Reader RG sent me a link to a year-old paper from the New York Fed (PDF) which pretty clearly lays out the policy rationale for paying interest on excess bank reserves, and in the course of doing so helps explain why it’s a mistake:
Paying interest on reserves breaks this link between the quantity of reserves and banks’ willingness to lend. By raising the interest rate paid on reserves, the central bank can increase market interest rates and slow the growth of bank lending and economic activity without changing the quantity of reserves. In other words, paying interest on reserves allows the central bank to follow a path for short-term interest rates that is independent of the level of reserves. By choosing this path appropriately, the central bank can guard against inflationary pressures even if financial conditions lead it to maintain a high level of excess reserves.
This is to say that back in the summer/fall of 2008, the Fed saw the economy’s problems as one of liquidity. So they created a lot of new liquidity. When doing so, they were concerned that this might lead down the road to out of control inflation. So they began paying a modest amount of interest on excess reserves in order to create a new tool that would allow them to engage in future monetary contraction by raising the rate. At the time, the theory was that the contractionary impact of the modest IOR payments would be more than offset by the beneficial impact of increased liquidity.
But here we are in the fall of 2010. Unemployment is high. Inflation has been running below target for almost two years, and market expectations are for it to continue to stay below target. So why not reduce IOR payments?