Question for Market Monetarists and MMTers: What Happens if IOR Goes to Zero?
For the non-cognoscenti: “IOR” is interest on reserves. Banks keep money in their accounts at the Fed. In October, 2008 the Fed started paying .25% interest on those accounts.
The Fed’s also engaged in “quantitative easing,” a.k.a. open-market purchases on steroids, creating new money and using it to buy $1.6 trillion dollars worth of bonds from banks. The money is deposited in banks’ reserve accounts.
The result: banks have $1.6 trillion dollars in excess reserves (in excess of what they’re required to hold) sitting in their accounts at the Fed.
This is the heart of the “pushing on a string” argument — giving the banks more reserves (making their holdings more “liquid”) doesn’t (necessarily) increase real-economy transaction volumes (on consumption or investment), either directly through spending by the banks or via bank loans to people and businesses who will spend it. This $1.6 trillion in new money issued by the Fed is effectively stuffed in an electronic mattress.
So I’m curious what would happen if the Fed no longer paid IOR.
I asked Scott Sumner this a while back:
if tomorrow the Fed dropped IOR to zero or even negative, what would happen to:
o Excess reserves
He gave a somewhat less than satisfactory answer:
The IOR question is a good one, and at the risk of being annoying I’m going to slightly dodge the question. I do think it would be expansionary, but it’s hard to know how much, because it’s almost inconceivable to me that it would be done by itself, without any other policy changes. It could be slightly expansionary, or if accompanied by other moves, wildly expansionary.
Less than satisfactory (for me) because he often engages in these kind of simplified thought experiments. Change Variable X, ceteris paribus: what would happen?
I’m basically asking for a free education here (hoping others would appreciate such an education as well), but I’m also hoping to spur a discussion on a tightly focused question that has not been cogently discussed, as far as I can find. (I certainly could have missed it. Pointers welcome.)
Cross-posted at Asymptosis.
Mark Thoma had something on this a while ago:
“It probably wouldn’t do much, but it would slightly lower the incentive for banks to hold cash rather than loaning it out” [this not considering the possible second- and third-order financial disruption effects discussed in the Fed article he quotes]
Seems to disagree strongly with James Oswald:
“There is no reason to think they 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.”
Oswald doesn’t enumerate what he means by “significantly.”
Main Street banking model would be broken, banks with excess reserves would have to start charging customers to take their deposits, shutting down branches, etc.
Normal monetary policy transmission is broken because of 1) the zero bound and 2) banks are not reserve-constrained, they are capital-constrained. Creating reserves has no impact on bank credit growth if reference rates are already zero, banks have plenty of reserves, and the banks and their customers are in deleveraging mode. Hello liquidity trap, bye-bye animal spirits.
So the Fed policy is to push zero rates out longer on the yield curve by promising to keep short rates low for an extended period, and up the credit curve by buying and making it easier to hold riskier instruments.
But while they do that, they don’t want to break banks’ business model of taking deposits. Plus, they’re not necessarily averse to a back-door bank bailout under cover of a technical policy tweak. Hence interest on reserves.
Like all actions, the effects of your action depends on how other people interpret it. They want to know what it *means*.
At one extreme, if this action is interpreted as a temporary mistake, just a slip of the pen that will be reversed tomorrow, it will have next to no effect.
At the other extreme, if this action is interpreted as a signal that the Fed will do whatever it takes to get NGDP up 5%, and growing thereafter at 5%, and that this is just the first step, then monetary Nirvana will immediately be upon us.
“What is the effect of Clint Eastwood’s hand moving 1″ towards his gun?”
Depends. Depends on how we interpret his action.
Back-of-the-envelope calc would be $1.4T becomes circulating again, ballparks to $3.5T (velocity = 2.5) increase in GDP.
I suspect–as I assume you and Thoma do, and as Nick Rowe suggests below–that this would be accompanied by some tightening. So NGDP rises, but probably not even by that whole amount. (If it did, we would basically have accomplished an NGDP rise of 5% p.a. since the beginning of the recession.)
My scenario has always been that IOR is idiocy; it’s a form of Extend and Pretend. A realistic scenario is that a lot of those “Excess Reserves” would be transferred onto Bank Balance Sheets as “assets” were marked more accurately. So Oswald is right in that banks would see their Excess Reserves return to “we’re managing properly” levels, but wrong in that the funds would go into circulation.
