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Quantitative easing is often described as printing lots of new money and using it to buy back government debt. It sounds too good to be true. And yet until recently there was relatively little inflationary consequence from all of this money printing. And even the recent spike in inflation could have been prevented if the central banks had raised rates a bit sooner.

But when something is too good to be true, there’s usually a catch. For the most part, central banks weren’t actually “printing money”. Rather they were buying longer-term bonds paying 2% interest with newly issued interest-bearing reserves, which at the time paid almost no interest at all. Central banks were essentially operating the world’s largest hedge funds. Borrowing short-term at low rates and lending long-term at a higher rate. 

But that carry trade remains profitable only so long as short-term rates stay lower than the rates on previously issued longer-term bonds. The vast profits earned by central banks over the past 13 years would turn into losses if short-term interest rates rose sharply. So perhaps it is only fair that central banks now earn some losses. 

But not everyone wants the central banks to pay up. Here’s The Economist:

Another option is to find a way for central banks to pay less interest on reserves. A recent report by Frank Van Lerven and Dominic Caddick of the New Economics Foundation, a British think-tank, calls for them to pay interest on only a sliver of reserves that affects their decision-making, rather than the whole lot. The ECB and the Bank of Japan already have such a “tiered” system. It was designed to protect commercial banks from the negative interest rates they have imposed in recent years.

Using tiering to avoid paying banks interest while their funding costs went up would be a tax in disguise. Banks, considered together, have no choice but to hold the reserves QE has force-fed into the system. Compelling them to do it for nothing would be a form of financial repression which may impair banks’ ability to lend. It would “transfer the costs [of rising rates] to the banking sector,” Sir Paul Tucker, a former deputy governor of the Bank of England, told parliament in 2021.

Maybe I’m missing something, but I have trouble following their argument. It’s hard to see how banks could be induced to maintain their large holdings of excess reserves if the reserves did not earn interest while other risk-free assets such as T-bills earned a positive rate of interest. Back in 2007, short-term interest rates in the US were about 5% and thus banks held only a tiny amount of excess reserves. Today, excess reserves are now roughly 1000-fold higher than before the Fed began paying IOR in 2008. 

There’s a reference to the tiered system in Japan and Europe, but that involved paying a higher interest rate on the infra-marginal reserve holdings (that is zero interest instead of the negative interest rate on the marginal holdings.)

It’s also a bit misleading to suggest that banks, in aggregate, are somehow “forced” to hold reserves injected through QE programs. One problem is that banks could make deposits less attractive and a portion of the reserves would leak out as currency. But even if you assume a world without currency, where 100% of the monetary base is bank reserves, it is still misleading to suggest that banks are forced to hold excess reserves just because the central bank injects them into the system.

Here it is useful to recall the distinction between the nominal supply of bank reserves and the real demand for bank reserves. Central banks determine the nominal stock of reserves, while the commercial banking system determines the real stock of reserves.  

To be sure, central banks can induce commercial banks to hold a very large stock of reserves—even if real terms—if they are willing to pay sufficient IOR. But if you assume that no interest would be paid on most bank reserves, why would banks choose to hold large a real stock of excess reserves?

If all banks simultaneously tried to get rid of excess reserves, this would lead to changes in the prices of goods, services, and assets. Eventually, the price level would rise high enough so that banks were holding their desired real stock of reserves. But when you consider that excess reserves in America are roughly 1000-fold higher than in 2007, the required price level increase would presumably be very large. (It’s difficult to say how large, as there have also been some regulatory changes since 2007 that have boosted the demand for bank reserves.) I suspect that the UK would face a similar problem. 

Ultimately, someone must pay the cost of financing the public debt. If the central bank buys back the government’s debt in QE programs, then there are three options:

1. Have the central bank pay IOR indefinitely, which is costly.

2. Impose an implicit tax on the banking system with regulations that require banks to hold large quantities of reserves that pay no interest.

3. Impose an inflation tax on the public by not requiring banks to hold large quantities of reserves, but also not paying interest on those reserves.

I fail to understand the rationale for imposing a tax on banks during periods when QE results in losses for the central bank. As an analogy, imagine if the Prince of Monaco visited the casino of Monte Carlo every so often. On some days he ended up winning money. Other days he would suffer losses. Now suppose that on days when his luck was bad the prince imposed an ad hoc tax on the casino equal to his losses. That doesn’t seem fair!

Central banks have essentially been running a giant hedge fund. Why should commercial banks have to pick up the tab on those occasions when the bets of the central bank turn sour?

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