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

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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