On the Fed's new authority to pay interest on reserves at the Fed - New silver bullet?

Economics Economics Questions
1

I remember hearing or reading Bernanke happily talking about the Fed’s new ability to pay interest on the reserves banks keep at the Fed. He said that European banks had been doing it successfully and now that they had been given that authority it would be another powerful tool in their arsenal to guide the economy.

Here’s a YouTube segment Hard Rain had posted in which Bernanke mentions it as a way they are planning on keeping the money supply under control:

http://www.youtube.com/watch?v=eZA0qNsf4m0&feature=player_embedded

Since the money on deposit at the Fed isn’t being loaned out, and in fact is not even counted as a part of the money supply, they can in effect pull money out of the economy pretty quickly and easily by raising the interest they will pay on those deposits. When they do, member banks would gladly put their money on deposit at the Fed and earn a risk free return, whenever it is near or above the going rate in the economy.

It allows them to drain money from the economy without having to sell Treasuries on the open market, which would drive interest rates up.

It costs them a little extra interest, but that’s no big deal. They can just change a few of the digits on their electronic accounts, and presto - they have their interest! I wonder if that interest is even counted as a part of the deficit since the Treasury probably doesn’t even have to be involved. No new bonds need be issued.

It sounds to me as if he thinks they have their new silver bullet to fix all of those debt problems, at least for awhile. When Treasuries aren’t selling too well, they can pick up the slack by having others purchase them for them:

The Fed Already Buys Back Last Week’s Treasury Notes

How The Federal Reserve Is Monetizing Debt

That, of course, may throw too much fuel (money) on the fire so they can soak some if it back up relatively painlessly by having member banks just keep it on deposit rather than letting it float around in the econmy.

I can’t imagine that this game can be played to infinity, however, without it causing some major ramifications somewhere along the line.

What is the weak spot in this game plan? What are the adverse consequences? Where may it blow up?

2

What is the weak spot in this game plan?

game plan? is it true or not?

3

The way that the Federal Reserve contracts money is by selling securities on the open market (technically, the ones they originally bought). The problem is that contraction is more difficult than expansion. So, what we have now is banks sitting on their reserves making income (negative interest rates does not mean that the Federal Reserve physically pays banks to hold money; it means that the Federal Reserve loses on its investment [rate of interest adjusted for rate of inflation]). Let’s say that the Federal Reserve raises interest rates. This doesn’t physically pull money out of circulation. What it does is that it usually freezes lending, because it raises the costs of capital, so less people are willing to take out loans. This is not a contractionary policy. The problem is that if money stops increasing in volume at an exponential rate then the malinvestments of the boom begin to show, as the true cost of capital-goods relative to consumer-goods becomes apparent; this is what causes credit contraction.

4

Yeah, that’s the way they’ve historically done it, but now they have a new tool. Here’s an article I just found in the Wall Street Journal, by none other than Ben Bernanke himself:

The Fed’s Exit Strategy
By BEN BERNANKE
http://online.wsj.com/article/SB10001424052970203946904574300050657897992.html

…When the time comes to tighten monetary policy, we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy.
…
Even if our balance sheet stays large for a while**, we have two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves.** We could use either of these approaches alone; however, to ensure effectiveness, we likely would use both in combination.

Congress granted us authority last fall to pay interest on balances held by banks at the Fed. Currently, we pay banks an interest rate of 0.25%. When the time comes to tighten policy, we can raise the rate paid on reserve balances as we increase our target for the federal funds rate.

Banks generally will not lend funds in the money market at an interest rate lower than the rate they can earn risk-free at the Federal Reserve. Moreover, they should compete to borrow any funds that are offered in private markets at rates below the interest rate on reserve balances because, by so doing, they can earn a spread without risk.

Thus the interest rate that the Fed pays should tend to put a floor under short-term market rates, including our policy target, the federal-funds rate. Raising the rate paid on reserve balances also discourages excessive growth in money or credit, because banks will not want to lend out their reserves at rates below what they can earn at the Fed.

Considerable international experience suggests that paying interest on reserves effectively manages short-term market rates. …
…the problem can be addressed by supplementing payment of interest on reserves with steps to reduce reserves and drain excess liquidity from markets—the second means of tightening monetary policy. Here are four options for doing this.

