This week, Federal Reserve Board chairman Ben Bernanke testified before Congress that the Fed is prepared to take additional actions to stimulate the economy in the event that growth falters. Unfortunately, the Fed does not yet appear to be considering an end to its ill-advised policy of paying interest on excess reserves at banks, which is in effect a subsidy to them for not lending.
Historically, the Fed operates primarily through short-term interest rates. It largely controls a special rate called the federal funds rate, which is the rate at which banks borrow reserves from each other on overnight loans.
Although it is generally assumed that the fed funds rate automatically impacts longer-term rates, there is little evidence that this is the case. In 2004, the fed funds rate was 1.35 percent, the corporate bond rate was 5.63 percent, and the home mortgage rate was 5.77 percent. Then the Fed tightened and the fed funds rate rose to 5 percent. But the corporate bond rate was about the same at 5.56 percent and so was the mortgage rate at 6.41 percent. Now the fed funds rate is close to zero and the corporate bond rate is 4.69 percent and the mortgage rate is just over 5 percent.
Accounting for Inflation
There are many reasons why long-term rates don’t necessarily move with short-term rates. One is risk — the further out one goes in terms of a loan’s maturity, the greater the risk of default or some other factor, such as a deep recession, that might impair a borrower’s ability to repay. Another important risk is inflation, which would erode the principal of the loan.
Suppose we start from a period of zero expected inflation and the nominal interest rate is 3 percent. Then that will also be the real rate. But if inflation unexpectedly rises to 5 percent, then the real interest rate will fall to negative 2 percent (three minus five). The lender will be repaid in dollars worth less than he lent and lose money on the deal.
To protect themselves, lenders will include an inflation premium in interest rates if they have reason to expect inflation. Thus, if the real interest rate is 3 percent and inflation is expected to be 5 percent over the life of a loan, then lenders will demand a market rate of 8 percent (three plus five). The problem, of course, is that it’s very hard to predict inflation and harder still to measure inflationary expectations.
In the Case of Deflation
The opposite situation comes about when there is deflation — a falling price level. Rather than being subtracted from market rates to calculate the real rate, deflation adds to market rates. If the market rate is 3 percent and prices are falling at a 5 percent rate, then the real rate is actually 8 percent. Consequently, during deflationary conditions market interest rates that are quite low may actually be quite high in real terms.
As long as there is inflation, the Fed can create negative real rates if it chooses to do so by reducing the fed funds rate below the inflation rate. But the Fed has a serious problem when deflation is the problem because it can’t cut the fed funds rate below zero. (This is known as the zero bound problem.) If the deflation is modest, the Fed can do what it has been doing and reduce the funds rate close to zero. But if the deflation is serious then the proper fed funds rate may need to be negative.
But no lender is ever going to lend at a negative market interest rate; he will just hold on to his money and in effect make a risk free return as the value of his money increases as prices fall. If deflation is 5 percent, anyone with cash is making the equivalent of 5 percent interest just by sitting on their money and doing nothing, because the value of what their money will buy is rising by 5 percent.
Not only does deflation discourage lending, it also imposes an added burden on those who borrowed before the deflation began. In effect, they are repaying loans in dollars that are worth more than those they borrowed in the first place.
Why Banks Aren't Lending
Thus the zero-bound problem is a very severe constraint on monetary policy. Presently, the Fed can’t reduce nominal interest rates enough to encourage lending, which would get money circulating throughout the economy, stem the deflation and raise growth.
This is why the Fed’s monetary expansion of the last two years has been largely ineffective. As I pointed out in my column last week, banks have more than $1 trillion of excess reserves — money that the Fed has created that banks could lend immediately but are just sitting on. It’s the economic equivalent of stuffing cash under one’s mattress.
Economists are divided on why banks are not lending, but increasingly are focusing on a Fed policy of paying interest on reserves — a policy that began, interestingly enough, on October 9, 2008, at almost exactly the moment when the financial crisis became acute.
The Fed has long required banks to hold a percentage of their deposits in reserve at the Fed itself — in effect, the Fed is the bank for banks. This serves two purposes. It protects depositors from a bank run and it helps the Fed control the money supply. Raising reserve requirements will reduce the funds that banks have available to lend; reducing reserve requirements will make more money available.
Historically, the Fed paid banks nothing on required reserves. This was like a tax equivalent to the interest rate banks could have earned if they had been allowed to lend such funds. But in 2006, the Fed requested permission to pay interest on reserves because it believes that it would help control the money supply should inflation reappear.
It’s not clear whether the Fed contemplated the impact of paying interest on reserves in a deflationary situation such as we have now. Although the interest rate that is paid is very modest presently — one quarter of a percentage point — it is a risk free rate and has the deflation rate added to it. As noted above, during deflation cash in effect earns a rate of return even when interest rates are near zero.
Thus many economists believe that the Fed has unwittingly encouraged banks to sit on their cash and not lend it by paying interest on reserves. Eliminating interest on reserves would therefore encourage lending. A rumor that the Fed might do so caused the stock market to rise earlier this week, according to press reports. But the policy remains in place.
Discouraging Excess Reserves
Some economists go further and suggest that the Fed impose a penalty rate on excess reserves. This is what Sweden’s central bank does. There, banks currently pay 0.25 percent on reserves — called the deposit rate — rather than receiving 0.25 percent as they do here. This may be a key reason why Sweden has bounced back much more rapidly from the worldwide economic crisis than the United States has.
Interestingly, Ben Bernanke is probably the leading academic expert on what the Fed should do when facing the zero bound problem, and one of his former colleagues at Princeton, Lars Svensson, is now deputy governor of Sweden’s Riksbank. However, rather than follow the lead of his former colleague, Mr. Bernanke is sticking with more of the same — saying that the fed funds rate will be held near zero for an extended period and keeping the rate paid on reserves unchanged.
Former Fed economist Joseph Gagnon, now at the Peterson Institute, argued in a July 21 commentary that because deflation is a more serious risk for the economy than inflation, the Fed should be more aggressive. He suggests a package of actions including cutting the interest rate on reserves to zero combined with a policy of buying longer-term Treasury securities. Gagnon thinks the economic impact would be equivalent to a $600 billion fiscal stimulus.
Over the longer term, serious thought needs to be given to the question of whether zero inflation is really a desirable goal for monetary policy. Although it sounds good in principle, it means that any recession is guaranteed to create deflation and tie the Fed’s hands from being able to ease monetary policy sufficiently. It may be better for the Fed to target a higher inflation rate because that’s a lesser evil than double-digit unemployment.
The Fed says that it is targeting a long-run inflation rate of 1.5 percent to 2 percent, but it expects just 1.1 percent this year, a reduction of 0.4 percent since April, when it was predicting 1.5 percent. This disinflation borders on deflation and is eroding the Fed’s credibility as a stimulative force in the economy. To use a hackneyed phrase, the Fed needs to think outside the box and be more innovative and aggressive about getting money to circulate, getting banks to lend, and raising inflationary expectations. Ending payments to banks on money they aren’t lending would be a step in the right direction.
Note: My daily readings list for today provides links to academic research bearing on the problems of deflation, the zero bound and the payment of interest on reserves.
Bruce Bartlett is an American historian and columnist who focuses on the intersection between politics and economics. He blogs daily and writes a weekly column at The Fiscal Times. Bartlett has written for Forbes Magazine and Creators Syndicate, and his work is informed by many years in government, including as a senior policy analyst in the Reagan White House. He is the author of seven books including the New York Times best-seller, Impostor: How George W. Bush Bankrupted America and Betrayed the Reagan Legacy (Doubleday, 2006).
