David Beckworth has a new Mercatus paper that examines the Fed’s decision to adopt a “floor” system for interest rates.  Beginning in October 2008, the Fed began paying interest on bank reserves.  This effectively created a floor on market interest rates, as banks would have no incentive to lend money at rates lower than they could receive on reserves held on deposit at the Fed. Prior to 2008, the Fed controlled short-term interest rates by adjusting the supply of base money, a “corridor system”.  Now they have two independent policy tools, changes in the money supply (open market operations), and changes in money demand (done via interest on reserves.)

David sees several flaws in this new system:

The Fed’s floor system, then, may be a drag on economic growth for two reasons. First, it may weaken aggregate demand growth by setting the target interest rate above the natural interest rate. Second, it may inhibit credit and money creation by removing banks’ incentives to rebalance their portfolios away from excess reserves. If so, the critics are right to be worried about the Fed’s floor system, because it would constitute a Great Divorce for monetary policy.

I worry that deposit insurance biases banks toward too much lending, so at the moment I’m most worried about the first issue.  In monetary history, one recurring theme is central banks misjudging the stance of monetary policy because they focused too much on interest rates and not enough on the money supply.  Thus during late 2007 and early 2008, the Fed wrongly assumed that it was “easing” monetary policy, even as the growth in the monetary base came to a halt.

Admittedly, this excessive focus on interest rates can occur even without IOR.  But the system of interest on bank reserves makes the mistake even more likely to occur, as the quantity of money becomes even less informative.  Monetary policy is seen as being all about changes in interest rates, not changes in the supply and demand for base money.  The Fed’s monetary policy stance during the fall of 2008 would have almost certainly been less contractionary if Congress had not authorized the Fed to pay interest on reserves.

Josh Hendrickson has an important new (forthcoming) paper in the Journal of Macroeconomics. Here’s the abstract:

Over the last several years, the Federal Reserve has conducted a series of large scale asset purchases. The effectiveness of these purchases is dependent on the monetary transmission mechanism. Former Federal Reserve chairman Ben Bernanke argued that large scale asset purchases are effective because they induce portfolio reallocations that ultimately lead to changes in economic activity. Despite these claims, a large fraction of the expansion of the monetary base is held as excess reserves by commercial banks. Concurrent with the large scale asset purchases, the Federal Reserve began paying interest on reserves and enacted changes in its Payment System Risk policy. In this paper, I estimate the effect of the payment of interest on reserves (as well as other payment policy changes) on the demand for daylight overdrafts through Fedwire. Since Fedwire provides overdrafts at a fixed price, any fluctuation in the quantity of overdrafts is a change in demand. A reduction in overdrafts corresponds with an increase in the demand for reserves. I show that the payment of interest on reserves has had a negative and statistically significant effect on daylight overdrafts. Furthermore, I interpret these results in light of recent theoretical work. I argue that by paying an interest rate on excess reserves that is higher than comparable short term rates, the Federal Reserve likely hindered the portfolio reallocation channel outlined by Bernanke. Thus, the payment of interest on reserves increased payment processing efficiency, potentially at the expense of limiting the ability of monetary policy to influence economic activity.

And here Josh describes the role of overdrafts:

Reserves are held both to meet unexpected withdrawals and to settle payments between banks, with the latter motive being substantially more significant. Large-scale wholesale payments processed through Fedwire are done through a real-time gross settlement system. This means that payments to and from banks are credited and debited in real-time. If the bank has insufficient reserves to cover a debit in their reserve account, the bank is extended credit that is expected to be repaid by the end of the Fedwire day. Historically, a large portion of these daylight overdrafts have been backed by pledged collateral of the bank.3 It follows that banks can hold either highly liquid, short-term debt such as Treasury bills and other forms of short-term debt that can be sold quickly or used in repurchase agreements in the event of an overdraft or banks can hold reserves sufficient to fund payments. Prior to the paying of interest on reserves, banks faced a trade-off of holding short-term debt or reserves. If the bank held reserves it would enable more efficient settlement of payments at the cost of foregone interest on short-term debt. Holding interest-bearing assets provided a positive rate of return, but overdrafts due to insufficient reserve balances were subject to fees. With the payment of interest on excess reserves, this tradeoff is eliminated because the policy change allows banks to earn interest comparable to alternative assets while avoiding fees associated with overdrafts. The market for daylight overdrafts therefore provides an opportunity to analyze the effect of the payment of interest on reserves.

The paper confirms that the adoption of interest on reserves in October 2008 was indeed a serious (contractionary) policy error.  More broadly, it reconfirms the importance of looking beyond interest rates when evaluating monetary policy, and specifically the importance of the portfolio rebalancing channel as a transmission mechanism for changes in the quantity of base money.