First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Second, the Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline.

The Treasury has been conducting such operations since last fall under its Supplementary Financing Program. Although the Treasury’s operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury.

Third, using the authority Congress gave us to pay interest on banks’ balances at the Fed, we can offer term deposits to banks—analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market.

Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.

Each of these policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.
—Mr. Bernanke is chairman of the Federal Reserve.

5

A note on my first comment. When I said that “raising interest rates does is not contractionary per sé” I was wrong. I was reading before going to sleep, and it hit me that I needed to correct this error. However, I think it holds that the majority of the credit contraction comes during the necessary liquidation, not when the Federal Reserve takes money out of the economy by selling securities on the open market (thus, increasing interest rates).

In any case, the new Federal Reserve policy seems counter intuitive. I have to go to sleep, but some immediate thoughts:

  1. It may be, in fact, true that banks will not lend money out because it’s more worthwhile to receive money from the Federal Reserve. But, the Federal Reserve will have to consistently expand the volume of money by paying that interest.
  2. If lending is curtailed, then how does productivity increase? It seems to me that the Federal Reserve’s actions would simply stall economic progress, and so although it may not be as inflationary as a fractional-reserve banking working at “full steam”, it just seems to replace that with a slightly less inflationary system which promises to provide a disincentive for capital accumulation (what’s the point; why would banks pay you a high enough interest rate for your savings, if they already have plenty of money substitutes masquerading as savings?) and investment.
  3. When they eliminate this policy, and return to a standard policy of having banks pay interest for money borrowed, how will the Fed cope with the increase in the volume of loans? It seems to me what they’re doing is building massive reserves, just ready to be lent out, that when it becomes profitable to do so will cause massive inflation.

These are just rudimentary thoughts, as I don’t have time to really think about it, but I think they are legitimate concerns.

6

As the demand for credit rises, and as the market seems increasingly stable (seems is a key word) the FED will have to pay higher and higher interest rates in order to prevent lending. This means that the FED must continuously increase the money supply in order to prevent the disaster they’ve created, to the point where the interest the FED pays rises to an enormous level. Paying interest on reserves does not make them go away.

Also, credit is pretty important for the economy. This new “monetary tool” will only perpetuate this crises.

7

thinking short term, as the Fed. usually doesn’t think of secondary, long term consequences (the excuse I usually hear is ‘we’ll deal with that when it happens’ type argument) - wouldn’t this mean that the Fed. is saving/bailing out banks. The banks that have gone bankrupt in the U.S. is over one hundred now seen on what is called Bank Fail Friday, the total keeps increasing each week. So this effort to keep reserves in banks (1) sustains more banks from going bankrupt at least in the short term; (2) makes it easier to shift reserves around from one bank to another as one bank may accumulate more reserves via this plan than other banks thereby increasing the effect of the FDIC.

those are my little thoughts on this

8

I don’t think they really want to prevent lending, but rather control the amount to tweak the economy as they see fit. If they want to goose the a little they can continue to inflate the money supply and encourage a little more of that money sitting in reserves to be lent out to individuals and businesses. If they think things are heating up a bit too much and inflation is a fear, they can raise the interest they pay and pull a little more of that money back into their reserves to slow things down some. At least that sounds to me like what Bernanke is envisioning here.

Well they’ve been inflating the money supply for quite awhile now. But I think the big problem now is that they’re at the point that they they were losing control of the ability to create the money they “needed” to help the Treasury by buying some of those Treasuries. If they didn’t do so, the interest rates would go far too high and make the economy that much worse. But if they “printed” sufficient amounts of money to buy enough Treasuries that were being auctioned off to finance that $1.6 trillion deficit and $12+ trillion debt, it would flood the economy with money causing hyper-inflation.

So it looks to me as if they “printed” the money and then printed a little more to pay interest to the member banks to keep “just the right amount” of money on deposit at the Fed to keep it from sloshing around the economy causing inflation or hyper-inflation.

Sure it is, but the trick they’re trying to pull off is to tweak the interest rates they are paying to keep the credit at the level that it will help them hit their targets. They are trying to get “full employment” which is probably around 4% while simultaneously keeping inflation rates low - probably around 2% or 3% as measured by their “official cpi”.

