"To me, all the policy shift has done is to pay banks not to lend."

Rebecca Wilder on News N Economics does what I like and asks and answers a question that explains something odd to us:

"The Fed’s paying interest on reserve balances has been bugging me lately. I simply don't understand why the Fed would initiate a policy shift desinged to "improve efficiency in the banking sector" when the banking sector is in the middle of a crisis. To me, all the policy shift has done is to pay banks not to lend."

So, the Fed is paying interest on money that is being held in accounts by banks, and not used for loans. In other words, the banks are making money by not lending. Shouldn't the Fed charge for the money it lends or provides?

"Here is what Vice Chairman of the Federal Open Market Committee (FOMC) Donald Kohn had to say about bank lending: “In recent weeks, bank lending appears to have dropped back, consistent with the significant tightening of terms and standards reported by bank loan officers in recent quarters as well as the weakening of economic activity.”

When in fact, what he really meant to say wass this: “In recent weeks, bank lending appears to have dropped back, consistent with the significant tightening of terms and standards reported by bank loan officers in recent quarters, as well as the the weakening of economic activity, and since banks are now earning interest on reserve balances."

Oops. Although I don't doubt that the banks are shell shocked.

"Apparently, the Fed deemed it urgent to pay interest on reserves (IOR) because they fast-tracked the authorization for IOR that was initially set to start in 2011. As part of the Economic Stabilization Act of 2008, the Fed was granted authorization to pay IOR three years early. Theoretically, IOR improves the Fed’s ability to conduce efficient monetary policy in a world where required reserves are falling (see this paper for a nice discussion of monetary policy without reserve requirements). The Bank of Canada, the Bank of England, and the Reserve Bank of New Zealand all conduct monetary policy without reserve requirements, so why not the Fed?"

If reserves are falling, it makes sense to pay people to hold them or to add them.

"The Fed said that the IOR policy would help “eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector”. But why would a central bank try to improve efficiency smack dab in the middle of a banking crisis?"

Are the reserves falling? Does it matter?

"The most likey reason is that the Fed saw the IOR policy as an easy way to keep the effective federal funds rate close to its target as numerous $ billions in liquidity were added to the banking system. Well, that didn’t work. I bet that the Fed did not intend for excess reserve balances to balloon as they have.

The chart illustrates total and excess reserve balances as a share of total bank credit (on the H.4.1 statement). The Fed’s added liquidity (added bank credit) - $1.3 trillion over the last yearpromote bank lending – has ended right back at the Fed’s doorstep in the form excess reserves. Banks are hoarding the funds and getting paid to do it!"

So the Fed did not foresee this happening. They did not see that paying people interest on money in a downturn was going to a major incentive for them. That's hard to believe. I understand Rebecca to be saying that the Fed wanted to offer this incentive to help the balance of inflows and outflows, given that the outflows are currently so large. They wanted to offer an incentive for inflows.

Instead, banks see this as the best deal in town and are taking full advantage of it to the detriment of lending money to people or businesses.

"But don’t worry, the IOR policy can simply disappear. If the Fed cuts to zero, which I believe is a very distinct possibility in January (or even December, who knows), the interest rate paid on reserves will also fall to zero (equal to the FOMC target). Headache gone; then we will see what happens to excess reserve balances.But now that I think of it, the Fed can always change its mind...and the formula used to calculate the IOR rate for the third time."

If the rate were to go to zero, the incentive would be gone, unless they follow the lead of some bond buyers in the news today.

The only thing that might also have been a factor was the hope of helping the capital reserves and general health of the banks by paying them this extra money. But how many ways do we have to give them money not to lend? This was a poorly designed move.