Quantitative easing is often described as printing lots of new money and using it to buying back government debt. It sounds too good to be true. And yet until recently there was relatively little inflationary consequence from all of this money printing. And even the recent spike in inflation could have been prevented if the central banks had raised rates a bit sooner.
But when something is too good to be true, there’s usually a catch. For the most part, central banks weren’t actually “printing money”. Rather they were buying longer-term bonds paying 2% interest with newly issued interest bearing reserves, which at the time paid almost no interest at all. Central banks were essentially operating the world’s largest hedge funds. Borrowing short-term at low rates and lending long-term at a higher rate.
But that carry trade remains profitable only so long as short-term rates stay lower than the rates on previously issued longer-term bonds. The vast profits earned by central banks over the past 13 years would turn into losses if short-term interest rates rose sharply. So perhaps it is only fair that central banks now earn some losses.
But not everyone wants the central banks to pay up. Here’s The Economist:
Another option is to find a way for central banks to pay less interest on reserves. A recent report by Frank Van Lerven and Dominic Caddick of the New Economics Foundation, a British think-tank, calls for them to pay interest on only a sliver of reserves that affects their decision-making, rather than the whole lot. The ECB and the Bank of Japan already have such a “tiered” system. It was designed to protect commercial banks from the negative interest rates they have imposed in recent years.
Using tiering to avoid paying banks interest while their funding costs went up would be a tax in disguise. Banks, considered together, have no choice but to hold the reserves QE has force-fed into the system. Compelling them to do it for nothing would be a form of financial repression which may impair banks’ ability to lend. It would “transfer the costs [of rising rates] to the banking sector,” Sir Paul Tucker, a former deputy governor of the Bank of England, told parliament in 2021.
Maybe I’m missing something, but I have trouble following their argument. It’s hard to see how banks could be induced to maintain their large holdings of excess reserves if the reserves did not earn interest while other risk-free assets such as T-bills earned a positive rate of interest. Back in 2007, short-term interest rates in the US were about 5% and thus banks held only a tiny amount of excess reserves. Today, excess reserves are now roughly 1000-fold higher than before the Fed began paying IOR in 2008.
There’s a reference to the tiered system in Japan and Europe, but that involved paying a higher interest rate on the infra-marginal reserve holdings (that is zero interest instead of the negative interest rate on the marginal holdings.)
It’s also a bit misleading to suggest that banks, in aggregate, are somehow “forced” to hold reserves injected through QE programs. One problem is that banks could make deposits less attractive and a portion of the reserves would leak out as currency. But even if you assume a world without currency, where 100% of the monetary base is bank reserves, it is still misleading to suggest that banks are forced to hold excess reserves just because the central bank injects them into the system.
Here it is useful to recall the distinction between the nominal supply of bank reserves and the real demand for bank reserves. Central banks determine the nominal stock of reserves, while the commercial banking system determines the real stock of reserves.
To be sure, central banks can induce commercial banks to hold a very large stock of reserves—even in real terms—if they are willing to pay sufficient IOR. But if you assume that no interest would be paid on most bank reserves, why would banks choose to hold large a real stock of excess reserves?
If all banks simultaneously tried to get rid of excess reserves, this would lead to changes in the prices of goods, services, and assets. Eventually, the price level would rise high enough so that banks were holding their desired real stock of reserves. But when you consider that excess reserves in America are roughly 1000-fold higher than in 2007, the required price level increase would presumably be very large. (It’s difficult to say how large, as there have also been some regulatory changes since 2007 that have boosted the demand for bank reserves.) I suspect that the UK would face a similar problem.
Ultimately, someone must pay the cost of financing the public debt. If the central bank buys back the government’s debt in QE programs, then there are three options:
1. Have the central bank pay IOR indefinitely, which is costly.
2. Impose an implicit tax on the banking system with regulations that require banks to hold large quantities of reserves that pay no interest.
3. Impose an inflation tax on the public by not requiring banks to hold large quantities of reserves, but also not paying interest on those reserves.
I fail to understand the rationale for imposing a tax on banks during periods when QE results in losses for the central bank. As an analogy, imagine if the Prince of Monaco visited the casino of Monte Carlo every so often. On some days he ended up winning money. Other days he would suffer losses. Now suppose that on days when his luck was bad the prince imposed an ad hoc tax on the casino equal to his losses. That doesn’t seem fair!
Central banks have essentially been running a giant hedge fund. Why should commercial banks have to pick up the tab on those occasions when the bets of the central bank turn sour?
