"Let the printing presses turn and the helicopters fly, but please don't confiscate my gold."

Interfluidity has a response to the Hamilton post:

"Fedthink

James Hamilton has an excellent post on the Federal Reserve and its changing balance sheet today( IT WAS EXCELLENT ). If you haven't been following this stuff obsessively, it's probably the single best primer to get up to speed( TRUE ).

To my mind, there are three signal facts about the brave new balance sheet:

1. The size of the Federal Reserve's balance sheet has ballooned, more than doubling over a period of three months. If we take the FOMC at its word for it, it's not going to shrink anytime soon. Given new programs already announced, we should expect the Fed's balance sheet to continue to grow. ( OK )
   
2. On the asset side, only a small fraction of the Fed's holdings are now US Treasury securities. Excluding securities lent to dealers, just 12.5% of the Fed's assets are Treasuries. The Fed has expanded the scope of its lending, from depository institutions, to primary dealers, to money-market funds and commercial paper issuers, to issuers of asset and mortgage backed securities, and very soon to private investment funds that invest in asset-backed securities. The Fed also periodically lends to support firms in, um, special circumstances, such as JPM/Bear and more recently AIG. ( OK )
   
3. On the liability side, the Federal Reserve has dramatically increased the degree to which it funds its activities with zero-maturity bank reserves, upon which it is now paying interest( YES. I'M NOT AS HAPPY WITH THIS ).

The Federal Funds rate is now effectively zero. We have hit the so-called "zero bound".

There are many ways of trying to make sense of all this. One broad-brush view is that for all its radicalism, the Fed is just a thermostat. As the private sector delevered, the Fed had to lever up (McCulley). As foreign central banks shift their portfolio from agencies to Treasuries, the Fed has to shift its portfolio from Treasuries to agencies (Setser)( TRUE ). More broadly, as the private financial sector has become unwilling to issue short-term, liquid liabilities against long-term illiquid assets, the Fed has had to do so to avoid a disorderly collapse of asset prices (see Kling)( OK ). One might imagine a canoe carrying a wild beast (that would be our "rational" private markets). The beast writhes and bends, and the Fed must throw its weight in the opposite direction to force the tipping craft upright despite all the upheaval.

"Stability" — price stability, financial stability — are to my mind like "liquidity": qualities widely considered virtues that are often actually vices. Nevertheless, the Fed pursues these goals, and in the immediate term, the thermostat analogy works pretty well. I don't doubt that we'd have tipped into steep deflation, outright collapse of core financial institutions and an in-the-streets economic crisis without the Fed's extraordinary measures( I AGREE ). Had the Fed not played thermostat from 2001-2003, perhaps( MAYBE ) the beast would have been chastened by a mild dunking, and today's heroics might have been less inevitable. But it was stability über alles then, when the bubble first tried to burst, and now we are where we are.

So, thanks to the Fed, things are better than they might have been. But I think there is as much to squirm about than to celebrate in how the Fed has comported itself.

On the asset side, as has been widely noted, the Fed has been taking on extraordinary levels of credit risk. We do not know against precisely what collateral the Fed is extending its trillions in loans, and how conservatively that collateral is being valued( TRUE ). We wish Bloomberg luck in their lawsuit. (ht CR, Alea).

We do know that the Fed is becoming ever more brazen about its risk-taking( YES ). When the Fed made a non-recourse loan in connection with the collapse of Bear Stearns, Chairman Bernanke was summoned by Congress to discuss the unusual move. A non-recourse loan is economically something between lending and purchasing. The Fed has the authority to lend to whomever it pleases under "unusual and exigent" circumstances, but it is not empowered to spend outright what are in the end US taxpayer dollars. Anticipating objections, Dr. Bernanke was very careful during the Bear debacle to ensure that since the taxpayer would "own" most of the downside, it would also capture the upside. Still, he was called to account for what was widely understood to be an unusual move of very questionable legality. But now, under TALF, the Fed will extend non-recourse loans to just about anyone. The Fed will assume much of the downside, while private investors capture the upside. In my view, it is not quite legal for the Fed to extend non-recourse loans, and the practice should be curtailed. Non-recourse loans should be approved by Congress and executed by the Treasury department. The recipients of loans from the Federal Reserve should be bankrupt before taxpayers take losses( HERE I AGREE ). Remember, the Fed is an an unelected technocracy "cognitively captured" (as Willem Buiter puts it) by the sector it purports to regulate. Yes, Congress sucks. But the Fed sucks too, and the rule of law does matter.

