The Fed’s Interest On Reserves Policy Is Not “Paying Banks Not To Lend”

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The FOMC has decided not to raise interest rates – for now. But it’s still widely expected that rate rises will come soon, possibly by the end of the year. Some people think that QE should be unwound first, but the Fed’s plan is to raise rates first. The Fed will unwind QE gradually as the securities it has purchased mature.

This creates a problem. Because of QE, the banking system is awash with reserves. Banks have more cash on deposit at the Fed than they need to settle customer deposit withdrawals (payments), and they therefore don’t need to borrow funds from each other as they would in normal times. Because of this, the Fed Funds rate – the rate at which banks borrow from each other – no longer influences bank behaviour. It has fallen to zero.

Well, nearly zero. Actually the Fed Funds rate hovers somewhere between zero and 0.25%. This is because the Fed is paying interest at 0.25% on excess reserves (IOER). Paying IOER prevents the Fed Funds rate from falling to zero. The Bank of England, which also pays IOER though at a slightly higher rate (0.5% instead of 0.25%), helpfully explains how this works (my emphasis):

Reserves accounts are effectively sterling current [checking] accounts for banks. Reserves balances can be varied freely to meet day to day liquidity needs, for example to accommodate unexpected end of day payment flows. The rate paid by the Bank on reserves account balances is also the means by which the Bank keeps market interest rates in line with Bank Rate.

Since March 2009, implementation of the Bank’s monetary policy has involved both keeping short-term market interest rates in line with Bank Rate, and undertaking asset purchases financed by the creation of central bank reserves in line with MPC decisions (so-called ‘Quantitative Easing’).

Under the reserves averaging regime used in more normal times, the Bank supplies the amount of reserves required for banks to meet their aggregate reserve targets. An excess supply of reserves, relative to that demand, would tend to push down on market interest rates. As a result of large scale asset purchases, the supply of reserves largely varies in response to the MPC’s policy decisions, rather than the changes in the demand for reserves. This potential imbalance in the demand and supply of reserves could have resulted in loss of control over market interest rates had banks been required to continue to set and meet targets. The Bank therefore suspended reserves averaging in March 2009, and banks are not currently required to set targets for their reserves balances.

Instead, the Bank currently operates a ‘floor system’ whereby all reserves balances are remunerated at Bank Rate. Because banks will not lend their surplus reserves to other banks at rates lower than can be obtained by depositing them with the Bank, this has the effect of flattening the demand curve for reserves after the point where there are sufficient reserves in the system for banks to manage their day to day liquidity needs.

So by paying banks to deposit funds with them, central banks set a “floor” on the rate at which banks will lend funds to each other – the Fed Funds rate, or “Bank Rate” in the UK. Therefore IOER is monetary policy. It enables the Fed to retain control of interest rates when the system is flooded with excess reserves.

Unfortunately the purpose of IOER has been widely misunderstood in mainstream media. Here’s Binyamin Appelbaum in the New York Times, for example:

Yet the Fed has found itself forced to experiment. The immense stimulus campaign that it started in response to the 2008 financial crisis changed its relationship with the financial markets. It has pumped so many dollars into the system that it cannot easily drain enough money to discourage lending, its traditional approach. Instead, the Fed plans to throw more money at the problem, paying lenders not to make loans.

Sorry, Binyamin, this is completely wrong. Banks are not being paid not to make loans. They don’t lend out reserves to customers. They only lend reserves to each other. By competing with banks in the market for reserves, the Fed controls the price at which they lend reserves to each other. It has nothing whatsoever to do with customer lending.

Unfortunately, because Binyamin has gone down the “paying banks not to lend” rabbit hole, he also fails to understand the rest of the Fed’s strategy. And he is certainly not the only one to do so. So here is my attempt to explain it.

If all US financial institutions had access to reserves, then the IOER rate would be the lowest rate at which they would lend. The Fed Funds rate would therefore sit at or above the IOER rate. But only banks have access to reserves. So banks can borrow from other financial institutions at a rate below the IOER rate and deposit those funds at the Fed, earning a spread. If this were a wholly perfect marketplace, such arbitrage would quickly cause rates to equalize. But because banks incur deposit costs (such as the FDIC levy), and non-banks limit their uninsured exposure to banks, the rate difference does not wholly disappear. As the Fed’s Simon Potter explains, the “floor” is somewhat flimsy (my emphasis):

Even if the market for funds were perfectly competitive, these costs should drive a wedge between IOER and other money market rates. As a result, the IOER rate does not directly establish a firm floor under money market rates, but instead can be thought of as a magnet, with the strength of its pull determined by these balance sheet and competitive frictions.

This causes something of a problem for the Fed’s rate normalization strategy. The Fed intends to pull the Fed Funds rate upwards by raising the IOER rate, taking advantage of the “magnet” effect. But there is a risk that banks will simply exploit the higher IOER rate to earn a wider spread on borrowing from non-banks, resulting in the Fed Funds rate and IOER rate diverging. So the Fed has designed another tool, the “overnight reverse repo” (ONRRP) to help lift the Fed Funds rate. The way it works is this.

For non-banks, an alternative to placing excess funds on overnight deposit with banks is borrowing Treasury bills. ONRRPs enable certain non-bank financial institutions to borrow Treasury bills overnight from the Fed at a rate slightly below the IOER rate. This is equivalent to an overnight cash deposit at the Fed. In effect, therefore, the Fed competes with banks to borrow from non-banks, thereby setting a floor on the price of that borrowing and thus preventing the IOER-Fed Funds rate diverging. We can think of IOER pulling the Fed Funds upwards while ONRRPs push it upwards.

None of this has anything to do with customer lending. It is all about the way in which funds circulate between banks, non-bank financial institutions and the central bank. It’s just hydraulics.
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Of course the external effect of raising the Fed Funds rate would be that interest rates to customers, both borrowers and depositors, would rise. But that’s the whole point of rate normalization, isn’t it?

Frances Coppola

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