READER COMMENTS
Mark
Sep 28 2022 at 8:18am
The bigger problem with option 2 is that it is just low interest rates on savings again. So there would be no point in raising interest rates only to artificially lower them again through a reserves mandate and low return system. This would just lead to inflation again and the reserve banks would lose all power to rein in society spending i.e. government spending is part of the inflationary problem as is private spending during inflationary periods.
Matthias
Sep 29 2022 at 9:45pm
I’m not sure we can argue that low interest rates on savings directly cause inflation.
Our gracious host has lots of posts on this topic.
I don’t know whether option 2 will cause inflation or not. But I don’t think your argument is valid?
Brent Buckner
Sep 28 2022 at 9:32am
You write: “Why should commercial banks have to pick up the tab on those occasions when the bets of the central bank turn sour?”
“Should” is a strong word, but perhaps because IOER (and maybe QE) constituted an earlier subsidy/bail-out.
Certainly not a time consistent first-best bundle of policies/practices!
ssumner
Sep 29 2022 at 2:35am
I don’t favor IOER, but I don’t see it as a subsidy. It’s generally set close to market interest rates.
Brent Buckner
Sep 29 2022 at 7:09am
You wrote: “It’s generally set close to market interest rates.”
Close, but above for a considerable period (perhaps not enough above to constitute a material subsidy).
As I have it, from 2009 through 2016 (inclusive) the IOER rate was on average above the three month Tbill rate. Per George Selgin (writing in 2017): “Yet almost since IOER was first introduced, in October 2008, the Fed’s practice has been to set its IOER rate above, if not substantially above, corresponding market rates” (from https://www.cato.org/blog/strange-official-economics-interest-excess-reserves ).
Scott Sumner
Sep 29 2022 at 10:33am
Agreed, but that’s a few basis points. What if they set IOER at zero at a time when T-bills yielded 3% or 4%?
I’m not saying you are wrong to be skeptical of IOER, I am too. But the proposals being discussed here are not at all justifiable on the basis of repaying past subsidies.
Brent Buckner
Sep 29 2022 at 11:27am
Yes, agreed, looking over that period I don’t see what I would consider a subsidy to exceed $10 billion in total.
Spencer
Sep 28 2022 at 10:50am
Banks aren’t intermediaries. Therefore, there is no tax based on reserve balances. Prior to when Bankrupt-u-Bernanke introduced the payment of interest on interbank demand deposits, the banks remained fully “lent up” between 1942 and 2008.
Bank reserves are “Manna from Heaven”, they are costless and are showered on the payment’s system. Between 1942 and Oct 1, 2008, the DFIs minimized their non-earning assets, their excess reserve balances.
They held no excessive amount of excess legal lending capacity to finance business, consumers, or the Federal Government. They utilized their excess reserves to immediately acquire a piece of the national debt, or other short-term creditor-ship obligations that were eligible for bank investment, whenever there was a paucity of credit worthy borrowers, pending a longer-term, and presumably more profitable disposition of their legal and economic lending capacity.
A brief “run down” will indicate just how costless, indeed how profitable – to the participants, was the creation of new money. If the Fed put through buy orders in the open market, the Federal Reserve Banks acquire earning assets by creating new inter-bank demand deposits (clearing balances).
The U.S. Treasury recaptures about 98% of the net income from these assets. The commercial banks acquire “free” legal reserves, yet the bankers protested that they didn’t earn any interest on their balances in the Federal Reserve Banks.
Given bankable opportunities (and the Federal Government is the largest creditworthy borrower providing zero risk-weighted assets), on the basis of these newly acquired free reserves, the commercial banks created a multiple volume of credit and money. And, through this money, they acquired a concomitant volume of additional earnings assets.
How much was this multiple expansion of money, credit, and bank earning assets? Thanks to fractional reserve banking (an essential characteristic of commercial banking) for every dollar of legal reserves pumped into the member banks by the Fed, the banking system acquired about $206:1 (c. 2006), dollars in earning assets through credit creation.
Link:
Charles Hugh Smith Blog | Bank Reserves And Loans: The Fed Is Pushing On A String | Talkmarkets
Spencer
Sep 28 2022 at 11:02am
Contrary to Jerome Powell, banks aren’t intermediaries. See: the Bank of England:
http://bit.ly/2sphBHD
See: Working Paper No. 529 “Banks are not intermediaries of loanable funds — and why this matters” –Zoltan Jakab and Michael Kumhof May 2015
BOE: “Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits. The amount of money created in the economy ultimately depends on the monetary policy of the central bank”
The principal ways to reduce the volume of bank deposits is for the saver-holder to use his funds for the payment of a bank loan, interest on a bank loan for the payment of a banks service, or for the purchase from their banks of any type of commercial bank security obligation, e.g., bank stocks, debentures, etc.