Patrick Sullivan directed me to a very interesting essay by Ben Bernanke.  As you’d expect, the article is well thought out and mostly accurate.  But there is one issue on which I strongly disagree:

Prior to the crisis, the Fed set short-term interest rates through open-market operations that varied the quantity of bank reserves in the system, a technique which involved on average low levels of reserves—perhaps $10 billion or so. Today, the level of bank reserves is much higher, which makes it impossible to manage interest rates through small changes in the supply of reserves. Instead, the Fed manages short-term interest rates by setting certain key administered interest rates, such as the rate it pays bank on reserves held with the Fed. This “floor system” (called that because rates like the interest rate on bank reserves set a floor for the policy rate) was adopted out of necessity but seems to be gaining favor with the FOMC as a better way to manage monetary policy.

The phrase “adopted out of necessity” caught my attention.  I think this is a very misleading way to describe what Ben Bernanke and I both think happened in October 2008. Presumably Bernanke means that given the Fed had decided to inject a large amount of reserves into the banking system in September 2008, and given the Fed had decided that it was unwise to reduce the interest rate target below 2% in September 2008, the IOR policy was necessary to keep the market fed funds rate close to the policy target.  But I think the average reader would not understand this very restrictive meaning of “necessity”.  The average reader might assume that Bernanke was saying something more like, “looking back on things, the imposition of IOR in October 2008 was necessary to meet the Fed’s policy mandate.”  In fact, it was just the opposite.  The decision to adopt IOR helped to prevent the Fed from achieving its policy goals, by making the Great Recession more severe than otherwise.  That’s not just my opinion; unless I am mistaken that’s the implicit message of Bernanke’s memoir, where he indicated that, in retrospect, the Fed did not move quickly enough to cut rates in the fall of 2008.

The world would be a better place today if the Fed had never instituted its policy of IOR in 2008.  I really don’t see how anyone can seriously dispute this claim.  If you want to dispute the claim, what specific way did IOR make the world a better place? When the policy was adopted in 2008, the New York Fed explained it to the public as a contractionary policy.  Can anyone seriously argue that the world would be worse off if monetary policy had been less contractionary in 2008-12?  Why?

Now of course its possible that in the future a policy of IOR could be helpful, and Bernanke provides several reasons:

As I noted here, there are reasonable arguments for keeping the Fed’s balance sheet large indefinitely, including improving the transmission of monetary policy to money markets, increasing the supply of safe short-term assets available to market participants, and improving the central bank’s ability to provide liquidity during a crisis.

What Bernanke sees as an advantage, I see as a disadvantage.  In a technical sense, the Fed actually has more ability to add liquidity in a world without IOR, because the balance sheet will be smaller at the onset of a crisis, and hence have more room to grow to its effective maximum size.  Presumably Bernanke would respond that IOR allows the Fed almost unlimited ability to inject liquidity without sacrificing their other macroeconomic targets.  In other words (a cynic might say), IOR will allow the Fed to make the same mistake in future crises that they made in October 2008—trying to rescue Wall Street without rescuing Main Street.  OK, that’s probably too cynical, but I think it’s important for people to think about Bernanke’s argument in terms of what happened in the Great Recession.  Bernanke may be 100% correct with regard to future crises, but it’s clear that his rationale for IOR was 100% wrong for 2008.

In my view the Fed should refrain from IOR, and I hope that causes the Fed to focus like a laser on macroeconomic stability.  If the problem is solvency, then leave bailouts of banks to the Treasury or FDIC, or better yet, don’t bail out banks at all.  There are some very promising proposals being developed that would allow for bondholders to be “bailed in” via debt to equity conversions during a crisis.  If we move away from IOR, it’s more likely that the authorities will be forced to come up with an alternative method for dealing with large bank failures.  As long as the Fed is supplying enough liquidity to keep expected NGDP growth at about 4%, I’m not at all worried about bank failures—let them fail.

If the banking system has a problem of liquidity but not solvency, then the usual Bagehot rules apply. IOR is not needed, as the size of base injections appropriate for meeting a surge in demand for liquidity is the same as the size of base injections needed to keep NGDP on track.  If banks truly do “need” more liquidity, then injections of liquidity will not be inflationary.  Let base supply grow as base demand grows.

My second reason for opposing IOR is that it moves us even further away from a quantity theoretic approach to monetary policy.  The Fed already puts too much focus on nominal interest rates when considering the stance of monetary policy—IOR will make this problem even worse.  One of the causes of the Great Recession was that low interest rates led the Fed (and almost everyone else) to falsely assume that policy was “accommodative” in 2008 and 2009, when it fact it was highly contractionary.  With IOR, the quantity of money is even less informative. Let’s go back to the pre-2008 situation, where 98% of the base was currency.

