Should the Fed go negative and charge lenders interest to hold excess reserves?

  • Yes (63%, 59 Votes)
  • No (37%, 34 Votes)

Total Voters: 93

The Federal Reserve pays lenders interest on excess reserves. Would going negative jump start the recovery?

Money for nothing

Presently, the Federal Reserve (the Fed) pays lenders 0.25% interest on required and excess reserves (IOR). Some experts have said it’s time for the Fed to get real and go negative.

We agree.

Let’s get down to reality. The recovery as it could be is not happening, despite the illusory numbers cherry picked by the media. In order to create jobs in an environment of price stability and engender a real recovery in the real estate market, the Fed must go negative.

Related articles:

The Wall Street Journal: Fed’s Bullard: Negative Interest on Reserves Is a Stimulus Option

The Wall Street Journal: How Bernanke Can Get Banks Lending Again

In accordance with the Federal Reserve Act, lenders are required to hold a percentage of their customer deposits on reserve. In addition to required reserves, lenders may also maintain excess reserves at the Fed.

In a healthy economy, excess reserves typically run very lean. After the financial crisis (marked by the collapse of Lehman Brothers in 2008), excess reserves spiked ten-fold – to 1.5 trillion dollars plus.

In a healthy economy, excess reserves typically run very lean.

Prior to 2008, reserves held on deposit at the Fed were non-interest bearing. This gave rise to complaints (made to Congress) from lenders. They argued that no interest on their money was akin to a tax. Money depreciates day by day to buy less the next day as inflation rises.

When The Financial Services Regulatory Relief Act of 2006 was implemented in 2008, the Fed began paying interest on reserves, both required and excess. While this had the effect of appeasing lenders, it also gave the Fed unprecedented control over the money supply.

Ostensibly, the Fed now controls the lenders’ opportunity cost. Unfortunately, under present conditions, lenders consider it to be more profitable to hold excess reserves with the Fed rather than lend the funds to borrowers.

Related article:

Monetary policy, money and inflation from the FRBSF Economic Letter

Following the money

Today’s Lesser Depression continues despite the very low (0.25%) interest rate the Fed pays lenders on reserve deposits. Low but positive business and consumer rates have been ineffective thus far in stimulating lending and creating demand. To counter this, the Fed ought to charge interest on excess reserves, a practice called going negative. Denmark’s central bank does this.

A lender’s raison d’être is to make money (profit) from money (capital), also known as collecting rents. The controlling key is the more interest the Fed pays lenders on reserves, the more likely lenders are to keep money on reserve and collect interest. Given the multitude of risk on the market today, especially driven by the weak jobs market, lenders are favoring the “risk-free” business of depositing money with the Fed.

A lender’s raison d’être is to make money (profit) from money (capital).

Negative interest rates act as a disincentive to lenders for their holding excess reserves with the Fed. The lender’s decision to either sit on cash or lend it comes down to a simple analysis of opportunity costIf I choose to do this, I will lose that.

In calculating opportunity cost, lenders consider two main variables:

  • return on investment (ROI); and
  • risk.

In days past, the only opportunity a lender had for realizing a return would be to lend funds to a borrower. With the advent of Fed IOR (not ROI!), lenders may now effectively realize a return, nominal though it may be, by simply sitting on cash. No need to build in a risk premium or account for overhead.

Lender perceptions of market risk remain incredibly high (ironically due to the lack of jobs Congress and the Fed have yet to produce). Thus, the very small reward of IOR is deemed to outweigh the risk of realizing a greater return by lending.

Going negative stops that thinking dead in its tracks.

Consider a negative interest environment. For example, the Fed charges lenders one percent per annum to hold excess reserves. For every $100 a lender holds in excess at the Fed, the lender would realize a payoff of $99, a loss of one dollar.

This loss, of course, would only be nominal. Compounded as they must by an annual inflation rate of two percent, the lender’s $100 is one year later purchasing only $97 in value.

