Why pay interest on excess reserves?
William Polley has a note on paying interest with links to Altig, DeLong, and others:
David Altig takes up the question with links back to Marginal Revolution, DeLong, as well as my post from yesterday. (Thanks, David!)
Rather than looking at it as what DeLong calls “Operation Twist”, Altig opts for the simpler explanation that it will put a lower bound on the effective fed funds rate. That is, of course, the fundamental effect that this would have in any circumstance–crisis or not. It puts the Fed in as the residual buyer of the funds and thus establishes the floor.
The apparent lack of a (non-zero) lower bound on the funds rate was first noticed over a year ago when there were trades happening at zero percent. Here’s what I said in August 2007:
So while I don’t have a full and definitive explanation [for the zero percent transactions], it would seem that borrower risk is a factor, and the fact that these are excess reserves (which earn no interest) is also a factor. In that case, the low end of the range could stay low until the reserve picture gets back to normal.
When the Fed began discussing it more seriously in May 2008, I said:
I’ll go on the record that this is a good idea. It will help to smooth out the recent fluctuations in the funds rate that garnered so much consternation at this blog among other places. It would prevent interest rate policy from getting in the way of policies for directly injecting liquidity into the financial markets by effectively keeping a floor on the funds rate even during a big injection of liquidity.
So I am clearly on board with the stated reasoning behind the move. Plus, I think it’s just a good policy to eliminate what is effectively a tax on reserves.
But I was struck by DeLong’s comment about open market operations on the risk premium rather than on the liquidity premium. The more this drags on and the more we learn, the more I am coming to the conclusion (see here, for example) that this is a problem with the risk premium. Why else would the CP market freeze up despite the massive injections of liquidity, not to mention the CDS market? There seems to be a lot of liquidity out there, but it’s not necessarily getting to where it needs to go.
And that got me wondering if paying interest on reserves might, as Tabarrok suggested, accomplish the goal of getting that liquidity where it needs to go in an Operation Twist sort of way. While the Fed is not yet targeting particular assets, we’re treading very close to the kind of environment where that might be necessary. (Have you seen a T-bill rate lately?) Having the ability to pay interest on reserves would not be counter to that purpose, even if it wasn’t the primary reason. Of course, it should also be noted that the paying of interest on reserves is a permanent change rather than a temporary one meant only for the crisis.
Paying interest on reserves is a good policy for a lot of reasons. The obvious ones and the ones that might still be a stretch–at least for now.