Here’s Nick Rowe:

I understand how monetary policy would work in that imaginary Canada (at least, I think I do). Increasing the quantity of money (holding the interest rate paid on money constant) shifts the LM curve to the right/down. Increasing the rate of interest paid on holding money (holding the quantity of money constant) shifts the LM curve left/up. Done.

It’s a crude model of an artificial economy. But it’s a helluva lot better than a simple New Keynesian model where money (allegedly) does not exist and the central bank (somehow) sets “the” nominal interest rate (on what?).

I think this is right.  But readers might want more information.  Exactly what goes wrong if you ignore money, and just focus on interest rates?  Let’s create a simple model of NGDP determination, where i is the market interest rate and IOR is the rate paid on base money:

MB x V(i – IOR) = NGDP

In plain English, NGDP is precisely equal to the monetary base time base velocity, and base velocity depends on the difference between market interest rates and the rate of interest on reserves, among other things.  To make things simple, I’m going to assume IOR equals zero, and use real world examples from the period where that was the case.  Keep in mind that velocity also depends on other factors, such as technology, reserve requirements, etc., etc.  The following graph shows that nominal interest rates (red) are positively correlated with base velocity (blue), but the correlation is far from perfect.

[After 2008, the opportunity cost of holding reserves (i – IOR) was slightly lower than shown on the graph, but not much different.]

What can we learn from this model?

1.  Ceteris paribus, an increase in the base tends to increase NGDP.

2.  Ceteris paribus, an increase in the nominal interest rate (i) tends to increase NGDP.

Of course, Keynesians often argue that an increase in interest rates is contractionary.  Why do they say this?  If asked, they’d probably defend the assertion as follows:

“When I say higher interest rates are contractionary, I mean higher rates that are caused by the Fed.  And that requires either a cut in the monetary base, or an increase in IOR.  In either case the direct effect of the monetary action on the base or IOR is more contractionary than the indirect effect of higher market rates on velocity is expansionary.”

And that’s true, but there’s still a problem here.  When looking at real world data, they often focus on the interest rate and then ignore what’s going on with the money supply—and that gets them into trouble.  Here are three examples of “bad Keynesian analysis”:

1. Keynesians tended to assume that the Fed was easing policy between August 2007 and May 2008, because they cut interest rates from 5.25% to 2%.  But we’ve already seen that a cut in interest rates is contractionary, ceteris paribus. To claim it’s expansionary, they’d have to show that it was accompanied by an increase in the monetary base.  But it was not—the base did not increase—hence the action was contractionary.  That’s a really serious mistake.

2.  Between October 1929 and October 1930, the Fed reduced short-term rates from 6.0% to 2.5%.  Keynesians (or their equivalent back then) assumed monetary policy was expansionary.  But in fact the reduction in interest rates was contractionary.  Even worse, the monetary base also declined, by 7.2%.  NGDP decline even more sharply, as it was pushed lower by both declining MB and falling interest rates.  That’s a really serious mistake.

3.  During the 1972-81 period, the monetary base growth rate soared much higher than usual.  This caused higher inflation and higher nominal interest rates, which caused base velocity to also rise, as you can see on the graph above.  Keynesians wrongly assumed that higher interest rates were a tight money policy, particularly during 1979-81.  But in fact it was easy money, with NGDP growth peaking at 19.2% in a six-month period during late 1980 and early 1981.  That was a really serious error.

To summarize, looking at monetary policy in terms of interest rates isn’t just wrong, it’s a serious error that has caused great damage to our economy.  We need to stop talking about the stance of policy in terms of interest rates, and instead focus on M*V expectations, i.e. nominal GDP growth expectations.  Only then can we avoid the sorts of policy errors that created the Great Depression, the Great Inflation and the Great Recession.

PS.  Of course Neo-Fisherians make the opposite mistake, forgetting that a rise in interest rates is often accompanied by a fall in the money supply, and hence one cannot assume that higher interest rates are easier money.  Both Keynesians and Neo-Fisherians tend to “reason from a price change”, ignoring the thing that caused the price change.  The only difference is that they implicitly make the opposite assumption about what’s going on in the background with the money supply. Although the Neo-Fisherian model is widely viewed as less prestigious than the Keynesian model, it’s actually a less egregious example of reasoning from a price change, as higher market interest rates really are expansionary, ceteris paribus.

PPS.  Monetary policy is central bank actions that impact the supply and demand for base money.  In the past they impacted the supply through OMOs and discount loans, and the demand through reserve requirements.  Since 2008 they also impact demand through changes in IOR.  Thus they have 4 basic policy tools, two for base supply and two for base demand.

