Interest on Reserves

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If the country’s political press could redirect 10 percent of the attention currently being paid to the House Democratic leadership race and the GOP pre-campaign for 2012 to one thing I would suggest the Federal Reserve’s interest on reserves program. Insofar as people pay any attention to this issue, it comes via the suggestion that monetary stimulus can’t work because the Fed has already increased the money supply a lot and all that’s happened is that banks are holding more reserves at the Fed. I don’t think that’s quite right, but the core observation about soaring excess reserves is accurate. But then the analysis just stops.

But it should continue. In late 2008, the Fed for the first time ever said that if banks wanted to hold extra reserves they would get interest payments in exchange for doing so. Then they raised the interest rate. And then they raised it again. Via Scott Sumner, Louis Woodhill makes a very strong argument that this has been a massively underrated factor in producing the recession. The IOR payments led to a steep decline in the velocity of money, which in turn led to a collapse in Aggregate Demand.

Crucially, the Fed has never really explained why they’re doing this. The program was started at a chaotic time when lots of stuff was happening very quickly. At the time, the stated rationale was that the Fed’s counter-crash measures might work too well and prompt a need for a rapid change of course in an anti-inflationary direction. This could be achieved, they said, by hiking the IOR payments even higher. So the Fed believes that IOR payments are contractionary. But obviously nothing has happened in the two years since the IOR payments were started that supports the idea that we need more contraction. On the contrary, we need more expansion. This could be easily tested by cutting the right from 0.25 percent to 0.15 percent and gauging market expectation. But the Fed’s not doing it.