The Fed Has Painted Itself Into A Corner? They Need A Helicopter Rescue

A Benjamin Cole post

Fed officials speak copiously and continuously about their unfulfilled urge for higher interest rates. This is a deep desire that U.S. central bankers were able to somewhat satiate from the early 1980s to 2008.

It is true that through much of the 1980-2008 period many Fed-rate increases led to lower inflation, and to weaker growth and sometimes recession, leading to lower interest rates. Rates were in long-term secular decline, but there were those euphoric passages (for central bankers) when rates could again be boosted, as during any economic recovery.

But, as Milton Friedman noted, 1) a central bank cannot tighten its way to higher interest rates forever, and 2) nominally low interest rates are a sign that money has been tight.

A couple generations of money-tightening has produced predictable results of low interest rates, low growth, as well as miniscule inflation.

The Fed is presently trapped. The central bank has little grip on long-term rates, now near historic lows. So raising the Fed funds rate and interest on excess reserves (IOER), will only dampen long-term rates again, the opposite of what the Fed says it wants.


And then there is the tar baby the Fed tossed into the corner into which it then painted itself: IOER.

Banks make money “on the spread,” that is the difference between borrowing costs and lending returns, usually about 300 basis points. Banks have overhead, labor costs, fancy HQs so that spread gets cut thin on the way to the bottom line.

But now banks collect 0.50% on IOER, the same reserves hugely swollen by QE. The Fed is eager to boost that to 0.75% soon, and possibly even higher in the 12 months ahead.

At some point it will make sense to banks to do nothing.

IOER may be one reason why U.S. commercial real estate loan volume only reached 2007 levels again in late 2015. Actually, 2016 has been a decent year for commercial real estate loan volume—finally eclipsing 2007 levels—but if the Fed raises IOER again, perhaps the IOER will be higher than the profit on a commercial property loan. The banks can go golfing on the 0.75% they make for keeping money in the vault.

Nirvana for central and commercial bankers at last!

Yet this problem of IOER-addled banks is doubly important, as many say it is banks that expand the money supply, when they extend a loan. Before QE, the main creation of new money was through bank lending, and banks primarily lend on real estate.

This gets into the whole exogenous v. endogenous expansion of the money supply dispute, which can put any sane person into knots for days.

But suffice it to say, the Fed is following a reckless and suppressive mission with a view towards higher IOER. The money hose could run dry long before the Fed could arrange tools to replenish the supply.

Paying banks to do nothing is an imprudent and dangerous precedent, and of course, only banks will closely monitor and lobby this IOER issue going forward. Like any federal dope, it will quickly become addictive.


The Fed likely should have never paid IOER.  But what is done is done. This makes the quantitative easing (QE) option going forward more problematic, as banks will accrue even more indolence-inducing reserves.

But the US will enter recession again someday, and likely with interest rates near or lower than today’s levels.

Really, the only recourse is to the helicopters. And that begs the question: Why wait until there is a deep recession again? How about preventative air drops anytime core-PCE dips below 2% YOY?

Or, better yet, whenever NGDP growth drops below 5%?

Why the huge expansion in base money hasn’t produced inflation and only slow growth

A James Alexander post

Jeffrey Rogers Hummel has written a very useful post about base money in the US and the difficulties in accurately tracking the number. It has led us to an attempt to explain the interaction between base money, excess reserves, interest on those reserves and the 2008 crisis.

His last three charts lead him to a conclusion with which we want to take issue. Hummel says:

Confining the definition of the monetary base and total reserves to only non-interest bearing, Fed-created outside money would yield the results for the period from 2001 to mid-2015 depicted in Figure 3, 4, and 5. With this adjustment, the mere $500 billion increase in what we can call the “outside base” since September 2008 represents merely a slightly more rapid rate of increase than the rate of increase in the base the decade prior, and nearly all of that recent increase has been in the form of hand-held currency.

No wonder that the high inflation that so many expected from quantitative easing never materialized.

Market Monetarists are clear about why high inflation has not materialized. QE has been handicapped by other elements of monetary policy. Essentially, the Fed has not wanted higher nominal growth, and it has got its wish. The Fed could be said to be anti-nominal growth and, therefore, effectively anti-growth.

In a series of posts earlier this year at Historinhas, summarised here Mark Sadowski indicates that expansion of the broad monetary base by QE Granger-caused what nominal and real economic growth the US has enjoyed. The base expansion has been nothing like enough to lead to any inflation, of course. That it is no surprise to us is due to the offsetting effect of Inflation Targeting and other restrictive monetary policies on nominal growth. The recovery the US has been, as a consequence, like pushing water uphill.

