In a recent New York Fed blog post, “Why pay interest on excess reserve balances?“, three Fed economists listed only one answer to their rhetorical question: so that the Fed can operate monetary policy with a large balance sheet.[1],[2]
The authority to pay interest on reserve balances provided the Fed an important tool for implementing monetary policy. Instead of relying on small adjustments to the quantity of reserves to target a level of market rates, the Fed can steer market rates by adjusting the return banks earn on the balances held overnight in their Fed accounts. That is, by raising or lowering the rate paid on excess reserves, the Fed can alter the value banks place on reserves and influence rates in the federal funds market. Since the Fed can implement monetary policy through a rate-based rather than a quantity-based mechanism, it has the flexibility to provide a greater supply of reserves while still controlling short-term interest rates [emphasis added].
The rest of their note lists what they see as the benefits of providing an excess supply of reserves; that is, maintaining a large balance sheet.
This answer is surprising. When the Fed asked for and received the authority to pay interest on excess reserves, it does not appear to have been intending to use the authority to operate policy with a large balance sheet. Indeed, they appear to have been primarily interested in using the authority to control interest rate volatility but with a relatively low level of excess reserves.
For example, in the FOMC meeting immediately after the Fed was granted the authority to pay interest on reserves, then Chairman Bernanke asked the Director of the Division of Monetary Affairs at the Board to “…form a committee of senior staff around the System to begin talking about these issues….”[3] The committee reported back to the FOMC in April 2008, providing a paper titled “Interest on Reserves: A Preliminary Analysis of Basic Options.”[4] The paper included five options and only one entailed the Fed operating with a large balance sheet. In the other four, the authority to pay interest on excess reserves was only used to put a floor under market rates. In those cases, the interest rate the Fed pays on excess reserves would be 50 – 100 basis points below market rates. At that level, banks would be likely to hold very low levels of excess reserves and the Fed would return to a relatively small balance sheet. When the staff briefed the FOMC on the memo, they recommended two of the five options for further study; neither of the two was the large balance sheet option.[5]
Moreover, the Fed staff raised significant concerns at that time about the large balance sheet option.[6] It seems best to simply quote the Fed staff analysis at length:
For example, there may be perverse outcomes in which an individual institution might find Fed account balances to be a very attractive asset and choose to hold a very large quantity of balances rather than lend in the market. Banks might see Fed account balances as largely superior to holding Treasury bills and other very short-term assets, potentially creating upward pressure on Treasury yields. A particular risk arises when there is a sudden change in the financial climate that makes banks want to increase their hoarding of reserves, leaving other banks deficient despite a very large supply of reserves in the aggregate. This same risk does not exist under the current system or with some of the other options because the opportunity cost of holding excess reserves is relatively high in those systems. (p. 35)
A significant question mark in evaluating potential implications of [the large balance sheet option] for payment is related to the possible impact of these options on the efficiency of interbank markets. The usual incentives for banks to trade reserves—the desire to avoid penalties for reserve deficiencies and overnight overdrafts and the opportunity costs associated with holding non-interest bearing excess reserves—would be much attenuated. As noted above, the marginal incentives for banks to trade reserves might be based on the potential costs associated with uncollateralized daylight credit, which seem likely to be rather small. With little trading activity and the funds rate mostly pegged very close to the target, the role for federal funds brokers could be considerably diminished. This possible degradation in the efficiency of the funds market could also have some corresponding impact on the efficiency of the payment system. (p. 38)
To summarize, the staff expressed concerns that a large balance sheet approach to monetary policy could put upward pressure on Treasury yields, could lead to banks hoarding reserves in a crisis, and could lead to a degradation in the efficiency in interbank markets with an accompanying reduction in the efficiency of the payment system.
