The latest economic data have surely warranted a downward revision in the Federal Reserve’s assessment of near-term economic performance. It therefore might be a good time to review the steps the Fed could take if it wishes to provide further economic stimulus.
One option that has been discussed is lowering or eliminating the interest that the Fed pays on deposits that banks maintain in their accounts with the Fed. These accounts typically amounted to about $10 billion in normal times, but have grown to over a trillion dollars since the Fed began paying interest on reserves in the fall of 2008.
But Dave Altig isn’t persuaded that eliminating interest on reserves would make much difference. He notes that the gap between what banks can earn by leaving the funds idle in their accounts with the Fed at the end of the day (0.25%) and a used car loan (about 8%) is so large that increasing it another 25 basis points by eliminating the payment of interest on reserves really wouldn’t make much difference for banks’ incentives to make this kind of loan. Instead, Dave endorses the conclusion of Barclays Capital’s Joseph Abate:
If banks didn’t get interest from the Fed they would shift those funds into short-term, low-risk markets such as the repo, Treasury bill and agency discount note markets, where the funds are readily accessible in case of need. Put another way, Abate doesn’t see this money getting tied up in bank loans or the other activities that would help increase credit, in turn boosting overall economic momentum.
But Dave doesn’t quite finish the story. If I as an individual bank decide that a repo or T-bill looks better than zero, and use my excess reserves to buy one of these instruments, I simply instruct the Fed to transfer my deposits to the bank of whoever sold it to me. But now, if that bank does nothing, it would be left with those reserve balances at the end of the day on which it earns nothing, whereas it, too, could instead get some interest by going with repos or T-bills. The reserves never get “shifted into short-term, low-risk markets”– instead, by definition, they are always sitting there, at the end of the day, on the balance sheet of some bank somewhere in the system.
The implicit bottom line in the Abate story is that the yields on repos and T-bills adjust until they, too, look essentially to be zero, so that banks in fact don’t care whether they leave a trillion dollars earning no interest every day.
The essence of this world view is that there are two completely distinct categories of assets– cash-type assets which pay no interest whatever, and risky investments like car loans that banks don’t want to make no matter how much cash they hold.
But I really have trouble thinking in terms of such a two-asset world. I instead see a continuum of assets out there. As a bank, I could keep my funds overnight with the Fed, I could lend them in an overnight repo, I could buy a 1-week Treasury, a 3-month Treasury, a 10-year Treasury, or whatever. Wherever you want to draw a line between available assets and claim those on the left are “cash” and those on the right are “risky”, I’m quite convinced I could give you an example of an asset that is an arbitrarily small epsilon to the right or the left of your line. Viewed this way, I have a hard time understanding how pushing a trillion dollars at the shortest end of the continuum by 25 basis points would have no consequences whatever for the yield on any other assets.
The way to do the same thing in a bigger way is of course to raise the implicit penalty on idle cash through inflation. Whenever I make this point, some readers respond that I am proposing to turn America into Zimbabwe or steal the earning power of honest workers. If I as a modest blogger face such reactions, I can understand the difficult public-relations tightrope act faced by the U.S. Federal Reserve. Notwithstanding, it is very clear to me that deflation can be quite harmful, and that particularly given our present circumstances, moderate inflation rather than deflation would produce a clearly superior real outcome for essentially all Americans of every walk of life. But how exactly can the Fed prevent deflation?
If the Fed announced a policy of “20 percent weaker dollar or bust,” and proceeded to buy euros, yen, and other currencies, by golly, I do not think that private speculators would try to get in the way. And if foreign governments tried to get in the way, that would probably lead to some sort of worldwide monetary expansion that I imagine would make [Scott] Sumner happy.
A weaker dollar would of course not only prevent deflation, but would also help discourage U.S. imports, which I see as both a near-term drain on domestic aggregate demand as well as a profound long-run challenge.
But let me close with the same caution I offered when discussing this issue two weeks ago. There are limits to what we can expect monetary stimulus to accomplish, and the speed-limit sign I recommend that the Fed should observe comes from watching what happens to commodity prices. If a strategy of dollar depreciation begins to show up in significant moves in relative prices, I think that’s an indication the policy has accomplished all that it could.
It’s a mistake to ask too much of monetary policy. But preventing deflation is definitely something we should ask the Fed to do, and well within the Fed’s power to achieve.