Central Banks Should Stop Paying Interest on Reserves
In
2008, the Federal Reserve began paying interest on reserve balances
held on deposit at the Fed. It took more than seven decades from the US
leaving the gold standard — in 1933 — for the fiat regime to do this and
thus revoke a cardinal element of the old gold-based monetary system:
the non-payment of any interest on base money.
The academic catalyst to this change came from Milton Friedman’s essay
“The Optimum Quantity of Money” where he argued that the opportunity
cost of paper money (any foregoing of interest compared to on
alternative money-like instruments such as savings deposits) should be
equal to its virtually-zero marginal cost of production. Opportunity
cost could indeed be brought down to zero if base money (bank reserves,
currency) in large part paid interest at the market rate. Under the gold
standard, the opportunity cost of holding base money largely in
metallic form (gold coin) was indeed typically significant. All forms of
base money paid no interest. And the stream of interest income foregone
in terms of present value was equal in principle to the marginal cost
of gold production (this was equal to the gold price).
Interest on Reserves are Important to Controlling Markets and Imposing Negative Rates
Friedman,
however, did not identify the catch-22 of his proposal. If the
officials of the fiat money regime indeed take steps to close the gap
between the marginal production cost and opportunity cost of base money,
with both at zero, then there can be no market mechanism free of
official intervention and manipulation for determining interest rates.
That
is what we are now finding out in the few years since central banks in
the US, Europe, and Japan started paying interest on reserves. (The ECB
was authorized to do this since its launch in 1999, while the Fed and
BoJ began following the 2008 financial crisis.) Central banks can now
bind the invisible hand operating in the interest rate market to an
extent almost unprecedented in peacetime. In some cases, central banks
have even deployed a negative interest rate “tool” which would have been
impossible under the prior status quo where base money paid no
interest.
How We Got Here
The signing into law of the
Financial Services Regulatory Relief Act in 2006 authorized the Federal
Reserve to begin paying interest on reserves held by depository
institutions beginning October 1, 2011. On the insistence of then Fed
Chief Bernanke, that date was brought forward to October 1, 2008 by the
Emergency Economic Stabilization Act. He was in the process of
dispensing huge loans to troubled financial institutions but wanted
nonetheless to keep interest rates at a positive level (one purpose here
was to protect the money market fund industry).
Accordingly, the
Federal Reserve Board amended its regulation D so that the interest rate
paid on required reserves and on excess reserves would be at levels
tied (according to distinct formulas at the start) to market rates. An
official communiqué explained that the new procedure would eliminate the
opportunity cost of holding required reserves (and thereby
“deregulate”) and help to establish a lower limit for the Federal Funds
rate, becoming thereby a useful tool of monetary policy.
This was
useful indeed from the viewpoint of rate manipulators: by setting the
rate on excess reserves the Fed could now determine the path of
short-term interest rates and strongly influence longer term rates
regardless of how the supply of monetary base was growing relative to
trend demand. By contrast, under the gold standard and the subsequent
first seven decades of the fiat money regime, interest rates in the
money market were determined by forces which brought demand for base
money into balance with the path of supply as set by gold mining
conditions or by central bank policy decision respectively. A rise in
rates meant that the public and the banks would economize on their
direct or indirect holdings of base money and conversely.
Back Before the Fed Paid Interest on Reserves
Yes,
under the fiat money system the central bank could effectively peg a
short-term rate and supply whatever amount of base money was needed to
underwrite that — but the consequential growth of supply in base money
was a variable which got wide attention and remained an ostensible
policy concern. Right up until the Greenspan era, the FOMC implemented
policy decisions by directing the New York Fed money desk to increase or
reduce the pace of reserve growth and changes in the Fed funds rate
occurred ostensibly to accomplish that purpose. This old method of
determining money market interest rates under a fiat regime — in which
banks’ need for reserves was minute given deposit insurance, a generous
lender of last resort, and too-big-to-fail — depended on the banking
industry enduring what was essentially a tax on its deposit business,
which was then magnified by fairly high legal reserve requirements.
Thus, it is not surprising that the original impetus to paying interest
on reserves, whether in the US or Europe, came from the banking lobby.
There was no such burden under the gold standard even though the yellow
metal earned no interest. Banks in honoring their pledge to deposit
clients that their funds were convertible into gold had to visibly hold
large amounts of the metal in their vaults or at hand in a reserve
center. Actual and potential demand for monetary base by the public is
more limited under a fiat money regime than under the gold standard as
bank notes are hardly such a distinct asset as gold coin from other
financial instruments.
More Problems with Friedmanite “Solutions”
Friedman,
when he advocated eliminating the opportunity cost of base money under a
fiat regime, hypothesized that this could occur under a long-run
declining trend of prices rather than by the payment of interest. The
real rate of return on base money could then be in line with the
equilibrium real interest rate. This proposal for perpetually declining
prices would also have been problematic, though. The interest rate would
fluctuate, and in boom times be well above the rate of price decline.
In any case, the rate of price decline would surely vary (sometimes into
positive territory) in a well-functioning economy even when the
long-run trend was constant (downward). The equilibrium real interest
rate would be below the rate of price decline sometimes (for example,
during business downturns), meaning that market rates even at zero would
be too high. That situation did not occur often under the gold standard
where prices were expected to be on a flat trend from a very long-run
perspective and move pro-cyclically (falling to a low-point in the
recession from which they were expected to rise in the subsequent
business expansion, meaning that real interest rates would then be
negative).
What Can Be Done?
So what is to be done to
escape the curse? A starting point in the US would be for Congress to
ban the payment of interest on bank reserves. And the US should use its
financial power with respect to the IMF to argue that Japan and Europe
act similarly within a spirit of G-7 coordination such as to combat
monetary instability. We have seen in recent years how rate manipulation
and negative rates are made possible by the payment of interest on
reserves, and are potent weapons of currency warfare. Yes, the ban in
the immediate would force the Federal Reserve to slim down its balance
sheet so that supply and demand for base money would balance at a low
positive level of interest rates. The Fed might have to swap its
holdings of long-maturity debt for T-bills at the Treasury window so as
to avoid any dislocation of the long-term interest rate market in
consequence. That, not the Yellen-Fischer “
rate lift off day and beyond,” is the road back to monetary normalcy.
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