E A Scary Monetary Conundrum Arises From The Great Recession

There is a real and frightening conundrum that has arisen from the Great Recession.  It is the IOR Conundrum. What are we to make of payment of interest on excess reserves (IOR), held for the banks by the Fed? In a nutshell, the Fed says a floor must be created under the Fed Funds rate, which is a form of interbank stimulus, and IOR does that, while the Market Monetarists say that the Fed made the recession much worse by paying the IOR. So, which is it?

Many don't realize that the Fed says it gave interest on banks' reserves in order to put a floor under the Fed Funds Rate. The Fed is worried that banks would loan money between each other at lower rates than the Funds rate, perhaps leading to negative rates. Of course, the Funds rate has hovered under 1 percent, so you wonder what bank would actually do that. But here is what the Fed says:

 Essentially, paying interest on reserves allows the Fed to place a floor on the federal funds rate, since depository institutions have little incentive to lend in the overnight interbank federal funds market at rates below the interest rate on excess reserves.

We all want to be free from the horrible Scandinavian problem of negative rates. We all know by now, I hope, that this has become a serious reality show over there in Denmark, Sweden and Norway, with the biggest Norwegian bank recently calling for a ban on all cash. We certainly don't want to try their little experiment in cashlessness.

But the conundrum continues with the Market Monetarists showing pretty clearly that the Great Recession got worse because banks not only did not lend below Fed Funds rate, but they simply didn't lend at all except to big business. The MMers view interest on reserves as a monetary policy tightening.

The Fed disagrees:

A steep rise in excess reserves cannot be interpreted as evidence that the central bank's actions have been ineffective at promoting the flow of credit to firms and households.

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Disclosure: I am not an investment counselor nor am I an attorney so my views are not to be considered investment advice.

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Robert Molineaux 6 years ago Member's comment

This is the first item I have seen that attempts to deal with the effect of interest on reserves. When first installed, I was puzzled by the apparent application of a deflationary tool, when the stated objective of the Fed was to encourage bank lending. I concluded that the IOR was put in place with little thought to consequences, and merely intended as a gift to the commercial banks in their moment of need. It now appears to have metamorphosized into one more tool to control short term interest rates. Maybe this is not the worst possible result since the banks have been using their lending power, not to encourage capital investment, but rather to fund corporate stock buybacks.

Gary Anderson 6 years ago Author's comment

Certainly Market Monetarists and others have leveled the charge that the Fed is applying a deflationary tool. But the New Keynesians seem to have come to terms with the eventual application of negative interest rates in a deflationary environment. While I am not totally comfortable with Market Monetarism because of its complexity and potential for misuse, the NK's are crazy. This march towards negativity is fraught with peril and is madness, IMO.

Duke Peters 6 years ago Member's comment

I had a similar reaction.

Atiq Rehman 6 years ago Member's comment

I do not understand the method of earning. You should explain in a short words and step wise. what to be done first and its outcome, please

Gary Anderson 6 years ago Author's comment

I don't offer financial advice through this article, Atiqu. But surely caution is important. Watch what the Fed does about interest on reserves. Slow growth and a cautious Fed are likely to continue as long as the big banks receive payment on reserves. The Fed contradicts itself by, on the one hand, saying it worries about banks lending below the Fed funds rate and then saying it is unlikely they would. So which is it? Seems like the Fed simply wants any excuse to insulate the big banks regardless of the effects on the economy.

Daniel Robertson 6 years ago Member's comment

If you ask the author nicely, I'm sure he'll elaborate. @[Gary Anderson](user:4798) is very bright and seems to be a regular here on TM.