Should The Federal Reserve Be Paying Interest On Excess Reserves?

by: ColoradoWealthManagementFund


Interest on excess reserves initially had one primary purpose: to incentivize banks to reduce lending.

The arguments for using IOER when the economy is facing recession, possible deflation, and high credit risk premiums are weak at best.

By raising IOER, the Federal Reserve is paying banks not to perform their work.

If you were the Federal Reserve, what would you do? Would you pay IOER (Interest on Excess Reserves), and if so, how much would you pay? The question may seem strange on a few levels. On the most literal level, a person would not be the Federal Reserve. On the more theoretical level, it begs for discourse on the relevance of IOER as a monetary tool during a period where a recession and deflation are bigger risks than rapid expansion, excessive credit risks, or inflation.

Allow me to clarify. Readers should understand IOER is one part of IOR (Interest on Reserves). The other part of IOR is the interest paid on required reserves. Interest paid on required reserves is designed to compensate the bank for the opportunity cost of maintaining the required reserves. I am only addressing the interest on required reserves to emphasize that it is not part IOER, since the E refers to excess.

What Is The Point of IOER?

This is a very important question and it is one that can be difficult to answer. The answer is apparently so complex, the Federal Reserve Bank of New York struggled with it on their website. In a page explaining what they do, they indicate that IOER is useful as a way to discourage DIs (Depository Institutions) from lending at lower rates. When Chairwoman Janet Yellen testified to the Financial Services Committee, her answers appeared to indicate that the Federal Reserve needed to raise rates to encourage the banks to continue making short-term loans to the Federal Reserve so it could finance its huge balance sheet. The need for short-term loans to finance long-term assets has precisely nothing to do with controlling the rate of inflation or pursuing full employment, which are the only two mandates that were set out for the Federal Reserve.

If we accept the description from the Federal Reserve Bank of New York, then we are accepting that the point of raising IOER is to discourage reckless lending by an overeager banking system. Judging from the substantial widening of credit spreads and decline in equity prices, I'd say we are pretty far away from "reckless lending". The only area where lending appears to be reckless is when it comes to loans that allowed producers of precious metals and oil to expand production since those industries are facing potential waves of bankruptcies. At the time those loans were made, the companies would have scored substantially better on credit metrics, so I wouldn't want to go all in blaming the banks.

If the only purpose of raising IOER is to encourage banks to step back from the lending business, then we must question the absurdity of raising IOER in the current environment. We are facing recession and the sheer idea of encouraging higher rates and less lending should be openly scorned.

New Normal

The buzzword has been "normalization". The constant pitch is that we need to get back to "normalized" levels. It is time to cut through the buzz and address the merits (or lack thereof) of the idea.

What is normal for the rate on IOER? We should look back through our entire economic history as a country to determine the normal level. The Federal Reserve was established on December 23rd, 1913. That gives us a long history to determine the normal levels for the Federal Reserve to pay. However, it is worth noting that IOER may not have been around the entire time. If we check in with the Federal Reserve Bank of New York again, we'll find the following disclaimer applied to IOER:

"Under the Financial Services Regulatory Relief Act of 2006 (and the Emergency Economic Stabilization Act of 2008 which accelerated the effective date to October 1, 2008), the Board of Governors amended its Regulation D (Reserve Requirements of Depository Institutions) to direct the Federal Reserve Banks to pay interest on required reserve balances and on excess balances."

Perhaps it would be better to think of normalization in regards to the "federal funds rate", which is the rate the banks are paying each other for overnight loans. This rate is exceptionally low by historical standards. If the Federal Reserve wanted to increase this rate, they might consider selling off treasuries so the banks had an alternative higher yielding asset available for purchase. Otherwise, the banks have no incentive to pay each other higher rates for overnight loans.

A Better Alternative

What is the purpose of a bank? I believe the primary reason for a bank to exist is to match up savers with borrowers. The biggest challenge then should be determining which borrowers are worthy of loans and that is a task that requires substantial due diligence. When the banks are being paid IOER, they are being paid to hold on to cash. Since the IOER rate would be higher than the rates paid to consumers, the banks would effectively be paid to not work.

Do we really want a federal entity that pays banks to not work?

Rather than raising IOER in an attempt to create a new normal, I believe the Federal Reserve should look to gradually lighten the balance sheet and establish that IOER = 0%. The only time IOER needs to be above 0% is when the Federal Reserve is genuinely trying to slow the economy down. That shouldn't be right now. Trying to slow the economy down while heading towards a recession is absurd. The best argument I've heard is that the Federal Reserve needs to raise the rates so that they have the ability to lower them. That is the best argument, despite being terrible, because it is the only one that does not have to end with "disclosure: long the companies that would be paid not to work".

Normalization should refer to allowing the free markets to be the largest determining factor. The yield on the bonds should be based on what investors are willing to spend to acquire them. The concept of "normalization" as referring to the central bank paying interest on idle money should be laid to rest.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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