That’s what I’m thinking too, but I’m not quite sure where that pressure will blow out.

9

That is true, but the Fed doesn’t seem to have any qualms about expanding the volume of money and it doesn’t really cost them anything.

It seems to me that they still want lending, they just want another tool to be able to reign it in when they want to. ie. if price increases are starting to ripple through the economy and everyone is wailing about the inflation rate. - actually, they’d like to curtail it before that point if they could. But the traditional way of doing that , selling securities on the open market, causes interest rates to go up and that causes a lot of problems in other areas. Right now, with so many mortgage companies and banks on the ropes they apparently like the option of being able to sop up some of that money without necessarily raising interest rates, or at least not as much.

Currently interest rates for savings are near zero. But the Fed can actually set a floor under interest rates if they like. If they, for instance, raised the interest they paid on the reserves on deposit with them to say 2%, the banks could offer to pay you 1.5% and then deposit it at the Fed for a 1/2% risk free profit. If that induced enough people to save their money rather than spend it, that money would be taken out of circulation. If they hit their target for the money supply, or inflation or interest rates or unemployment or some combination of the above they could then sit tight. If it wasn’t enough, they could raise the interest rates they pay a little more, or if it was too much, they could lower the rates a bit again.

I think they are planning on using this tool as a means to manipulate how much will be loaned out and how much will be kept in their vaults and out of the economy at large. If they want money to flow out as loans to goose the economy a little, they can lower the interest they pay the banks and that will make the interest on the loans they could make in the “real world” relatively more attractive. If they want to slow the economy down a little, they can raise the interest rates and pull some of that money back into their coffers to cool things off.

It seems to me that the big problem they are facing and that will probably overwhelm this system is the monstrous debt and deficit that needs to be financed. There is some $2 trillion dollars that will need to be refinanced this year alone and other countries are already squawking about how treacherous investing in the dollar appears. Some have already held talks about finding a different reserve currency, and others are beginning to put a little more of their reserves into gold rather than the dollar. As the sheer number of Treasuries comes on sale as the rest of the world balks at buying them, that means the Fed is going to have to continue picking up the slack by monetizing the debt. That, of course, floods the economy with hundreds of billions of additional dollars and is a recipe for inflation, or hyper inflation.

I think they’ll monetize the debt and then try to use this new method of soaking some or all of it back up. I suppose time will tell how well that will work, but I’m guessing that other problems will begin popping up causing the whole thing to collapse, though perhaps later than would otherwise have been the case.

10

That wasn’t the point behind what I said.

When they raise interest rates it curbs lending. What it seems now is that either:

  1. The Federal Reserve is making up ways of restricting the growth of money to assuage inflation fears.
  2. The Federal Reserve cannot sell those securities for the price they bought them at.

If you re-read the parts you bolded it’s clear that by paying more interest on what they lend (i.e. negative interest rates) they curb lending. That’s the entire point, and so my argument still holds. If banks make more money by sitting on their reserves than by lending it, then banks won’t lend the money.

We are talking about the article you posted, not anything else. Re: what I wrote above.

Exact calculation, as you propose it, is impossible. They are either looking to restrict lending or they are looking to push lending.

But, this is exactly the same thing that would occur if they had “positive interest rates” (i.e. banks pay them interest for money held at in the Federal Reserve’s books) and they lowered or increased them. By lower interest rates they inspire lending, because entrepreneurs can borrow capital at lower prices, while if they increase interest rates they curb lending. So, let’s look at this new “policy” within this perspective. You will immediately notice that the measure is inane and does not actually accomplish anything they couldn’t do before.

The only thing it seems to do is continue monetary expansion (both, money creation to keep interest rates low and money having to be created to pay said interest), and at the same time slow economic progress.

11

“It sounds to me as if he thinks they have their new silver bullet to fix all of those debt problems,”

Exactly. Its just another manifestation of the “we can control the economy” fantasy mentality, so beloved of the “scientific” mindset. Their new play toy, thats all.

Of course it won’t work in the way its intended, but as to when and how the market readjusts/self corrects to overcome the rampant stupidity of these fantasists, that is anyones guess.

Given that as long as government, and central banking exists this behavior must/will continue, as I see it, the most important question for the individual is :" how can I protect my hard-earned wealth from these [and other] meddlers"?