Going Broke by Fractions of a Percent

Ben Bernanke should stop paying interest on reserves

Federal Reserve Chairman Ben Bernanke's rollout of $600 billion in quantitative easing was a public relations disaster that deserves to be studied in college communications classes. And he could have avoided it by giving up a shiny monetary tool he got in 2008—one that may be at the root of the extended recession.

The Federal Reserve Bank's shopping spree of distressed debt will, Bernanke claims, create 700,000 jobs over the next two years. But if one of its immediate goals was to inspire market confidence, Quantitative Easing II (QE2) could hardly have gone worse.

In the three months since Bernanke floated the idea of a second round of large-scale asset purchases, the U.S. dollar index has declined by about 5 percent. With household net worth at $54.6 trillion, according to the Fed's most recent Flow of Funds data, this means about $2.73 trillion of domestic wealth may have vanished in three months.

While much of that fall took place during the period between Bernanke's QE2 trial balloon in late August and the rollout of the actual program two weeks ago, events since QE2 actually hit the streets have not been encouraging. German Finance Minister Wolfgang Schaeuble called the move "clueless," and China's Dagong Global Credit Rating Co. downgraded long-term U.S. debt. The Anglophone financial press tends to dismiss such criticisms as nationalist trash talk, but QE2 cast a glare over President Barack Obama's Asia junket and made what would ordinarily be considered an average performance—the president failed to close a trade agreement with South Korea and came home with few solid results—into a demonstration of U.S. powerlessness.

The domestic response has been just as gloomy, but for opposite reasons. While yields on U.S. Treasury debt have ticked up (the yield on the 10-year note has risen 0.23 percent since the beginning of November), at home the problem is that QE2 is not creating the lending boom and subsequent price inflation that Bernanke for nearly two years has been trying to conjure through frenzied rain dances. A survey of currencies pegged to or closely aligned with the dollar reveals pockets of robust inflation, but U.S. economic activity is horizontal at best: Retail activity has picked up a little, while house prices, housing starts and mortgage purchase activity are all dropping.

Even Wall Street failed to respond. After a smaller-than-anticipated post-QE2 rally, the Dow Jones Industrial Average has been sliding steadily, and is now lower than it was a month ago. (Though it's still 1,000 points above its late-August level, suggesting that whatever market excitement QE2 will arouse has already subsided.)

So quantitative easing (large-scale central bank purchases of public and private debt instruments designed to keep interest rates down and increase the flow of money into the economy) is on the verge of striking out twice. Bernanke's 2010 is ending pretty much like his 2009, except that he's unlikely to return as Time magazine's Person of the Year.

Could he have done things differently?

Yes, he could have. There may be no scenario under which Bernanke's extremely accommodative monetary policy (one which follows the late Milton Friedman's recipe) would have made a difference in an environment where a broke populace has no appetite for debt and banks see few credit-worthy lending opportunities.

But he could have been spared some of the humiliation if he'd listened to dissenters (including a growing number within the Fed) and tried some other tool to get banks, as the politicians say, lending again.

To be clear: Bernanke would not have gotten banks lending again. He just would have been spared some shame.

The Fed is two years into an experiment that is new in the central bank's 97-year history. It is paying banks interest on reserves. According to Fed and independent analysts, interest on reserves is a powerful new tool that allows the Fed to create all the new money implied by QE2, while preventing that money from flooding into the private sector and causing uncontrollable inflation. "We can have an enlarged balance sheet and not have a long-term inflation problem," New York Fed President William Dudley told CNBC on Tuesday. "This is because we can pay interest on excess reserves, which can moderate credit demand. We did not have this tool before 2008. So if you're reading the old textbooks about money and banking, you would be very concerned."

Like many bad ideas, interest on reserves originated with Milton Friedman, but it is being applied in a way the great Chicago economist and monetary theorist did not foresee. Friedman advised payment of interest on those reserves banks are required by law to keep. The Fed is paying interest on both required and excess reserves—the latter of which have ballooned in the last 18 months and now stand at about $1 trillion, a level that is unique in U.S. banking history.

