The increase in REG Q ceilings in 1965 created a lack of mortgage funds in the housing industry (just like the collapse of the non-banks during the Great-Recession). Although this was the fifth in a series of rate increases promulgated by the Board and the FDIC beginning in January 1957, it was unique in that it was the first increase that permitted the commercial banks to pay higher rates on savings than savings and loans and the mutual savings banks could competitively meet.

    There is evidence that the Board’s primary objective in raising Regulation Q ceilings in December 1965 by a full percentage point was to “bail out” certain large New York city banks. These banks, beginning in 1961, stated issuing large denomination negotiable certificates of deposit (CD’s). This instrumentality has many of the marketability and liquidity qualities of Treasury bills. Its use enabled these large banks to draw funds out of banks all over the country and indeed the world. By late 1965 market interest rates had risen to levels that no longer made 4 ½ per cent CD’s attractive. Consequently as they matured they could not be replaced, the issuing banks had large outflows of funds and faced a liquidity crisis.

    Assuming under the circumstances an increase in ceilings was justified it should have been a selective increase confined to the large denomination negotiable CD. The Board contends it did not have this selective power. If this explanation is accepted then the Board should have insisted from the beginning that large banks as well as small banks follow the old fashioned practice of storing their liquidity. They should not have been permitted to attempt to buy their liquidity through an open market instrument. Essentially the negotiable CD is a device for buying liquidity. But it obviously cannot fulfill this function if the issuing banks do not have the option of raising the rates they pay to meet any market conditions that may prevail. In other words if the Board did not as it insisted have selective control powers over interest ceilings for the various types of CD’s issued by the banks,. It was, by allowing the banks to introduce the negotiable CD abdicating its Regulation Q power.

    As a consequence of the virtual stoppage in any net inflow of funds into the savings and loans, and the sharp decline in mutual savings bank deposits growth, the residential mortgage market collapsed. Mortgage money simply dried up, we had a “credit crunch.”

    Thoroughly alarmed by the deteriorating situation the Board (and the FDIC) reversed their earlier action and on July 20, 1966 made the first reduction in interest rate ceilings on time deposits since February 1, 1935. The maximum rates payable on multi-maturity, nonnegotiable CD’s were reduced from 5 ½ to 5 per cent on certificates maturing in 90 days or more, and from 5 ½ to 4 per cent for certificates maturing in less than 90 days. These are the “consumer type” CD’s issued by the banks that are most competitive with the share accounts and share certificates issued by the savings and loans and the savings deposits offered by the mutual savings banks.

    A second reduction in Regulation Q ceilings was effected on September 26, 1966 when the maximum rates payable on single maturity negotiable and nonnegotiable CD’s of less than $100,000 denomination were reduced from 5 ½ to 5 per cent.

    When the Federal Home Loan Bank Board (FHLBB) and the FDIC were given (September 1966) temporary emergency powers to fix dividend and interest rate ceilings for savings and loans and mutual saving banks they established ceilings which preserved to a small degree a rate differential advantageous to the intermediaries.

    The effects of restoring a rate differential in favor of the intermediaries is apparent in the reversal of the trends of the first seven months of 1966. Time deposits in commercial banks which had increased $10.1 billion in the first seven months and stood at a figure of $156.8 at the end of July grew by only $2.0 billion during the remainder of the year.

    Share accounts in savings and loan associations by contrast which stood at a figure of $110.9 billion at the end of July had $3.1 billion of their total 1966 growth of $3.6 billion during the last five months of the year.

    Mutual Savings banks were less affected but were able to post a gain of $1.5 billion in the last five months of 1966, compared with $1.1 in the preceding seven months; bringing total savings deposits in these institutions to $55.0 billion by the end of 1966.

    In summation, even by encouraging the flow of funds thru the thrifts, commercial bank credit expanded at an annual rate of approximately 6 per cent. This compared to an annually compounded rate of increase of approximately 7 per cent in the preceding ten years, and a rate of about 5 percent for the entire period since World War II. Concurrently, the supply of loan-funds increased, long-term interest rates decreased, commercial bank profits increased, & the housing industry gradually recovered — without the infusion of government credit & government guarantees.
    ———————-
    Similarily, the introduction of IOeRs today induces dis-intermediation (an outflow of funds), among the non-banks. Disintermediation is where the financial intermediaries (non-banks & shadow banks), shrink in size, but the size of the commercial banking system remains the same.

    Professional economists have no excuse for misinterpreting the savings investment process. They are paid to understand and interpret what is happening in the whole economy at any one time. For the commercial banking system, this requires constructing a balance sheet for the System, an income and expense statement for the System, and a simultaneous analysis of the flow of funds in the entire economy.

  • flow5

    The justification for the FSRR Act was: “These measures should help the banking sector attract liquid funds in competition with nonbank institutions and direct market investments by businesses”

    That should scare you because the non-banks don’t compete with the CBs.

    One of the FSRR’s provisons” “the Board–as authorized by the act–could consider reducing or even eliminating reserve requirements, thereby reducing a regulatory burden for all depository institutions”

    Not so. The only tool at the disposal of the monetary authority in a free capitalistic system through which the volume of money can be controlled is legal reserves.

  • flow5 is crazy

    awaiting your demonstration mr flow5