Paying interest on reserves allows the Fed to provide liquidity and maintain financial stability.
The Federal Reserve takes a lot of criticism, but on occasion we should stop and cheer its successes. Over the past 15 years the Fed has engineered a fundamental advance in monetary policy by paying interest on reserves and supplying “ample” reserves.
Reserves are accounts that banks have at the Fed. Banks settle transactions by transferring reserves between those accounts. Reserves are the most liquid asset in the economy. Before 2008 the Fed paid no interest on reserves. Banks held as little in reserves as possible, typically below $50 billion. In 2008 the Fed started paying interest on reserves. In the quantitative-easing era, the Fed bought assets, creating a lot of new reserves. Reserves are currently $3.5 trillion.
Milton Friedman described the “optimal quantity of money” as that situation in which money and short-term investments pay the same interest rate. Then banks, people and businesses hold a lot of cash, and waste less effort economizing on its use. Since the Fed can costlessly buy bonds and issue interest-paying money, providing such “liquidity” is free. So, provide it in abundance. Money is the oil in the economy’s engine, and it’s free. Fill ’er up.
Ample reserves are also great for financial stability. Bank runs happen when banks hold illiquid interest-bearing assets to back their deposits. When banks funnel deposits into reserves, a run can’t break out. All financial institutions holding lots of interest-paying cash more easily stay out of trouble.
Why not? Experience of the past 15 years has put to rest most of the objections.
Banks holding lots of reserves don’t lend less. If the Fed buys Treasury bonds to create reserves, banks hold more in reserves and less in Treasurys. Money available for lending is the same.
Economists worried that paying interest on reserves would unhinge the price level by eliminating the separation between money and bonds. Many predicted inflation or deflation spirals. We learned that simply isn’t the case. Inflation trundled along from 2008-21 at 2% or so. Inflation spiked recently, but nobody thinks the Fed was primarily responsible. The Fed bought a lot of assets during the pandemic, but the same purchases had no effect in the 2010s. The cause of inflation was massive fiscal stimulus, not interest on ample reserves.
More deeply, we learned that the Fed can fully control the short-term interest rate by simply varying the rate it pays on reserves without having to ration money.
Other advantages seem to be unfolding in front of us. Why didn’t a widely predicted recession break out when the Fed raised interest rates 5 percentage points? Well, back in the day, to raise interest rates the Fed reduced the quantity of reserves, and with that, via reserve requirements, the amount banks could lend and deposits people could hold. Scarce money and credit, arguably, caused the economy to tank. Now, raising interest rates has no such credit and quantitative effect. The Fed used to slow the car by draining oil. Now it just eases off the gas.
Will the Fed lose some control over inflation? A common story says that the Fed cools the economy, and, via the Phillips curve, that lowers inflation. If the Fed can’t cool the economy as effectively, then it loses some control over inflation. Yet most observers chalk up today’s easing inflation to the Fed’s interest-rate rises, though the economy hums along. If they are right, the new regime will have doubly proved itself, eliminating painful credit crunches and recessions as needless casualties of Fed action.
In fact, the Fed has always had less control over inflation than most thought. The burst of inflation was a one-time effect of the pandemic-era fiscal blowout, and the Fed is now just helping on the margin. But that doesn’t mean we need to return to the old way of deliberately inducing a credit crunch to control inflation.
The system can be improved. There is no economic reason for the Fed to limit the quantity of reserves. Many other central banks basically announce deposit and borrowing rates, and let banks have whatever they want at those prices. There is also little reason to give banks better rates than other financial institutions.
Illiquidity can still break out when banks choose to hold higher-yielding illiquid assets. As Dallas Fed President Lorie Logan pointed out in a recent speech, banks and the Fed should be better prepared to borrow reserves quickly against collateral.
The Fed’s choice of which assets to buy, including long-term Treasurys and mortgage-backed securities, has had negative consequences. Shortening the maturity structure has made interest costs on the debt spike quickly, multiplying the Treasury’s awful decision to bet on low rates by borrowing short. Buying other assets distorts credit allocation.
Many of these problems would be solved if the Treasury issued overnight, fixed-value, floating-rate debt directly. Then the Fed could worry only about immediate liquidity to the banking system, and not be in the business of providing the safe asset for the whole economy or managing interest rate risk for the federal government.
But these are little fixes, which just make a good system better. Well done, Fed.
Mr. Cochrane is a senior fellow at the Hoover Institution, an adjunct scholar at the Cato Institute, and author of “The Fiscal Theory of the Price Level.”
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Appeared in the December 27, 2023, print edition as ‘The Federal Reserve Deserves a Pat on the Back’.