Monday, February 2, 2015

IOR part 2

IOR 1 is here

In IOR 1 I laid out a pretty basic outline for when interest on reserves would be inflationary/contractionary, here I am thinking about practical implications for Fed policy.

If the Fed wants to use IOR as a tightening tool we have to expect that inflation or expectations of future inflation are getting to high.  Since the Fed seems perfectly happy with inflation in the 2-2.5% range I assume it would take something more than that for them to try out a new program on a large scale (the Fed is frequently viewed as conservative, especially by MMs).  Also for it to impact inflation the transmission of price increases has to be primarily through bank loans, otherwise paying interest on reserves won't accomplish much if anything.

in 2014 the Fed remitted ~80 billion to the Treasury, and excess reserves are currently over 2.5 trillion dollars. Going back to IOR #1- IOR should expand the MS when payments exceed Fed profits (ie remittences)- so if the Fed tries to tighten with IOR it will start fighting itself with those ratios around a 3.2% interest rate.  The Fed isn't jacking up IOR anything soon according to its guidance, and its remittances have been relatively flat since 2010 while excess reserves have increased at over 300 billion per year during that span.  5 more years of those trends (Japanese "lost decade" range) and the Fed would be facing issues at a 2% rate, and another 5 years to 1.5%.  Japan is currently 25 years into an environment like this, which would put the Fed in a pickle before it hit the 1% mark.

Point #2 is that IOR is only effective if the rate is high enough to convince banks not to lend.  Well if inflation is significantly above 3% then deposit rates should be in that range, so banks are unlikely to willingly take less than that from the Fed to lend* as they would slowly be bleeding out even while getting "free money" from the Fed.

This isn't a definitive treatment, but it is a substantial blow to those who think the Fed should and could push for a return to trend growth.  A big push to get multiyear inflation (or nGDP if you prefer) above the historical trend to bring the curve back up is likely to put the Fed in position where its attempts to tighten lead to a larger money supply- and unlike most of QE a MS in which it holds no claims against.  If inflation were to push into the 4-5% range the Fed would be playing with fire and would risk losing control of the MS.

*The effective rate the Fed has to set to curtail lending will likely be higher than the deposit rate as the portfolios of banks will be heavily weighted to loans made over the past 5+ years with extremely generous terms to borrowers, and banks will have to make up those losses in the event of a substantial increase in rates.

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