Excess reserves are commonly seen as “outside money” not “inside money”

The monetary base causes much confusion. As Hummel says, until 2008, US Base Money was essentially just “hand-held” currency, or cash in circulation, at least since WW2. There were large excess reserves built up during the Great Depression.

Hummel is wrong to classify interest-earning excess reserves (i.e. assets of the commercial banks held at the central bank) as “inside money”, at least according to  Gurley and Shaw the originators of the distinction with “outside money” . The mere act of paying interest on reserves fails to change it from “outside money” to “inside money”, if one sticks to these original meanings.

“Inside money” is precisely defined. It is essentially private liabilities matched by private assets. For example, deposits at commercial banks are liabilities of the banks, but also assets of the private depositors.

Central banks control the quantity of “outside money” (ie base money)

Commercial bank deposits or reserves at the central bank are assets of the commercial banks and liabilities of the central bank, but the central bank is special.  It is a public institution and as the central bank it alone can create base money (medium of account) at will, out of thin air. So, the Fed’s balance sheet grows via its own new base money creation. Very broadly speaking, commercial banks balance sheets can only grow in aggregate if the Fed allows base money to grow. It has become harder to track this phenomenon in recent years with the rise of financial disintermediation.

The whole “inside/outside money” concept is not commonly used by monetary economists who tend to avoid using the terms. They are more familiar to specialists in finance. Much of the confusion arises because money for monetary economists is “outside money” or base money, and is narrower than money in the mind of the general public.

Not all money is the same, but not quite how Hummel sees the distinction

Hummel’s “outside base” money concept could be even narrower, but is not in common usage. Changes in base money are what predict changes in the nominal economy, which Market Monetarists see as sometimes having heavy impacts on the real economy in the short-term and medium-term. Changes in these broader definitions of money have much less predictive power. It is best not to think of “inside money”, or non-base money, as money at all when it comes to thinking about monetary policy.

The velocity of the commercial bank reserves with the central bank can be just as volatile as velocity of currency in circulation. Both types of money can be hoarded during negative shocks, and rendered inert, other things being equal. A negative shock drives up the value of money and drives down the prices of non-money (deflation). Or vice versa, a positive shock, i.e. “hot economy”, drives down the value of money and drives up the prices of non-money (inflation).

Interest on excess reserves would be unimportant above the ZLB

More importantly, whether these excess reserves earn interest or not is almost an accident of history. The Fed could have chosen to pay zero or negative rates on these reserves if it wanted. In the circumstances, the decision to pay interest on excess reserves had some profound consequences but not the ones Hummel brings up. As Peter Ireland wrote in his widely referenced article on excess reserves:

the Federal Reserve’s [then] recent decision to begin paying interest on reserves is unlikely to have large effects on the behavior of macroeconomic variables such as aggregate output and inflation, once normal times return. [my emphasis]

There were hardly any excess reserves in the post-WW2 era. Why would there be? The interest rate on excess reserves was zero and market rates were in the hundreds of basis points. There were also no serious, system-wide, bank runs.

The financial crisis changed everything. Commercial bank (excess) reserves at the central bank exploded when Lehman went bust. These reserves were created as the inevitable counterpart of the emergency Treasury/Federal Reserve funding of banks and other financial institutions who’d found that in the pre-Lehman, but especially post-Lehman, liquidity crisis market-sourced funds were hard to come by.

The trouble with IOER, explained better

The decision to pay interest on those reserves highlights a somewhat hidden episode of the financial crisis, but one that Scott Sumner , David Beckworth  and others have repeatedly called into question.

IOER was a new concept for the US but is actually a very familiar part of the monetary policy landscape in the majority of monetary regimes. It is a second tool with which central banks can control the monetary base, by altering demand from banks for money, in addition to traditional open market operations buying financials assets (with new money, like QE) or selling financial assets (for existing money and thus reducing the amount of base money). In most regimes IOER is a little below market rates and has no significant impact on monetary policy or the amount of base money as it is more attractive to buy other short-term risk-free assets like T-bills.

Most countries also have required reserves, usually as a percentage of some definition of deposits. In the US they are currently $91bn, versus $2,500bn of excess reserves or 25x as much.

However, it is not the existence of IOER that is the problem, but the level of the remuneration in an environment of zero or near zero interest rates. The Federal Reserve decided to pay a rate of IOER above overnight and T-Bill rates because the market was driving those rates below where the Fed thought was desirable.