PPPS.  Today interest rates and IOR often move almost one for one, so the analysis is less clear.  Another complication is that IOR is paid on reserves, but not currency.  Higher rates in 2017 might be expected to boost currency velocity, but not reserve velocity.  And of course we don’t know what will happen to the size of the base in 2017.

David Beckworth did a very interesting podcast with Miles Kimball.  You probably know that Miles is an economics professor at Michigan and blogs under the name “Supply Side Liberal” (a label not far from my own views.)

Here are some good points that Miles emphasized:

1.  If the Fed had been able to do negative interest back in 2008, the average interest rate over the past 8 years would probably have been higher than what actually occurred.  Lower in 2008-09, but then higher ever since, as the economy would have recovered more quickly.  He did not mention the eurozone, but it’s a good example of a central bank that raised rates at the wrong time (in 2011) and as a result will end up with much lower rates than the US, on average, for the decade of the “teens”.  Frustrated eurozone savers should blame German hawks.

2.  He suggested that if the Fed had been able to do negative interest rates back in 2008-09, the financial crisis would have been milder, because part of the financial crisis was caused by the severe recession, which would itself have been much less severe if rates had been cut to negative 4% in 2008.

3.  Central banks should not engage in interest rate smoothing.  He did not mention this, but one of the worst examples occurred in 2008, when it took 8 months to cut rates from 2% (April 2008) to 0.25% (December 2008.)  The Fed needs to be much more aggressive in moving rates when the business cycle is impacted by a dramatic a shock.

Although I suggested negative IOR early in 2009, I was behind the curve on Miles’s broader proposal (coauthor Ruchir Agarwal), which calls for negative interest on all of the monetary base, not just bank deposits at the Fed.  To do this, Miles recommends a flexible exchange rate between currency and electronic reserves, with the reserves serving as the medium of account.  Currency would gradually depreciate when rates are negative.  Initially I was very skeptical because of the confusion caused by currency no longer being the medium of account.  I still slightly prefer my own approach, but I now am more positively inclined to Miles’s proposal and view it as better than current Fed policy.

Miles argued that the depreciation of cash against reserves would probably be mild, just a few percentage points.  Then when the recession ended and interest rates rose back above zero, cash could gradually appreciate until brought into par with bank reserves.  He suggested that the gap would be small enough that many retailers would accept cash at par value. As an analogy, retailers often accept credit cards at par, even though they lose a few percent on the credit card fees.

If cash was still accepted at par, would that mean that it did not earn negative interest, and hence you would not have evaded the zero bound?  No, because Miles proposes that the official exchange rate apply to cash transactions at banks.  This would prevent anyone from hoarding large quantities of cash as an end run around the negative interest rates on bank deposits.  So that’s a pretty ingenious idea, which I had not considered.  Still, I think my 2009 reply to Mankiw on negative IOR holds up pretty well, even if I did not go far enough (in retrospect.)

Why is negative interest still not my preferred solution?  Because I don’t think the zero bound is quite the problem that Miles assumes it is, which may reflect differing perspectives on macro.  Listening to the podcast my sense was that he looked at macro from a more conventional perspective than I do.  At the risk of slightly misstating his argument, he sees the key problem during recessions as the failure of interest rates to get low enough to generate the sort of investment needed to equilibrate the jobs market.  That’s a bit too Keynesian for me (although he regards his views as somewhat monetarist.)

In my view interest rates are an epiphenomenon.  The key problem is not a shortfall of investment, it’s a shortfall of NGDP growth relative to nominal hourly wage growth.  I call that my “musical chairs model” although the term ‘model’ may create confusion, as it’s not really a “model” in the sense used by most economists.  In my view, the key macro problem is the lack of one market, specifically the lack of a NGDP futures market that is so heavily subsidized that it provides minute by minute forecasts of future expected NGDP.  If the Fed would create this sort of futures/prediction market (which it could easily do), then the price of NGDP futures would replace interest rates as the key macro indicator and instrument of monetary policy. Recessions occur when the Fed lets NGDP futures prices fall (or shadow NGDP futures if we lack this market).  Since there is no zero bound on NGDP futures prices, we don’t need negative interest rates.  However, in place of negative rates the central bank may need to buy an awful lot of assets.  You could say there is a zero lower bound on eligible assets not yet bought by the central bank.  Which is why we need to set an NGDPLT path high enough so that the central bank doesn’t end up owning the entire economy.

To conclude, although Miles’s negative interest proposal is not my first preference, put me down as someone who regards it as better than current policy.

PS.  I was struck by how many areas we have similar views.  For instance he thought blogging was really important because what mattered in the long run was not so much the number of publications you have, but whether you’ve been able to influence the younger generation economists (grad students and junior faculty).

PSS.  I will gradually catch-up on the podcasts, and then do another post on the 2nd half of the Brookings conference on negative IOR.