The Federal Reserve’s Liberty Street Economics blog published an article today on why the Interest on Excess Reserves (IOER) should be kept at 25 bps in the current environment. The author, Gara Afonso, makes the case that lowering the IOER is important for maintaining interest rates in positive territory, and that this, in turn, is important for financial stability. The blog had a story with different authors but the same conclusion back in August that we covered as well (“Fed’s LSE blog chimes in on why not to lower Interest on Excess Reserves rate; we think they miss the point“). This time around the author uses a model to show causality between IOER and the Fed Funds rate. Our rebuttal to today’s post continues to argues for an change of the Fed’s view.
In a nutshell, Afonso summarizes the many reasons for keeping IOER at the current level: the fear of reducing interest rates to negative territory; too much downward pressure on money funds; and further damage to the already battered Fed Funds market are all cited. The theoretical justification is that “it has typically been argued that the interest rate paid by central banks on required reserve balances effectively compensates depository institutions for the implicit tax that reserve requirements impose on them, while the interest rate paid on excess balances provides the central bank with an additional tool for conducting monetary policy.”
The new information Afonso and Ricardo Lagos at NYU present is the model-based positive correlation of IOER and interest rates. That is to say, lowering the IOER would reduce Fed Funds rates. While conceptually we agree they are probably right, we note that the way that Afonso and Lagos modeled Fed Funds transactions has been roundly criticized by the Fed itself (“How to track Fed Funds? Even the Fed doesn’t know, and that’s a problem“). The vitally important paper, “What Do We Know About Federal Funds Activity” by Olivier Armantier and Adam Copeland has now been reposted on the Fed’s website after a hiatus with a new title. It can be viewed here. But methodology problems aside, let’s presume that there is some basic relationship: the more money in the market with nothing to do, the more that money might be invested at the Fed Funds rate. The more money seeking Fed Funds, the more that Fed Funds is driven down.
Right now, the volumes of IOER is awfully high, around US$1.5 trillion according to the Fed. That’s a bit less than the size of the US tri-party repo market or the global securities lending market. If IOER went to zero tomorrow, that would be a very large quantity of cash looking for a home. Rates for all sorts of short-term investments would invariably decline. These are the arguments for keeping IOER at 25 bps, and they are good ones. Here are the data:
Having provided the Fed’s argument for continuing IOER, here is ours that we started in August 2012 and are continuing here: IOER, along with FDIC insurance, is at heart a market distortion. It may be important for now in a very low interest rate environment to keep IOER high, but even in the short term maintaining IOER at 25 bps gives banks a reason to not use that money effectively. This does not serve shareholders or the economy. When people talk about the huge volumes of cash on the sidelines, this US$1.5 trillion is one such pool. It would be fine, we think, to have a slow and controlled release of this cash – we don’t want to see negative interest rates either. But the risk/reward of IOER at 25 bps we think is too high and comfortable for the current market. Further, IOER at 25 bps and Fed Funds daily average at 16 bps means that Fed Funds is suffering from low volumes for artificial reasons — the GSEs can’t leave money at the Fed.
It is time for the Fed to revise its IOER policy alongside related market distortions that are encouraging banks to hoard cash and negatively impacting the important Fed Funds trade and the benchmark it creates. Banks can do better if the IOER option is taken off the table in a measured way, and the US economy, not to mention the global economy, will benefit.