Strikingly, staff’s dismissal of a large balance sheet monetary policy framework occurred after the financial crisis was underway and the Fed had begun large amounts of discount window lending, lending to other foreign banks, and emergency lending to the primary dealers. While it had been able up to that point to avoid a swelling of excess reserves by allowing Treasury securities to roll off as the credit programs grew, it seems unlikely that it could not foresee at that time the possibility that future actions in response to the financial crisis would require it to operate policy at least temporarily with a large balance sheet. Indeed, the staff memo notes “…the structure of [the large balance sheet] option might be well suited to managing the unusual liquidity injections that may prove necessary during times of financial stress.” (p.35)
The unfortunate consequence of the Fed’s recent blog post is that it links the Fed’s authority to pay interest on excess reserves (IOER), an authority that is under siege, to its operation of monetary policy with a large balance sheet and hence a large quantity of excess reserves. Moreover, when monetary policy is conducted with a large balance sheet, market interest rates are intended to be equal to the IOER rate. As a result, the blog post equates the ability to pay interest on excess reserves to a world where the Fed is making huge interest payments to commercial banks.
In fact, the country benefits if the Fed has the ability to pay interest on excess reserves even if the Fed returns to operating monetary policy with a relatively small balance sheet and the IOER rate is well below market rates. In that case, as explained in the Fed staff memo, IOER allows the Fed to put a floor under market rates, reducing interest rate volatility. Because reserve balances are low in this case, and because the IOER rate would be well below market rates, Fed’s interest payments to banks would be relatively small.
Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of The Clearing House or its membership.
[1] Reserve balances are deposits of commercial banks or U.S. branches and agencies of foreign banks at a Federal Reserve Bank. Required reserves are deposits held to meet reserve requirements (a percentage of bank deposits); excess reserves are the amount held in excess of required reserves. The Fed sought the ability to pay interest on required reserves to reduce incentives for banks to avoid holding such reserves through means such as sweep accounts, which sweep reservable deposits into non-reservable money-market funds at the end of each day. See “Testimony of Donald L. Kohn before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, June 22, 20014. https://www.federalreserve.gov/boarddocs/testimony/2004/20040622/default.htm.
[2] On October 4, 2017, the Fed’s had $4.5 trillion in assets and $2.2 trillion in reserve balances (Fed H.4.1 statistical release) of which $2.1 trillion were excess reserve balances (Fed H.3 statistical release). Because demand for currency (a Fed liability) grows over time, the Fed’s balance sheet also tends to grow. In terms of monetary policy operating frameworks, a “large balance sheet framework” is one with a high amount of excess reserves albeit lower than today; a “small balance sheet framework” is one with a low amount of excess reserves. The terms do not mean the balance sheet will be larger or smaller than today; under any monetary policy regime, because currency will keep growing, the balance sheet will eventually be larger than today.
[3] Transcript of the FOMC meeting on October 24-25, 2006, p. 3. https://www.federalreserve.gov/monetarypolicy/files/FOMC20061025meeting.pdf
[4] “Interest on Reserves: A Preliminary Analysis of Basic Options,” staff memorandum to the FOMC for the April 29-30 meeting. https://www.federalreserve.gov/monetarypolicy/files/FOMC20080411memo01.pdf
[5] Transcript of the FOMC meeting on April 29-30, 2008, briefing by William Dudley, manager, System Open Market Account, pp. 155-58. https://www.federalreserve.gov/monetarypolicy/files/FOMC20080430meeting.pdf
[6] It is worth emphasizing that these are the concerns the staff expressed in April 2008 and so are only relevant to the question of whether the Fed sought the authority to pay interest on excess reserves in order to operate monetary policy with a large balance sheet. The Fed has since accumulated nine years of experience actually operating monetary policy with a large balance sheet, so their current judgements about the pros and cons are much better informed. See, for instance, the of monetary policy implementation frameworks in the minutes to the July 2016 FOMC meeting (pp. 2-3). https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20160727.pdf.
For an argument in support of the Fed’s returning to a small balance sheet monetary policy framework, see Nelson, William (2017), “FOMC go home,” eighteen53 Blog, February 7, 2017. https://www.theclearinghouse.org/eighteen53-blog/2017/february/07%20-%20fomc%20go%20home.