For all of that, it is the liability side of the Fed's balance sheet that is most interesting. The Fed is financing its gargantuan balance sheet expansion by conjuring unsterilized bank reserves. A year ago, there were less than $18B of reserves deposited at the Fed. Today there are $800B. A year ago the Fed wasn't paying interest on bank reserves. Today it is.

Interest rates are, for the moment, excruciatingly low. But a subsidy to the banking system, once put into place, will be quite hard to dislodge( IT'S A PROBLEM ). So, let's imagine that the Fed will pay interest on bank reserves in perpetuity, that it will pay such interest at or near the risk-free short-term interest rate, and that the expansion of the Fed's balance sheet is more or less permanent. How large a subsidy to the banking system do the interest payments on reserves represent? Some problems are arithmetically challenging, but not this one. The present value of a perpetual stream of market-rate interest payments is precisely the amount of the principal. Therefore, the present value of the Fed's de facto commitment to pay interest to banks on $800B of freshly created reserves is $800B. We fought and wailed and gnashed our teeth over potentially overpaying for TARP assets. Meanwhile, we are quietly allowing the Fed give away, as a direct, literal subsidy, more than the entire $700B that Paulson was allowed to play with. Note there is no question about this being an "investment": The interest payments that the Fed is now making to banks on its suddenly expanded balance sheet are not loans. The banks owe taxpayers absolutely nothing in return for this windfall.

Now the bankers will object, as they always do. Bankers have forever cried that they are required to hold reserves at the Fed, that to be forced to lend their cash interest-free to the central bank is a hidden tax. I hope we all understand by now that the pronouncements of the banking industry are about as reliable as a monthly statement from Bernie Madoff. The reserves in the banking system are created by the Fed, and the quantity outstanding is now enough to cover banks' regulatory and settlement needs many times over. This is not in any sense "their" money. It is money the Fed printed in order to pursue its own objectives. The banks have no right whatsoever to earn interest on this money( TRUE ), and absolutely do not merit an $800B subsidy. Further, the core rationale for paying interest on reserves has disappeared entirely. Originally, the Fed wanted the power to pay interest on reserves so that it could expand its balance sheet to pursue "stability" goals without stoking inflation by letting the short-term interest rate fall to zero( TRUE ). Now the short-term interest rate has fallen to zero, and the dominant concern is that we are in a "liquidity trap". Yet we are still paying the banks 25 basis points to hold this freshly created money at the Fed. James Hamilton, towards the end of his piece, points out that this is counterproductive. I want to point out that it is also obscene( OK ).

Now I have to admit that, personally, I feel a bit caught out, bent out of shape, gypped, by the whole paying-interest-on-reserves thing. A long while back, I argued against giving the Fed this power, because I knew they would abuse it. During the TARP debate, I did a one-eighty. At least the Fed, I reasoned, would only lend taxpayer money. If we took losses, the institutions that shoved them onto us would go down first. Paulson clearly wanted to assume bank liabilities outright by overpaying for toxic assets. Having the Fed lend taxpayer money seemed like a better deal than letting Paulson give it away. The cost of paying interest on reserves, when I had written about it previously, was about only $11B in present value terms, insignificant in the grand scheme of things. (By the end of September, when I flipped, reserves had already grown to $100B... but I missed that.) Now we have the worst of all worlds: Not only has our corrupt, dysfunctional banking system won the small subsidy it has long lobbied for, but the size of that subsidy has grown by almost 8000%. The Fed is no longer lending only to financial institutions that would have to go under before taxpayers eat their losses. Under TALF, the Fed will lend to anyone who owns the kind of securities whose prices the Fed wants support. The borrowers will take the upside, while taxpayers eat the downside( A PROBLEM, YES ). (Does anybody know what kind of leverage the Fed will support under TALF? I've looked, but haven't found.) The non-recourse lending that was extraordinary and barely legal when Bear went down is now the new normal, except that the Fed no longer bothers to ensure an upside for taxpayers. By institutionalizing non-recourse lending, the Fed has arrogated the power to do everything the original TARP would have done, except without the opportunity for people like me to write Congress in anger.