With each of the Big Banks holding billions in excess reserves, this loss would be too much to bear. In fact, taking such a loss is not an option. It would lead to the ultimate demise of the lending institution (but might eliminate the “too big to fail” issue). Holding excess reserves would be tantamount to suicide.

In such a scenario, lenders are more than merely encouraged to lend. They are in fact forced to lend by the threat of death.

Under the current regime of positive IOR, the amount of excess reserves lenders keep at the Fed has increased dramatically. From July 2008 to August 2012, required reserves doubled as matter of regulatory monetary policy; the monetary base tripled due to expansionary measures; excess reserves increased exponentially, from 1,977 in July 2008, to 1,477,751 in August 2012 (reported in millions).

Related articles:

September 27, 2012 Federal Reserve Statistical Release: Aggregate Reserves of Depository Institutions and the Monetary Base

December 29, 2008 Federal Reserve Statistical Release: Aggregate Reserves of Depository Institutions and the Monetary Base

It seems mind-boggling that lenders would choose to earn 0.25% on reserves rather than take some risk on lending the cash and earning a much greater return.

However, consider the fact that the Fed has tripled the monetary base. They did so by providing free cash hand over fist to the lenders for several years now. With a quarter of a percentage point on billions of dollars in cash reserves, lenders are provided a nice risk free ride.

Lenders follow the money. If the money (profit by way of IOR) is at the Fed, they will park funds there. Unfortunately, job creation occurs only if lender liquidity is unleashed — an unlikely occurrence in the present situation of money for nothing. Bankers may be stupid, but stupidity ironically has its rational limits.

The negative side to going negative

Detractors of going negative argue negative rates will not produce any real positive effect on job growth. Instead, they claim it will demolish the Federal Funds market.

By driving lenders away from holding excesses at the Fed, lenders would pile-in to private money market funds. The fear is that the Fed would lose control. Thus, the Fed is hen-pecked into paying positive interest or losing their steady girl.

Purported repercussions of negative rates include:

  • impeding the flow of funds to borrowers through money market mutual funds;
  • backlogged treasury auctions (perhaps even rationing of securities purchases) as banks rush to buy up treasury notes (and drive interest rates down) instead of keeping excess reserves at the Fed; and
  • severe devaluing of the dollar by way of hyperinflation.

Related article:

Hyperinflation — yesterday’s news

Because of the conceptual novelty of negative interest rates, the outcome of lowering them to such a degree is a bit unpredictable. However, it is currently being done in the Eurozone, which is proving to be a useful example for the U.S.

Related articles:

NY Federal Reserve Bank: If Interest Rates Go Negative…Or, Be Careful What You Wish For

NY Federal Reserve Bank: Why Is There a “Zero Lower Bound” on Interest Rates?

Pull out the defibrillator

The Fed’s so-called traditional expansionary methods of keeping short-term interest rates low and providing free cash to lenders are not enough.

Jobs have not been created. When Congress will not act, the Fed must. This is the key reason the Fed is not tied to political strings so it can act independently.

When Congress will not act, the Fed must.

A third round of quantitative easing (QE3) was recently announced by the Fed. The mere existence of the program forthcoming has already given a boost to the stock market (and possibly real estate based on the hyperinflation synopsis). Along with purchasing $40 billion in mortgage-backed bonds (MBBs) a month, the Fed has also stated its intention to extend current, low Federal Funds rates into at least 2015.

This means low interest rates on home loans will continue. However, will this help homebuyers or will it make lenders even more reticent to originate loans while safe money is still to be had from IOR?

For truly dynamic lending stimulus, negative interest rates must be coupled with QE3; press lenders to do business with borrowers. This will lead to more jobs and thus a stronger real estate market. The Fed has given lenders cheap (if not free) money; now lenders need to pay it forward.

Granted, there are some risks to going negative. However, any results of the action that prove harmful to the recovery are easily rectified, such as excess consumer or asset inflation. The Fed simply raises the IOR to whatever level of return needed to recapture lender dollars. This, the Fed has discretion to do overnight.

Related articles:

Beyond the basics: asset price inflation in the real estate market

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