Why IOER, oh why IOER, oh why IOER, did I ever do IOER?

A James Alexander post

(With apologies to Leonard Bernstein

Why would you deliberately set out on a path to a goal only to deliberately tie a rope to the start point and tie yourself to the rope?

The Interest on Excess Reserves (IOER) question is a bit like that. Frances Coppola expresses the smart view on the issue here, but it is all a fuss about nothing.

Looking at JP Morgan’s (JPM) balance sheet (from the 10K, p .314) for 2014 you see an average balance of “Deposits with Banks” of US deposits of $328 billion. It earns 25 basis points of interest (0.25%), or $825 million. All the $328 billion is with the Fed.

The question is, what would happen if that 25 basis points of Interest on Excess Reserves went to zero?

For a start JPM would lose $825 million of gross interest income. Not a huge deal for JPM given its $44,619 million of of gross interest income less gross interest expense, ie net interest income.The IOER thus represents just 2% of the total earned on the spread between its balance sheets assets and liabilities. It would lose just 3% of JP Morgan’s $30,000 million pre-tax profit in 2014.

So why does the Fed bother to pay it?

Apparently, the reason is that without paying IOER the Fed would “lose control” of market interest rates. When it set the effective funds rate at 15 basis points it wants it to stick, fair enough, as far as it goes. But if they are also doing massive QE then there will also be a lot of extra liquidity, especially at first. This excess money has to come back to the Fed as excess reserves, sure, all the new cash has to end up back with the banks. And if the Fed didn’t pay the 25 basis points as a minimum then, quel horreur, the excess cash in the system would be expected to force market rates below 15 basis points and the Fed’s rates structure would therefore be unsustainable.

What the sophisticates don’t spot is that this situation proves that the Fed’s rate is the wrong rate. The market rate should be allowed to go much lower if it wanted. The standout feature for Fed interest rates over the last twenty years is the Zero Lower Bound, and its artificiality.

JA_FFT-IOER

So why doesn’t the Fed let QE do it’s work quickly, lowering market rates to wherever they settle, getting out of the way and letting the new cash work its “hot potato” magic?

Well, it doesn’t like the market running things. The Fed knows best and 15 basis points of effective rates is the right level. Official.

Isn’t QE being self-defeated, or at least seriously self-limited, by the Fed itself preventing the free market from working? Yes, broadly. It’s a deeply interventionist, anti-market approach by the Fed. All it’s so-called extra liquidity is mopped by the Fed itself. Sterilised. Wasted.

We’ll never know what might have happened if the Fed hadn’t started paying IOER at the start of the crisis. It sure wasn’t smart if they were trying to reflate the economy. The Fed needed to credibly persuade the markets that it wanted to inflate, but the message was that it didn’t want to do it that badly, hence the floor on market rates. And we had the slowest recovery on record.

There may also be a fear of what market-determined rates in a QE environment might do to bank and customer behaviour. But is this right?

In 2014 JPM’s 10K also shows it held an average of $372 billion of interest free deposits in the US on which it cannot easily charge negative rates, though it could. It had in the US $625 billion of interest-bearing deposits earning the depositors an average of just 13 basis points. It could go to zero on these, or even negative also.

In Europe, a number of countries have moved to negative deposit rates without huge problems. There may be a limit before depositors start hoard cash rather than seeing their bank deposits fall in nominal value via negative interest rate deductions. Andy Haldane recently proposed abolishing cash altogether as one way around this problem. That really would be another wonderful victory for interventionism, following one freedom-limiting policy with another.

The one benefit that even sterilised QE might have had was to bring down longer term interest rates as it bought longer term bonds, especially mortgage backed securities. Even here it was going about its work in a self-defeating way as a successful reflation would have added upward pressure on longer term bond yields.

Fortunately the Fed also adopted forward guidance and said it won’t raise rates until various triggers have been met, or until some constantly moving point of time in the future is reached. This forward guidance has arguably underwritten the economy and allowed the steady, but unspectacular recovery.

Unfortunately, the inflation target of 2% has morphed into a ceiling and become a cap on recovery, and is becoming a trap, especially as the Fed’s definition of full employment has been met several times now. It has got around this problem until recently by continually moving the target down.

Ultimately, the question of what would JPM do if it got zero IOER is not that interesting. Although on balance it would probably seek a higher return from other securities, driving their prices up and their yields down. It might seek to lower the interest paid on interest-bearing deposits. On balance, some of those depositors might seek alternative places to earn a return. However, it is not obvious that either JPM or its lowly-rewarded interest earning depositors would be that minded to move their money elsewhere while the Fed is so clear in having a 2% inflation ceiling, and being willing to put rates up if the current 1% inflation rates began to move towards 2%. Zero IOER with hawkish guidance may still have been just as self-defeating, or self-limiting, as 25 basis points of IOER.