Despite all this, I am becoming rather Zen about the Federal Reserve lately. I have some sympathy( AS DO I ): They are dancing to a tune that they no longer call, struggling to keep pace with an accelerating beat. The Bernanke Fed is clever and inventive, delightful as spectator sport. So many trillions of dollars have been spent or committed or guaranteed, that the amounts have gone meaningless( THAT'S HOW I FEEL ). I think that the current financial system and the Fed itself are quite doomed, and I'm less inclined to get bent out of shape by the particular ordering of the death throes( HERE I DON'T AGREE. WE'LL GO BACK TO BAGEHOT. I GUESS THIS MAKES ME A CONSERVATIVE OF SOME SORT.). There will be a great crisis. Hopefully it will only be a financial crisis. I'd prefer it to be an inflationary rather than a sharp deflationary crisis, both because I think that a great inflation would be less destructive( I AGREE ), and because that's the way my own portfolio tilts. So really, I should root for the Fed. Let the printing presses turn and the helicopters fly( THAT'S MY POSITION ), but please don't confiscate my gold.

Since the current Fed loves bold and unorthodox action, I thought I'd end this with a (sort of) constructive suggestion. As the composition of the monetary base changes from mostly currency in circulation to largely electronic reserves, the zero-bound on nominal interest rates can be made to disappear. How? Simple: Rather than paying interest on reserves, the Fed can tax them( WE'VE PREVIOUSLY CONSIDERED THIS AND STAMPING ). If banks were taxed daily on their reserves, banks would compete to minimize their holdings, and interbank lending rates would go negative. With a high enough tax, banks could be made desperate to lend, even though in aggregate the banking system has no choice but to hold the reserves. Presumably, banks would pass costs to depositors by eliminating interest on deposits, increasing fees, and ceasing to offer term CDs. Money in the bank would go from what everyone wants to something nobody can afford to hold. People would strive to minimize transactional balances, and invest any savings in money markets or stocks or bonds, anything not subject to the tax. (This is similar in spirit to a suggestion by Arnold Kling.)

Of course there would be tricky consequences: Gresham's law would kick in, as people would hoard physical cash to avoid the tax. Coins and bills would cease to be used for exchange, but would be held as stores of value. That would introduce some friction into small transactions: we'd end up using debit cards to buy candy bars, accelerating our transition to a cashless economy. But electronic money would be legal tender, and the appreciation of paper money would be no more relevant to the overall price level than the fact that older "wheat pennies" are worth much more than 1¢. With a sufficiently large electronic monetary base, there need be no zero-bound on nominal interest rates, and we can use "conventional" monetary policy to fight deflation by letting nominal rates go negative. I laugh in the maw of your liquidity trap."

I'm letting this go( ALTHOUGH IT IS FUN TO THINK ABOUT ), because I see a different future for the Fed and banks.

"The bottom line is that Bernanke has made a gamble with something approaching 2 trillion."

James Hamilton on Econbrowser:

"Federal Reserve balance sheet

Here I survey how we got here, where things currently stand, and what it all means.

Let me begin by reviewing some first principles of what the Fed is all about. How did the cash currently in your wallet get there? You withdrew it from an ATM, perhaps. But these wonderful contraptions don't just give you the green stuff for free-- you had to have deposits in the bank to be able to withdraw the cash. You can think of your account with your bank as credits you can use to get cash whenever you want it.

But where did your bank get the cash? It likely has an account with the Federal Reserve System, which account, just like the one you have with your bank, shows a certain level of deposits that the bank has in its account with the Fed. Your bank can then go to the Fed and withdraw those deposits in the form of cash. So you can think of your bank's deposits with the Fed as credits it can use to get cash whenever it wants.