At 0% IOR: Nothing happens. The banks are keeping the money on deposit at the Fed for lack of any more productive use, they aren’t going to loan it out because there isn’t sufficient demand for loans by viable businesses and solvent consumers to loan it out (consumers and businesses are busy de-leveraging at the moment, i.e., paying off their credit cards and loans, they aren’t taking out new ones).
At -0.5% IOR: Nothing happens. This is the effective return rate on short-term U.S. Treasury bonds once you consider transaction fees and other overhead related to trading short-term Treasuries, so on a competitive basis there is no real alternative to keeping the money on reserve at the Fed given that there is nobody solvent to loan money to.
At -1% IOR: Mass outflight of money from the Federal Reserve, but the core issue of low consumption meaning there are no viable customers for bank loans remains. The withdrawn money would be used to either rent warehouses and armed guards for warehouses full of $100 bills (i.e. it’d still be cash reserves, just not cash reserves on deposit at the Fed) or would supplant investor money in the short-term Treasury market, and those investors would then either deposit their money in banks (i.e., we just “washed” the mattress money but it still ends back under a mattress at the Fed) or if banks are forced to pay negative interest on deposits, will instead withdraw their money and place it under mattresses as *literal* mattress money rather than the current *figurative* mattress money — i.e., all we’re doing is shuffling which mattress the money is under, but the money is still going to end up under a mattress somewhere.
Once you think about this in terms of, “what are banks going to do with the money if they withdraw it from the Federal Reserve?” and realize that they are not going to loan the money out in the current economic climate, you then realize that all you’re doing is removing money from under one (virtual) mattress and putting it under another (virtual or physical) mattress. So negative IOR isn’t going to solve the problem of poor economic conditions leading to a collapse in lending, it’s just going to result in plump mattresses *elsewhere* in the economy.
Oh wait, I forgot another possibility for investors, which is that instead of putting the money under mattresses, they instead buy and stockpile commodities with their money. This would have the net effect of increasing commodity prices and decreasing economic activity further, since stockpiled commodities are not available for use by the economy and the inflated price of commodities would not be matched by corresponding increased wages (since there is a shortage of commodities, not a shortage of workers to consume the commoditeis), meaning higher unemployment since spending on necessary commodities would supplant other spending in the economy. I.e., it’s oil shock stagflation deja vu all over again. And once they’re done purchasing the commodities, what will the producers do with their unexpected windfall? We have data on that: They’ll retain their unexpected windfall as cash reserves on deposit with a Federal Reserve bank (i.e., all we did was recycle the money *again* while hurting the economy in the process).
In short, I see nothing good that can happen by lowering IOR to below zero. Even simply reducing it back to zero could result in higher commodity prices due to commodities hoarding, and correspondingly lower economic activity elsewhere in the economy due to higher commodity prices supplanting other spending in the economy.
– Badtux the Economics Penguin
PS: Clearly I’m not a MMT’er. I think MMT might work under “normal” conditions but is silliness once you hit current economic conditions, because any MMT “solutions” just as with conventional monetarist solutions will just be creating inflated mattresses, not inflated circulating currency.
Would it be fair to summarize your comment as “at the ZIRB, Fed policy is impotent?” Or at least pretty darn weak. And if so, isn’t that a big part of the reason why the correct policy solution is in fiscal policy?
I wouldn’t say *completely* impotent, there are certain things that could be done via monetary policy that would improve general business conditions, I’ll just say that the most important thing — forcing freshly printed money to be used for activities that employ Americans (since the primary *job* of an economy is employment, not vice-versa) — is pretty dang hard to do without fiscal policy.
But *COULD* a helicopter drop work, if it were big enough? What if the Federal Reserve went big and dropped a check for $500,000 freshly printed dollars into the mailbox for every single household in America? Hmm. Interesting thought experiment there. Could it be that simply printing money *would* work, if you scatter-gunned sufficient amounts of it to enough people that you’d get it into the hands of sufficient people with a propensity to spend that you’d get the economy revving up again? I would have to think long and hard about that one, it may be that monetary policy *could* be effective, if the helicopter drops were big enough and direct enough to get it into the hands of sufficient people with pent-up propensity to spend. Note that this would be a quite *inefficient* way of doing things, since most of the people you’d be dropping money to aren’t going to spend it, they’re going to pay off any outstanding debts then save the remainder given the current expectations that the money will be more valuable to them in the future than it is in the present, i.e., deleveraging but not consuming… but on the other hand, deleveraging is sort of what we need right now to get everybody solvent enough that the system can start working properly. The 1% would hate it because it kills their rents, but for everybody else even if they didn’t spend it they’d benefit.