This aversion to lowering either party’s demand for money tells us that through its hawkishness Fed will fail in its responsibility to maintain stable prices. Inflation will keep on falling, or hovering around 0%. Perhaps the Fed’s mission of “stable prices” means zero inflation? Or worse, it means an average of zero.

Eventually, a shock will come along, perhaps even caused by the Fed itself and its constant creation of uncertainty. The US government will probably then force the Fed in some explicit or more likely implicit move towards the correct policy of NGDP Forecast Targeting, or at least flexibly (higher) inflation targeting. And history will probably judge the whole QE episode as a massive, but hugely controversial, sideshow.

Oh, and the Fed will then probably abolish IOER, too.

Frances, on IOER I’ve done my homework

A James Alexander post

I was involved in somewhat arcane Twitter exchange yesterday with Frances Coppola, after she retweeted Cullen Roche criticising a NYT article by Binyamin Applebaum. The piece was  trying to explain the tricky technicalities of rate-raising given QE.

Somewhat ironically, I think Roche may have misunderstood the article but the Twitter exchange was based on a real issue. The sub-headline he objected to suggested Interest On Excess Reserves held by commercial banks at the Fed was “Paying Banks not To Lend”. Actually, the article was merely presenting the Fed’s view that they would have to raise IOER as they tightened monetary policy. A fairly uncontroversial notion even if the raise itself is highly debated.

Coppola, Roche and Market Monetarists are all sceptical about the need of the Fed to raise rates now. So, in that sense we are all on the same side. Where we differ, I think, is over the point of paying any IOER when you are also trying to do Quantitative Easing (QE). At the moment the Fed pays 25bps.

I suggested that the 25bps was counter-productive but got rather slapped down and told to go off and read this  and this.

Well, I have read both now and I still don’t get it. What was the overarching point of QE except to ease monetary policy at or near the Zero Lower Bound? If at first it was technically to add to liquidity to prevent more banks going to the wall, by QE3 it was a substitute to moving interest rates nominally negative.

My question remains: Why pump new money into the economy only to incentivise banks to do nothing with it by paying IOER? Why pay any interest at all? What’s the point?

Scott Fulwiler at New Economic Perspectives in the first link just asserted:

“The Fed simply must set a price—it cannot do otherwise.  Not setting a price of reserves when it attempts to expand the monetary base simply means setting the price of reserves at zero.”

Well, what’s wrong with setting the price at zero, especially if you are trying to ease monetary policy.

Paul Sheard, S&P Chief Economist in the second link had an answer, of sorts:

“It might be asked: if banks cannot lend the excess reserves that the central bank provides, what is the point of the central bank supplying them? The answer to that question is simply that QE does serve to ease financial conditions.”

That’s clear. I and everyone must have rather missed the point.

To be fair the subsequent text from Sheard indicated there might be some minor practical impact via having interest rates for lending lower than they otherwise would be, but that was it.

I certainly understood the creation of excess reserves being a function of the rising Fed balance sheet in the absence of any strong nominal growth. But there is no need to explain the bleedin’ obvious in such painful detail. People want to know why it isn’t working very well. Why have the Fed and the other central banks pumped up their balance sheets and seen so little, or rather, less inflation, and less growth that we all want.

Using the identity of MV=PY as a starting point, PY (aka Aggregate Demand or Nominal GDP) has not risen despite the rise in M because V has not really got going. In fact must have fallen. Why has V fallen? How can it be got going?

Surely, one way would be to stop incentivising the piling up of all these excess reserves? I understand the reserves are not crimping lending if there was more demand for loans, but they are crimping velocity. Stop paying IOER and the banks have less incentive to lock them away with the Fed. The banks could buy securities or other financial assets from the market and get the cash circulating. It may still come back, but they the banks will just have to try harder. And not have the Fed take away the hard work from them, don’t make it so easy to do nothing!

It’s as if the central banks gives us money to go and party, but then induces us not to with special offers on its alcohol-free liquor from its own store. How will that work out?

Of course, Market Monetarists suggest an even better way that may actually erase the need for QE at all – work with market expectations. This would end the other self-defeating central bank paradigm of Inflation Targeting set at 2% – a sort of endlessly dull low alcohol party. Japan found that the market’s fear of central bank tightening anytime a recovery threatened any sort of a move to their inflation targeted killed the recovery. The Fed seems to be entering the same trap.

My “no tightening now” friend Frances Coppola should not turn into an enemy on these two issues. it doesn’t seem like she’d have to make a great leap, and I just can’t see the obstacles. We both want prosperity. So, ending sterilisation of Excess Reserves and moving to Nominal GDP Level Targeting would help achieve our common goals.