And how did your bank come to have those deposits with the Fed? These deposits are something the Fed has the power to create out of thin air. This indeed is its primary power-- the ability to create money( TRUE ). That's a power that could be easily abused, so our system is set up to prevent the Fed from creating deposits willy-nilly. Specifically, the traditional operation of the Federal Reserve was to purchase assets such as Treasury securities from a private dealer, paying for them by simply crediting the dealer's account with the Fed with new deposits. The Fed hasn't created any wealth with this transaction, it has simply introduced a new asset (ultimately, money) and retired an old (the Treasuries that were formerly held by a member of the public are now held by the Fed). ( OK )

Although private sector wealth is unchanged as a result of this transaction, there is one important implication for the Treasury. Before the Fed made this open-market purchase, the Treasury was obligated to pay interest on those securities to someone in the private sector. Now as a result of the open-market purchase, the Treasury is making that payment to the Fed. The Fed in turn returns those payments back to the Treasury. You can see those payments from the Fed back to the Treasury each month in Table 4 of the Monthly Treasury Statement( GO TO FMS LINK ).

But wouldn't the Treasury want the Fed to simply buy up all of its outstanding debt, and relieve the taxpayers forever of that nasty burden? It might, but to do so would require so much new money creation that it would cause a horrific inflation. To avoid that, we have a careful separation of powers, asking the Fed to take responsibility for inflation and letting the Treasury worry about how to pay its bills.

The Fed could always use its power to acquire assets other than Treasury securities. For example, the Fed could make a loan to a private bank through its discount window. The bank receives the loan in the form of new deposits with the Fed, which again the Fed simply creates out of thin air. The receiving bank presumably used those deposits to pay somebody else, but that transaction simply transferred the Fed deposits to another bank, so that newly created deposits stay in the system until they are withdrawn as cash. The Fed in this case acquired an asset (the loan) whose value by definition exactly equaled that of the newly created deposits( OK ).

Alternatively, the Fed might want to add reserves to the banking system temporarily, to satisfy what it saw as a temporary liquidity need. Traditionally it would do so with a repurchase operation, in which the Fed temporarily takes ownership of an asset held by a dealer, and temporarily credits the reserves of the dealer in exchange. Essentially a repo is a collateralized short-term loan from the Fed to someone in the private sector.

There are some other categories of assets the Fed could acquire, and some other potential disposition of reserves it creates on the liabilities side. The chief among the latter that I will mention here is the Treasury's account with the Federal Reserve. This traditionally was used by the Treasury for cash management of its receipts and expenditures. Some of the deposits that the Fed creates (for example, with a discount window loan) might have ended up being transferred between banks (as individual customers send checks to customers of other banks) and ultimately end up in the Treasury's account (as income taxes get withheld, for example). Since the Treasury isn't going to withdraw these funds as cash, they're counted separately on the liabilities side of the Fed's balance sheet.

There are a lot of other little categories we could discuss, but historically there was really just one big story-- the Fed created deposits primarily by buying Treasury securities, and these ultimately ended up as cash held by the public( OK ). The left column of the table below summarizes the assets (factors supplying reserves) and liabilities (factors absorbing reserves) as of December 5, 2007. At that time, 85% of the Fed's assets were held in the form of Treasury securities, and 89% of its liabilities took the form of currency held by the non-bank public.

Balance sheet of the Federal Reserve.
(Based on end-of-week values, in billions of dollars). Data source: Federal Reserve Release H.4.1.

	Dec 5, 2007	Dec 17, 2008
Securities	779.7	493.8
Repos	46.5	80.0
Loans	2.1	1039.9
Other	92.0	733.0
Factors supplying reserve funds	920.4	2346.7
Currency in circulation	819.3	877.7
Reverse repos	36.7	71.9
Treasury accounts	5.1	484.6
Service and reserve balances	16.0	801.8
Other	43.4	110.7
Factors absorbing reserve funds	920.4	2346.7
Off balance sheet
Securities lent to dealers	4.5	186.5

Over the last year, however, there were some profound changes in the composition of the Fed's balance sheet. These initially were dictated by the desire of the Fed to make more loans (which it thought it needed to do to alleviate problems in the credit market) without creating any new money (which it worried would create inflation). The way the Fed sought to achieve this was by selling off a large chunk of its holdings of Treasury securities, and replacing them with loans and alternative assets. These came in a variety of shapes and colors, but the two biggest categories at the moment are the Term Auction Facility, which essentially is a systematic program to encourage a particular volume of borrowing by banks from the Federal Reserve, and amounted to $448 billion as of last week, and currency swap lines, the biggest factor in the "other" asset category reported on the Fed's H.4.1, said other category coming to some $682.4 billion last week. Up until September of this year, the Fed was implementing these changes without increasing the total level of assets on its balance sheet. The graph below plots the composition of the end-of-week asset holdings of the Federal Reserve over the last two years.