That is, savings flowing through the payment’s System never leave it, unless one is hoarding currency or converting to other National currencies.
Unlike the nonbanks, the commercial banks suffer no disintermediation when savers decide to shift their savings to another type of investment. Shifting from time deposits in the commercial banks to nonbank types of investments has no effect on the total assets or the volume of earning assets of the commercial banks. It merely involves a transfer in the ownership of existing deposit liabilities, from time to demand deposits within the payment’s System.
Commercial banks do not loan out time deposits, demand deposits or the equity of bank owners. Commercial banks acquire earning assets through the creation of new money. When commercial banks make loans to or buy securities from the nonbank public new money- demand deposits are created in the banking system.
The aggregate lending capacity of the payment’s System is determined by the monetary policy of Federal Reserve Authorities. It is in no way dependent on the savings practices of the public. People could cease to hold any savings in the commercial banks and the lending capacity of the payment’ System would be unimpaired.
Roger Sparks
Sep 28 2022 at 1:36pm
IMHO, the question needing an answer is “Do CBs buy bonds using ‘newly created money’ or do they reuse money created by some-entity?”
To answer the question, we need to first ask “Who owns the bond the CB is buying?”
In my mind, a detour into bank reserves is a detour into bank mechanics. It has little to do with the financial ownership that concerns pension funds and the investing private sector.
Matthias
Sep 29 2022 at 9:47pm
An unexpected tax on banks is paid for by the shareholders of banks (and perhaps banks’ employees in the form of lower bonuses.)
Those shareholders are probably pensions etc that you mention.
Thomas Lee Hutcheson
Sep 28 2022 at 2:58pm
Instead of what? QE is one possible instrument to keep/return the price level/NGDP on target. Is the point that the expected real rate of return on QE part of the decision on what is the optimal target?
Capt. J Parker
Sep 28 2022 at 5:08pm
I can think of one reason: At least some of QE was to bail out banks whose MBS positions and derivatives thereof had gone south. You might argue that if Central Banks hadn’t let nGDP fall there would have been no need for a bailout. Even so, the need for QE wasn’t because of something Main Street did. Why should they pick up the tab?
Scott Sumner
Sep 29 2022 at 2:38am
I don’t see how QE was a bailout—bonds were bought at market prices with the goal of stabilizing aggregate demand. That’s just normal monetary policy.
bill
Oct 1 2022 at 6:37pm
The IOR was the bailout. Not the QE.
Kailer Mullet
Sep 28 2022 at 7:01pm
Poor folks at Treasury worked to lock in long term loans at historically low rates only for the central bank to buy it all up and replace it with overnight loans.
vince
Sep 28 2022 at 7:46pm
Shouldn’t the primary beneficiaries of QE now pick up the tab? Maybe the S&P should drop to about $2500. Banks that did nicely from the 2008 bailouts should pitch in too.
Scott Sumner
Sep 29 2022 at 2:39am
Again, QE is not a bailout.
vince
Sep 29 2022 at 12:09pm
Don’t you agree the stock market has benefitted from QE?
Are you distinguishing QE as something the Fed does from the 2008 bailouts as something the Treasury did?
Majid Hosseini
Sep 29 2022 at 5:49pm
How did exactly the stock market benefit from the QE? If your response is “lower rates”, then please explain this graph:
https://fred.stlouisfed.org/graph/?g=UheC
vince
Sep 29 2022 at 9:04pm
What does the graph say to you?
Where did the QE go? Not to CPI. It went somewhere.
Scott Sumner
Sep 30 2022 at 4:49am
Stocks do well if the Fed does sound monetary policy that produces a healthy economy–stable NGDP growth. That’s not a “bailout”.
vince
Sep 30 2022 at 4:08pm
Stocks did outstanding all of 2021 when monetary policy, at least regarding inflation, was a disaster.
Majid Hosseini
Sep 28 2022 at 10:08pm
I was hoping you could explain the mechanics of this more (esp in the absence of currency):
How would they execute that? Would it be through purchase of bonds from the treasury? How would that translate into higher prices for everything else? Thanks!
Scott Sumner
Sep 30 2022 at 4:51am
This is the basic quantity theory of money. If you inject more money than people wish to hold, they’ll try to get rid of their excess cash balances. This drives up aggregate demand and prices.
