Posts Tagged ‘louis woodhill’

Why is the Fed still paying interest on reserves?

12 November 2010

Matt Yglesias, channeling Scott Sumner and Louis Woodhill, makes a good case that the interest rate on bank reserves, which was 0% up until just a couple years ago, should be lowered from its current 0.25%.  He suggests lowering it to 0.15%; I’d go lower, to 0.10% if going back to zero is out of the question.

Paying interest on reserves made some sense back in 2008 when the Fed was flooding the system with reserves in order to prevent a deflationary catastrophe.  The fear then was that when the economy picked up, banks would start loaning those reserves out and unleash a huge inflation; to prevent that, the Fed put an interest rate on reserves that could be raised whenever it became necessary to “soak up” those reserves.  But nothing like that is happening now — instead we have a banking system with about $1 trillion in reserves that they’re not loaning out, and the amount is likely to grow as the Fed makes its monthly $75 billion purchases of longer-term bonds under QE2.  The string the Fed is pushing on ought to move a little more if the interest rate on reserves were closer to zero.  0.25% might not sound like much, but it’s more than the federal funds rate on any given day and more than the short-term Treasury bill rate.  If banks could only earn 0.10% on reserves, I think they’d be more likely to loan them out, i.e., monetary policy would be more likely to work.

When the recovery finally shifts into high gear (and it could be sooner than most of us think, considering all the “green shoots” among leading indicators at present) and banks start loaning out those reserves, then the Fed can raise the interest rate on reserves.  But keeping it this high now gives preemption a bad name.

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