Say It With Me Now: Interest On Reserves Isn't Sterilization!

by: Cullen Roche

Here's a very excellent Ben Bernanke blog post on interest on reserves. In one section, he trolls Joe Stiglitz a bit, who stated that banks might be sitting on reserves due to interest on reserves (something I also criticized in this post):

"This claim, made even by some good economists, is puzzling. Before December, the Fed paid banks one-quarter of one percent on their reserves. If the Fed had not paid interest, the return to reserves would have been zero. Accordingly, the only potential loans that would have been affected by the Fed's payment of interest are those with risk-adjusted short-term returns between precisely zero and one-quarter percent-surely a tiny fraction of the total. In fact, over the last four years bank lending has increased at about a 5 percent annual pace (including around a 7 percent annual rate the past two years), with only residential mortgage lending lagging in the aftermath of the housing bust. "

Here's Tyler Cowen saying that he's not convinced:

"Without IOR, what do Fed models predict would have been the price level impact of those trillions of new reserves following 2008? (Note that at some margin banks can just convert those new reserves into dividends, without any additional lending, if they are so satiated with trillions of unwanted liquidity. I'm not saying it would happen that way, but think of that as a limiting case.) No, I'm not advocating hyperinflation, but less sterilization of those new reserves would have maintained aggregate demand at a higher level post-2008, boosting investment, output, and employment through a quite traditional channel, as advocated say by the market monetarists."

Bernanke wins this fight with a 1st-round KO. What Tyler is implying is that these reserves would have somehow been inflationary had they not been suppressed by IOR. As if banks are sitting on this money earning interest because the Fed has incentivized them not to spend it or lend it out. Of course, as I've noted so many times, banks don't lend reserves to non-banks. But more importantly, let's look at the basic accounting of reserve increases between banks and the Fed as a result of QE:

Scenario 1 - Bank sells $100 in T-bonds to Fed¹

Federal Reserve balance sheet:

Change in Assets = +$100

Change in Liabilities = +$100

Change in Net Worth = $0

Bank's balance sheet:

Change in Assets = $0 (T-bond is swapped for reserves)

Change in Liabilities = $0

Change in Net Worth = $0

When QE is implemented, the bank has no greater ability to spend than it did before, because it swapped one liquid asset for another. The idea that interest on reserves is sterilization is Money Multiplier thinking. It's based on the false assumption that banks suddenly have more lending or purchasing power than they did before QE. Of course, since banks don't lend reserves to non-banks, the lending theory is wrong. And since the banks' net worth is the same as a result of the asset swap, there's no reason to think they might be able to spend more.

But there's more. If the Fed didn't pay IOR, then the private sector, in the aggregate, would have that much less income. Remember, the Fed has already removed about $100B per year in interest income because they hold the higher interest-bearing assets after the asset swap (T-Bonds versus reserves). So, this means the private sector as a whole has that much less income. If the Fed also didn't pay IOR, then the $7B or so in income that goes to the banks would also go to the Treasury, where it reduces the size of the deficit.²

Therefore, in the current environment, the aggregate income loss is just $93B ($100B-$7B), whereas in Tyler's alternative world where the Fed pays no interest on reserves, the aggregate loss is $100B. This would have been even more deflationary than it already is. In other words, Tyler's thinking that this is suppressing potential inflation is precisely backwards.


1. Understanding Quantitative Easing (2014, Moi)

2. The Fed pays its interest expenses out of revenues earned on its overall portfolio.