Federal Reserve assets in billions of dollars. Data source: Federal Reserve Release H.4.1..

Beginning in September, the Fed decided it couldn't afford to sell off any more of its Treasuries, but wanted to lend more and still have no effect on the money supply. To do so it needed to find a way to funnel the reserves created by the new loans it would make into categories on the liabilities side that would not result in more cash held by the public. The first such device was to reach an agreement with the Treasury for the Treasury to simply hold on to a huge volume of Federal Reserve deposits, some $484.6 billion as of last week. The way this worked is that two operations were implemented simultaneously. First, the Fed created a lot of new deposits, for example, $318.8 billion from the Commercial Paper Lending Facility alone. Second, the Treasury borrowed an additional half trillion from the public, forcing somebody in the public to send a check to the Treasury. In the aggregate, the reserves created by the Fed through the CPLF end up just being parked in the Treasury's account with the Fed, with no creation of money. The graph below plots the composition of the liabilities side of the Fed's balance sheet over the last year. By definition, the height of the line in the graph below is identical for every date to the height of the line in the graph above.

Federal Reserve liabilities in billions of dollars. Data source: Federal Reserve Release H.4.1..

The second measure that the Fed employed to allow this ballooning of its assets was to start paying banks an interest rate on reserves that is exactly equal to its target for the fed funds rate itself, essentially eliminating any incentive for the banks to lend fed funds and encouraging banks instead to simply let excess reserves accumulate. Last week, banks were sitting on about $800 billion in excess reserves with the Fed, doing absolutely nothing with them. The Fed was in effect lending those funds in place of the banks. I have been quite apprehensive about this scheme( I THOUGHT IT WAS AN INCENTIVE TO HOARD, AND NOT LOAN IN THE CURRENT SITUATION ), particularly now that we have reached a point where, in my opinion, the Fed in fact does want the money supply to increase so as to cause a little inflation. But the present arrangement makes it quite awkward for the Fed to do so( YEP ).

And what's the risk associated with the Fed's new strategy? Back when the Fed held $800 billion in Treasuries, these were a liability of the Treasury and an asset of the Fed. In effect, the Treasury's nominal obligation was one for which taxpayers would never owe a dime. Now that more than half of those securities have been lent or sold off by the Fed, and the Treasury has borrowed a half-trillion extra to make this work, that's more than a trillion extra for which the taxpayers are potentially on the line( OK ). If the loans and other assets that the Fed has acquired with those funds do not make a loss, then all is still well and good. But if the Fed's new loans do not perform, there won't be a positive receipt in the Monthly Treasury Statement corresponding to interest returned from the Fed to the Treasury. In other words, the federal deficit will rise by the amount of the extra interest the Treasury owes on up to a trillion dollars in new debt( THAT'S THE RISK ).

And how about the Fed's "free money" from the ballooning excess reserves? If those funds do start to end up as cash held by the public, then the Fed will need to worry again about inflation, in which case it has two options. One is to sell off some of its remaining assets (or fail to roll over some loans). In this case, the consequences for the Treasury are the same as above-- that income from the Fed's earnings is no longer coming back to the Treasury, and it's as if the $800 billion in excess reserves was again replaced by direct Treasury borrowing.

The second option is just allow the inflation.

The bottom line is that Bernanke has made a gamble with something approaching 2 trillion. If the gamble wins, taxpayers owe nothing. If the gamble loses, taxpayers are committed to borrow a sum equal to any losses and start making interest payments on it( THAT'S IT ).

For the record, let me reiterate my personal position on all this.

