Stanford economist Robert Hall presented the first paper at this morning's monetary policy confab in Jackson, Wyoming, and while he touched on a number of topics, one stood out because it reflects deep misunderstandings about the banking system.
Paying an above-market rate on reserves changes the sign of the effect of a portfolio expansion. Under the traditional policy of paying well below market rates on reserves, banks treated excess reserves as hot potatoes. Every economic principles book describes how, when banks collectively hold excess reserves, the banks expand the economy by lending them out. The process stops only when the demand for deposits rises to the point that the excess reserves become required reserves and banks are in equilibrium. That process remains at the heart of our explanation of the primary channel of expansionary monetary policy. With an interest rate on reserves above the market rate, the process operates in the opposite direction: Banks prefer to hold reserves over other assets, risk adjusted. They protect their reserve holdings rather than trying to foist them on other banks. An expansion of reserves contracts the economy.
This startling argument has two parts, both of which are wrong. First, banks don't lend reserves. Reserves aren't needed for lending, and creating additional reserves doesn't make banks more likely to extend credit to households and businesses. But don't take my word for it. James Tobin, the legendary Yale economist, explained all this half a century ago. William Dudley, the president of the Federal Reserve Bank of New York, made the case even more forcefully back in May:
Our view is that asset purchases work primarily through the asset side of the balance sheet by transferring duration risk from the private sector to the central bank’s balance sheet. This pushes down risk premia, and prompts private sector investors to move into riskier assets. As a result, financial market conditions ease, supporting wealth and aggregate demand. The fact that such purchases increase the amount of reserves in the banking system and the size of the monetary base is a byproduct -- not the goal -- of these actions.
The second problem with Hall's argument is that he ascribes too much importance to the minimal 0.25 percent interest rate that the Fed pays on reserves held by commercial banks. I'll defer to Paul Krugman, who demolished a similar argument a few weeks ago. Krugman notes that the Bank of Japan paid no interest on reserves during its asset-purchase programs yet was as incapable of increasing the quantity of broad money as the Fed. Moreover, the amount of currency in circulation has increased sharply over the past five years, even though the Fed pays no interest on pieces of paper with pictures of old white men on them.
One might think that Hall would recommend liquidating those darned interest-bearing reserves so that they could stop retarding the recovery. Yet at the end of the paper, he concludes by warning that the Fed must resist "the intensifying pressure to raise interest rates and contract its portfolio well before the economy is back to normal." Maybe if I could make sense of all those contradictions I, too, could be a tenured professor.
(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter.)