Majid Hosseini
Sep 30 2022 at 6:34pm
Thanks. I think I figured it out. Setting the IOR to zero will also force the FFR to zero (and probably T-bills). Considering that banks won’t have the income from the interest on excess reserves, they are incentivized to lend (thanks to the abundant reserves they have, they won’t have any issues wrt to maintaining their leverage ratio). Increased lending is inflationary.
Thank you very much again for your response, as well as your book and blog posts. They’ve been quite a revelation
Arqiduka
Sep 29 2022 at 8:19am
To the degree that “central banks running losses” is code for / leads to devolving their monstrous assets bqse back into the market, all for it.
Spencer
Sep 29 2022 at 10:17am
The sterilization of LSAPs suppresses the real rate of interest. It makes real growth more expensive than holding existing assets. I.e., lending by the banks is inflationary, whereas lending by the nonbanks is noninflationary.
Jeff
Sep 29 2022 at 4:04pm
What if the Fed just pays interest on reserves to each bank at a rate equal to the lowest rate that bank pays to depositors? Why should banks get better treatment from the Fed than they give members of the public?
What is going on right now in retail is insanely “tiered”… retail deposit rates are still at the ZLB nearly everywhere except on a few “specials” like brokered CDs or deals for high dollar clients. The banks are getting a massive subsidy from this. https://www.chase.com/content/dam/chase-ux/ratesheets/pdfs/rdny1.pdf
Matthias
Sep 29 2022 at 9:52pm
How would you determine the lowest rate?
How would you weigh benefits in kind? Eg low rates on deposits in return for excellent customer service?
Assuming you found some answer to these questions. Then I would do the following:
Short the stocks of all banks. Buy a small bank. Make it pay -1,000% on deposits. Profit.
Matthias
Sep 29 2022 at 9:55pm
Oh, I just noticed that you suggested that the Fed pay a different rate to each bank. In that case, my scheme wouldn’t work.
But you could probably cook up a different scheme where you pay an insanely high rate to some depositors, but with enough strings attached that you only have pay that rate on a few dollars of deposits in total.
Scott Sumner
Sep 30 2022 at 4:53am
That’s likely to be hard to implement in practice. I wish we’d just go back to the pre-2008 system of no IOR and very small excess reserves.
bill
Oct 1 2022 at 6:44pm
I agree.
But note, back then, the Fed required a certain level of reserves. They have stopped requiring reserves. Look up the FRED series for IOER and Interest on Required Reserves. They stop in July 2021. They’ve been replaced with Interest on Reserve Balances. The Fed could go back to requiring some reserves and paying zero interest on that. And if they paid zero on excess reserves, banks would try once again to minimize them.
https://fred.stlouisfed.org/series/IOER
https://fred.stlouisfed.org/series/IORR
Spencer
Sep 30 2022 at 8:23am
Basically, the economy is being run in reverse. It now has a credit/investment imbalance.
There’s a lack of investment opportunities (secular stagnation).
Asset valuation prices are driven from the appraisal of loan collateral, and loanable funds, which depends upon Gresham’s law: “a statement of the least cost “principle of substitution” as applied to money: that a commodity (or service) will be devoted to those uses which are the most profitable (most widely viewed as promising), that a statement of the principle of substitution: “the bad money drives out good”.
Roger Sparks
Sep 30 2022 at 9:18am
Commentator Spencer writes “Basically, the economy is being run in reverse.”
The normal order of any economy is ‘work-then-spend’. With this order, money used to pay workers is stored in banks. Products built by these same workers are stored on store shelves. With money in banks and products on shelves, the economy may pause while value-of-production balances with demand-for-production.
The reverse order of any economy is ‘spend-then-work(maybe)’. With this order, money is advanced to spenders for any number of reasons. Timewise, these spenders enter the normal economy before normal workers (who are constrained by earnings) and before the normal economy can find a value-production balance.
Both orders play in modern economies. As we shift the economy further into reverse order mode, price discovery becomes woefully incomplete, showing up as inflation. Workers spend their time building products desired by masters of the economy, not the desired products measured by willingness to work-then-spend values.
In my view, both politicians and economist need to better balance the two economic modes.
Thanks to Spencer for the quote. Thanks to Scott for providing the provocative article.
Spencer
Oct 2 2022 at 4:28pm
Bernanke’s “wealth effect” is exactly the opposite of what he claims. Funds dissipated in financial investment (the transfer of title to goods, properties, or claims thereto), as opposed to real investment, represents a leakage in National Income Accounting. In the circular flow of income, voluntary savings require prompt utilization if the circuit flow of funds is to be maintained and the deflationary effects avoided.
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