The crisis-induced birth of IOER – not a good omen

Our chart shows how the market, as represented by the 4-Week T-Bill was constantly below overnight rates in the run up to the crisis, well below both the US (Effective Fed Funds rate) and London (LIBOR) money market rates. The “money market” is something of a misnomer as the “market” element is heavily influenced, if not actually controlled, by what target interest rate the central bank desires.

The liquidity squeezes caused by financial turmoil in August/September 2007, March 2008 and then the third and final time in September 2008 are clearly visible by high levels of volatility. The fact that the 4-Week rate often fell further than rate cuts on rate cuts days shows how the market constantly worried that the Fed was behind the curve. The collapse in the 4-Week rate on the morning after the Lehman failure should have been the signal for the Fed to cut rates, as that was what the market both expected and wanted. But the Fed delayed, causing turmoil in money markets, that even spread to the rate closest to its control, the Effective Fed Funds.

The turmoil in money markets seen in the chart happened because the Fed was not doing enough to cope with surging demand for money, by supplying more. And what money there was available had to be hoarded in some other risk-free place, causing the collapsing T-Bill rates as their prices were bid up, especially in times of stress.

JA Inside-outside

Some non-bank market participants had direct access to them, but most non-bank economic actors just moved their money to the biggest, safest banks. Because those banks had no need for the deposits, in fact they wanted to shrink the risks on their balance sheets, the biggest, safest banks also bought T-Bills. Smaller banks were also de-risking their balance sheets, increasing demand for T-Bills too. And traders were obviously buying T-Bills in anticipation of the Fed cutting its target rate.

Was the Federal Reserve right to ignore what the markets were expecting and wanting, rates at zero and/or lower, or a massive injection of liquidity? To be fair it wasn’t just Fed fear of negative rates. Other pressures were bearing down on the Fed. For instance, going below zero would cause many money market funds to “break the buck”, i.e. break an implicit promise to protect investors capital and thus mask how they were sold, as higher remunerated, but unsecured, deposits.  This prompted further concern about instability, illustrating that moral hazard was not just confined to banks, of course.

But by instituting IOER the Fed actually added to the demand for money, as banks too in their own operations moved from higher risk non-central bank assets, to zero risk central bank reserves. This was not helpful in a time of liquidity crisis.

Even with IOER from early October 2008, 4-week T-bill rates still went negative twice during December 2008.  T-bills have also still been negative on at least 36 days since 2009 and have only averaged a measly six basis points over that period, showing just how strong demand for money remains versus supply and thus how tight monetary policy remains.

It’s not just about M but V too

“What if” there had been no IOER is harder to establish. Market pressures would probably have driven those rates negative, just like they have in many parts of Europe in recent years. This should lead to a quicker recovery other things being equal. But it is hard to forecast how negative rates in September 2008 would have played out, if money market funds had seen a flight too.

New money would still need to have been created to cope with the increased demand for it. As Mark Sadowski has shown, approximately each 10% rise in base money leads to a 1% rise in NGDP.

But that is only the money quantity part of MV working. The key to a recovery caused by a large drop in V is to raise expectations of more M, not just more M itself. If it is just more M it is not certain that the recovery will become self-sustaining unless there is a belief that the extra M is either permanent or will only be withdrawn once V is back up and running, i.e. after confidence has been restored.

The Federal Reserve has signally failed to engender that belief in increased M being permanent: it constantly, and very publicly, plans for a reduction in the balance sheet – causing uncertainty. It doesn’t engender confidence in growth as it constantly and very publicly searches for traces of inflation picking up where none exist. And it constantly, and very publicly, supports the Philips Curve/Slack Theory of macro and so for the last several years has led the market to expect a break out of wage inflation and immediate monetary tightening. Thanks for that!

But worse, it is so self-defeating. The constant and public hand wringing has led directly to the very sluggish recovery, and the constant and very public threat of a near term rate rise now appears to be slowing even this. Thanks again!

No monetisation, just poor, confusing monetary policy

Hummel also says this:

Thus, at least $2.5 trillion of the post-crisis explosion of the monetary base constitutes interest-bearing inside money that in substance is government debt merely intermediated by the Fed.

This is wrong, government debt has not been monetised. The Treasury intends to repay it. Government debt was bought because it was available. The Fed also bought hundreds of billions of agency debt, funding US housing. If the market really believed all this government debt and mortgage bonds had been monetised then inflation really would have been a problem. But as Hummel has noticed, it hasn’t been a problem at all. In fact, the opposite. The Fed has made it clear it will sell back the debt over time. And the market believes it. Some monetisation!

Perhaps some monetisation might have been a good thing and engendered a quicker recovery.

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.


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.