On the other hand, there would also be other side effects — side effects in interest rates, in producer prices, in all sorts of things. Sorting all that out will take some thinking on my part. I think the short-term answer is: It’d be very good for the 99%, and probably very bad for the 1%. That in and of itself is one reason why it might be good, and is the main reason it would never happen.
One thing I do think is clear, however: Sans helicopter drops of sufficient sums of money directly into the pockets of people with a propensity to spend, any amount of futzing around with interest rates or pushing money into money markets is not going to make a hill of beans difference to the economy, because you’re just re-arranging money under mattresses.
– Badtux the Helicopter-experimentin’ Penguin
the cost of holding reserves would be restored to it’s former level (before ior). bank’s net margins would be a tiny little bit thinner because (obviously) they will have just lose a source of interest income. banks would work harder to economize on reserves. the short term interest rate remains the same so no capital gain or loss is experienced because of this. This is a loss that hits bank balance sheets slightly which may mean they tighten lending standards slightly (because of the slight loss in retained earnings). Raising ior is a different story but luckily one we don’t have to talk about since it isn’t legal. i don’t think i missed anything.
IOR is negative in Sweden, right? 🙂
Repeating my question to James Oswald on Asymptosis (I might stop cross-posting these…)
“pushing around around 1.4 trillion dollars of high powered money into the economy”
1. Reserves *are* high-powered money. Increasing that quantity (massively) has had little effect, apparently.
2. How do banks “push” it into the economy?
Suppose the banks wanted to hold physical currency instead of reserves, because IOR is zero or negative. (At zero you’d think they’d prefer reserves; less costs to hold, and actually much more liquid.) They’d buy up vaults full of cash and sit on it, *draining* currency from circulation.
I can’t see how banks sitting on currency instead of reserves would increase anyone’s incentives to go buy things. (Ditto the next step up the liquidity ladder — reserves instead of bonds.)
StreetEye: “Main Street banking model would be broken”
I’m thinking this is the best answer, per the article Thoma links. The financial system would go schitzo, and there would be second- and third-order effects on the real economy. But the imagined first-order “quantity-of-money” effects would be, as he surmises, minimal.
If you have $10,000, do you spend more of it because it’s in your checking account instead of your savings account? (Especially when both are paying 0%; you don’t care where it sits *until you decide to spend it.*)
Excellent answer, IMO. How much “liquid money” *exists* (at least at the ZLB with depressed demand for loans?) is immaterial. As are the financial storage vehicles holding that money.
Again: you don’t spend *because* your money is in your checking account. You move money into your checking account (from your savings account, or by selling securities) because you’ve decided to spend it.
My understanding of the MMT answer is that the federal funds rate will fall towards zero as banks continually seek to shed excess reserves amongst themselves in the federal funds market, bidding the rate ever lower.
Hit post too soon.
In answer to the bullet points-
Excess reserves – are contingent on bank lending activity. Given the high level of excess and weak demand for credit, they would remain at around the same levels.
NGDP – Unless we’re to believe that a torrent of pent-up demand for credit is just a quarter point away, no effect.
Inflation – As above for NGDP.
Bottom line is pushing on a string describes the effect to a tee.
I might be missing something here. (Nothing new.) In the case of the banks, what if they can’t afford to “spend” it? It seems that under current conditions, IOR is the mechanisim that is holding the system together. Balance sheets are overstated as a result of the suspension of MTM rules. The books are not in balance. No?
Typical Sumner. Dodging the question. He simply has no idea how banks work so how can he commit to an answer? Read this comments thread, it is simply painful. He is taught basics of banking by some anonymous commenters.
MMT: if you drop IOR to zero you remove interest income from banks, so it is mildly contractionary. The Fed will see the interbank interest rate to drop to zero too, so if it wants anything higher, it has to undo QE and sell bonds. Reserves themselves are never lent out (Thoma is deeply wrong), because only banks have reserve accounts. Reserves vs bonds is simply how banks store their assets. When they want to make a loan they simply do, and then either borrow reserves, or convert some of their portfolio to reserves, end of story.