Comments like Dudley's above, backed up by Fed studies [pdf] and both Fed supporters and detractors, suggest interest on reserves (IOR) prompts banks to keep that money locked up in vaults rather than lending it out. If you are getting an interest rate higher than inflation from the Fed, the argument goes, you will keep the money parked where it is.

That raises a simple question: Rather than creating new money through QE2, why not reduce or eliminate the interest on reserves, and let the excess reserves flow out into the economy?

The official answer appears to be that the Fed now views the IOR rate as so low (it is currently 25 basis points, or 0.25 percent) that it cannot go any lower. Within the Fed, 25 basis points is considered the effective zero lower bound of interest on reserves.  To go any lower than this, say Bernanke and Fed officials I spoke with for this article, would drag the benchmark Fed funds rate down and create havoc in money markets.

This doesn't make a lot of sense. Money markets worked fine prior to the implementation of interest-on-reserve payments in September 2008. But it does suggest something that needs attention: The IOR rate, not open market activity, is now the mechanism for making changes to the Fed funds rate. That's the import of Dudley's comment about the textbooks. By long tradition, market watchers have tracked the Federal Open Market Committee's decisions on the Fed funds rate to know which direction interest rates would go, and to get a sense of what level of inflation the Fed is seeking. Now that signal is no longer clear.

There's also a potential issue of governance. The IOR rate is determined by the Fed's Board of Governors, while the Fed funds rate is determined by the larger Fed Open Market Committee (FOMC), which contains regional bank heads and a few dissenting voices. The governors now have a tool that effectively negates the policy work done by the FOMC. In fact, IOR and the Fed funds rate have become more or less the same thing, with some debate over why they don't track each other exactly. Whether you agree with the FOMC's readings or not, it's important that they be internally consistent. Now how do you know?

But political uncertainty may be only a small part of the havoc wreaked by IOR payments. In a recent study at Real Clear Markets, the Club for Growth's Louis Woodhill correlated the implementation of IOR with stock market performance and suggested that this contractionary mechanism is doing just what you'd expect it to do: causing contraction in the economy. In an email interview, he disputes the claim that the rate of IOR can't go any lower, noting that 25 basis points "doesn't sound like much, but the market interest rate on 90-day T-bills is 0.13 percent right now." 

Woodhill may be overstating the power of IOR. Right now the prime rate of interest is 3.5 percent. Theoretically, banks should be lending out excess reserves to qualified customers, provided they can find any. In a slack economy experiencing historically high default rates for almost all forms of private debt, you don't need a lot of incentive to sit on whatever cash you have.  

But the truth is nobody knows, after two of the most miserable economic years since the 1970s, how big an impact, if any, IOR has had. The Fed wants us to believe mutually exclusive stories: Paying interest on reserves is an important deflationary tool that allows the creation of trillions of new dollars; and paying interest on reserves has nothing to do with the fact that banks are not lending out a historic excess of reserves.

The second explanation may be less incredible than it sounds. The U.S. economy continues to work its way back through at least 10 years of asset, credit, and wage inflation. It's possible that this long-overdue deflation could eat up an additional $600 billion, that the rate of IOR could remain nominal through another few years of frost in the climate for lending, spending, and hiring.

Bernanke's monetary strategy, which in the end owes less to Friedman than to the old lady who swallowed the fly, ensures that we will find out. By issuing this enormous pile of funny money, the Fed more or less guarantees it will at some point have to use IOR as an inflation rein. Bernanke might have gotten the same result—and a lot less heartache—if he'd just stopped paying the interest in the first place.

While this story doesn't have a moral, it may have a punchline. Market interventionists always lament the lack of coordination between the central bank and the government, and in this case they might be right. It would be a pretty good joke if the Fed's decision to lock up all those dollars actually caused the American Recovery Act stimulus to fail so abysmally. You'd have to be a Keynesian to believe it, but anything is possible. And now Bernanke's the one promising to create jobs.

Tim Cavanaugh is a senior editor at Reason magazine.