Monday, February 2, 2015


I have the impression that a few of the blogs I read regularly have offhandedly remarked that interest on reserves is contrationary.  The logic being that if you pay banks enough to hold money they will do so at the expense of lending money.  Let us look at this from a couple of angles.

From a base perspective IOR is inflationary.  If the Fed pays banks not to make loans those banks then distribute that money to their employees/bondholders/equity holders.  Of course the Fed is an insanely profitable institution- remitting tens of billions to the Treasury each year- if total IOR payments are less than or equal to those received by the Treasury then the Fed doesn't have to print, they just distribute those dollars differently, but when total IOR payments are > that line the Fed must increase the MS to make them.  Furthermore that would be a permenant increase.  The important ratios would be the IOR rate vs the rate on the assets on the Fed's balance sheet and the balance sheet to total reserves.  

From an incentive perspective IOR would "encourage" banks to hold deposits and so it is contractionary in terms of velocity.  How impactful this would be is dependant on the relative size of IOR vs the market rate, and the direction the market rate is moving.  If IOR is making banks less likely to make loans you would expect rates to increase until they felt that they were compensated for passing on IOR.  At 0.25% it is highly unlikely that IOR is discouraging major investments, just as a 0.25% reduction in the funds rate is unlikely to generate a large amount of economic activity.  With rates hanging out at or near historical lows since IOR was initiated it is highly unlikely that it has had a significant contractionary effect.  

There is a 3rd possible angle- liquidity.  Lets say banks didn't want to loan at all- economic conditions are deteriorting quickly enough that the likelyhood of default becomes the dominant factor over opportunity cost. If a bank was in this position they would not expect to make any loans at any price (higher interest rates could increase default probability more than the extra points are worth- hypothetically).  In this scenario a bank would be tempted to lay off employees, and shutter locations.  If conditions improved and loans flowed freely again then banks would scramble to catch up, rehire and retrain employees.  IOR could, possibly, give them enough return to retain them and allow banks to react to positive news faster.  

This third angle, along with just establishing the precedent and mechanisms for IOR, is probably what the Fed had in mind when they instituted such a paltry percent.  Just enough to allow banks to maintain operations without really holding back any quality loans.  

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