(1) I am doubtful of the Fed's ability to alter interest rate spreads through the kinds of compositional changes in its balance sheet implemented over the last two years. Whatever your prior ideas were about this, surely it's time to revise those in light of incoming data-- if the first trillion dollars didn't do the job, how much do you think it would take to accomplish the task? ( NOT SURE )

(2) I think the Fed's goal should be a 3% inflation rate( THAT'S REASONABLE ). Paying interest on reserves and encouraging banks to hoard them is inconsistent with that objective, as would be a new trillion dollars in money creation. ( ON THE FIRST POINT I AGREE. ON THE SECOND, WHAT WOULD THE INFLATION RATE BE ? )

I would therefore urge the Fed to eliminate the payment of interest on reserves( I AGREE ) and begin the process of replacing the exotic colors in the first graph above with holdings such as inflation-indexed Treasury securities and the short-term government debt of our major trading partners( WHICH PAY INTEREST ).

I think that this is a sensible moderate proposal, which would be great if it works. I simply believe that it might not work in creating inflation, but I hope that it does. I still think that we need to print money.

OK. Nick Rowe turned up in the comments with a more serious explanation of my concern:

"Let's compare the Fed's "gamble" with helicopter money.

With a "helicopter" increase in the money supply, the Fed's balance sheet shows a new liability, and no new asset( TRUE. THEY SIMPLY PRINTED MONEY AND GAVE IT AWAY ).

That is equivalent to the Fed buying an asset, with newly-printed money, and then the asset turning out to be worthless( TRUE ).

In other words, if you believe that a "helicopter" increase in the money supply is what is needed to get the economy out of a liquidity trap, then the destruction of the Fed's balance sheet net worth is exactly what the Fed is trying to achieve( YES ).

The only difference between helicopter money and the Fed's buying a worthless asset is in who gets the money: the person who picks it up off the ground (i.e. the one who receives the government transfer payment); or the person who sold the fed the worthless asset.

Let me put it another way: if it lost the gamble, the Fed would be forced to print money to make the same monthly transfer to Treasury, and this would be inflationary. But the expectation of future inflation is exactly what the Fed needs to create now, to escape the liquidity trap. This is a gamble the Fed wants to "lose".( TRUE )

Posted by: Nick Rowe at December 22, 2008 12:25 PM

Now a response from Hamilton:

"Nick Rowe: I agree that an increase in the monetary base is a good idea. I disagree that the appropriate number is a trillion dollars, or that uncertainty about what the number is going to be is a good thing."

Nick Rowe again:

"Uncertainty about the increase in the monetary base *is* a good thing, if the size of the increase in the money base is closely correlated with the amount that is needed, something about which we are equally uncertain.

The value of the Fed's risky assets is correlated with how quickly the economy returns to normal. If the economy returns to normal quickly, those assets will be worth a lot, and so the permanent increase in the money base will be very small. If the economy does not recover, those assets will be worth very little, and the permanent increase in the money base will be very large. And one trillion might not seem excessive in a worst case scenario.

So you have a negative-feedback equilibrating mechanism in place, created by the Fed's buying risky assets, the value of which is correlated with the Fed's success in getting the economy out of a deflationary slump.

It is as if Ben Bernanke made a very large bet, backed by the Fed's printing presses, about the future rate of recovery and inflation.

Posted by: Nick Rowe at December 22, 2008 01:19 PM

Now a question to Nick:

"Nick,

Not sure I understand your point on "helicopter money".

The Fed always has the option of asset backing a helicopter drop.

Why do it by debiting the Fed's capital position deliberately?

Posted by: JKH at December 22, 2008 01:20 PM"

Nick Rowe responds:

"JKH: "Helicopter money" is a *permanent* increase in the supply of money (by assumption), and it adds to private sector wealth, at the existing price level, (because it's just given away). These two features make it the most powerful form of increases in the money supply. Because it's permanent, it increases expected future price levels (which encourages people to spend money now). Because it's just given away, and increases household wealth (at the existing price level), you get a wealth effect on spending, not just the substitution effect (which is very weak or non-existent in a liquidity trap anyhow).

The purpose of "debiting" the Fed's capital position is to create the expectation that the Fed cannot buy back the money, so that it is seen as permanent, and thus more powerful.

Am doing a post on this at WCI now.

Posted by: Nick Rowe at December 22, 2008 02:09 PM"

I am essentially following Nick Rowe's reasoning in this. Thankfully he keeps commenting.

"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.