Hey I’m not proposing anything here. Just turning one dial (imaginatively) to see what would happen.
Hey Ron, here’s something I’ve wondered about, and since you’re here…
Let’s say Prairie Village Bank has capital of $50 million. They’ve lent out circa $500 million. I come to them and want to borrow $100 million against my very profitable, longstanding, and solid business, and I’m ready to give them a good percentage. What do they do?
They have reserves of $50M and loans of $500M so clearly they can’t loan out their reserves. Thus they’ll either sell some of their current loans to other banks or borrow reserves from other banks, depending on which one they believe will net them most margin. The end result is that for the banking system as a whole, in a good economy, the amount of reserves for pretty much every bank in the system ends up at pretty much the reserve requirement — the banks with excess reserves either loan them to other banks or buy loans from other banks with the excess reserves, they don’t keep them hanging around.
Of course, that assumes that banks trust each other enough to believe they’re not getting trash dumped on them by other banks. It’s normal that banks try to get rid of the weakest paper in their portfolio when selling part of their portfolio, but not normal that some of the loans in portfolios are probably worth less than half their face value if you look at the actual probability of them being actually repaid. So this, too, is one of those normal banking things that isn’t really working too well at the moment…
“Let’s say Prairie Village Bank has capital of $50 million. They’ve lent out circa $500 million. I come to them and want to borrow $100 million against my very profitable, longstanding, and solid business, and I’m ready to give them a good percentage. What do they do?”
You didn’t mention what their capital requirements are but let’s say it’s 9% so those numbers put them at their limit, with a total of $550 million in assets and $500 million in liabilities and a 9% capital ratio. (Since capital is assets – liabilities I state it in those terms)
First I write the loan, adding a $100 million asset (the loan) and a $100 million liability (the deposit) to my books. Now I’ve got $650 million in assets and $600 million in liabilities. Now my capital ratio has dropped to 8% and I need to raise new money so the FDIC doesn’t come along and shut me down.
I turn to the equity markets and issue $10 million in stock to raise the money which the markets are happy to provide because I run such a healthy bank and just got a great new customer.
After a successful issue, now I’ve got $660 million in assets and $600 million in liabilities and I’m back to the required 9%.
Reserves didn’t enter the discussion. Whatever additional reserves I need, if any, I top off from the fed funds market. Even if it weren’t awash in excess in the aftermath of QE as it is right now, the Fed will (and at all times in the past has) provide any reserves as needed. They must do to maintain a functioning system of payments.
Bad Tux, geerussell:
Thanks! Perfect. (I do appreciate a free education…) That’s roughly what I assumed (yes, including the 9%), but I’m such a bloody literal-minded fellow, I really need to have a concrete situation spelled out for me before I can understand.
Just to clarify for Steve, the Fed funds market is the mechanism that I mentioned above wherein reserves from banks with excess reserves end up at banks that have plenty of performing assets but need liquidity for new loans, and is also the reason why, Thoma states, the Fed is paying IOR — to keep the interest rate at which banks loan money to each other above zero (since they won’t loan money to each other at less than 0.25% since simply keeping it on reserve would be more profitablel to them).
Thing is, virtually every bank has excess capital on reserve (primarily to cover losses in their loan portfolio when they’re eventually required to MTM when they foreclose/write down the non-performing loans but also because of a shortage of good lending opportunities), plus banks aren’t lending anyhow, so the question of “why does the Fed care about the bank-to-bank funds rate?” is… interesting. I can’t answer it. Thoma attempts to, go read his article above if you’re interested.
Regarding issuing new equity in today’s market to raise capital for lending, not happening. The time frame required to comply with SEC requirements precludes it for one thing (assuming you want this loan done within the next six months — yes, it *can* take as long as six months to jump thorugh all the hoops to do a new issue), and for another thing, bank stocks are way below what their nominal asset values are due to the widespread notion that a significant number of those assets are non-performing, meaning that you (as member of board of directors) dilute your ownership by far more than the value of the new loan. I don’t see any bank board of directors signing off on any such thing in today’s market, though of course when banks are trading *above* asset values they could/would do such.