Negative Rates Bad, Negative IOR Good Says Scott Sumner. The IOR Debate

This article was first published by me on Talkmarkets:

I will try to simplify some basic concepts regarding market monetarism and the velocity of money and negative interest rates and negative Interest on reserves (IOR). The basics are not complex and I have done my best to sort it out. But the conclusions are for the reader to determine. The nuts and bolts of determining the effects of payment on reserves by the Fed make for interesting reading, so I will give Cullen Roche's opposing opinions regarding the debate over IOR at the end of the article.

As Scott Sumner has said regarding the MMers' stand against negative interest rates:

In a monetarist model, lower market interest rates are contractionary for any given monetary base, because they reduce velocity.  It’s the Keynesians who are likely to claim that lower rates are expansionary.  Now of course Friedman was talking about market interest rates, not IOR. Lower IOR is theoretically expansionary, and so far markets have reacted to negative IOR announcements as if they are expansionary.

Will that be true in the future?  Nothing is certain, as monetary policy is very complex...
Sumner says low interest rates are a sign of deflationary pressures, if I read him right. And he is likely correct, since the New Keynesians have not built a robust economy through lower interest rates. they got us off the mat, or at least big business off the mat, but that is about all. And, by the way, negative interest rates, as we see elsewhere in the world, appear to be failing as well as Sweden has pushed negative rates for years with no increase in their inflation targeting. (Market monetarists oppose inflation targeting and prefer NGDP targeting.)  

Now, one can argue that velocity is forever reduced by such a large amount of excess reserves, as banks have reduced interbank lending. But the market monetarists say that is not true, that negative IOR, ie., the Fed charging the banks for excess reserves they hold at the Fed, is expansionary.  Remember IOR is not negative interest rates on bonds.

And Scott goes on to say that banks do not have to hold excess reserves, as negative IOR takes affect. Banks could buy assets or bonds. I think buying bonds would be a bad idea due to the demand for them. Buying assets may be a good idea, that could start out good and maybe go bad later.

But at least there would be some stimulation to protect all that bad credit that could cause another credit freeze. However, there is moral hazard in protecting those who used inferior collateral to finance oil expansion.

So, while, I am not sold on Market Monetarism, I think the MMers have something to offer when the only option that the financial system will allow is New Keynesianism. It will not allow a total meltdown of credit, as Austrian economists want.  

So, Scott Sumner says that monetary policy can be loosened by negative IOR while credit policy could be tightened. He states that credit policy should never be confused with monetary policy. But, and I am inferring this, the New Keynesians like Paul Krugman confuse the policies all the time and put too much stock in interest rates and inflation and not proper stock in the current state of GDP at any given time. 

Market monetarism says banks don't have to lend excess reserves, but that banks can buy stuff with excess reserves.  But it is not as if there would be serious inflation if some excess reserves were loaned out, in this deflationary environment. The Richmond Fed disagrees, but market monetarists would most likely snicker at this article.

 Cullen Roche agrees with market monetarists that the Fed could buy physical assets as the Bank of Japan (BOJ) does. However, he does not believe negative IOR will work. Cullen, who contributes to Talkmarkets many interesting articles, has said two significant things in the past regarding IOR.

First Cullen says this about excess reserves:

Paying interest on reserves doesn’t constrain the bank from making new loans.  Ie, it doesn’t reduce the efficacy of monetary policy working through credit channels.  Banking is a business of spreads and since the spread on a creditworthy customer’s loan will almost always yield a better return than the IOER there’s nothing in the payment of IOER stopping banks from making loans just because they earn IOER.
 He says the NY Fed says this, essentially. But the Fed has also said

It is important to keep in mind that the excess reserves in our example were not created with the goal of lowering interest rates or increasing bank lending significantly relative to pre-crisis levels.
So, while Cullen may be right, something is constraining the big banks from lending significantly into this economy. The banks are constrained. The MMers say it is the payment of IOR, that needs to be reversed!

Second, Cullen quotes the Fed:

This role [of reserves] results from the assumptions that reserve requirements generate a direct and tight linkage between money and reserves and that the central bank controls the money supply by adjusting the quantity of reserves through open market operations.  Using data from recent decades, we have demonstrated that this simple textbook link is implausible in the United States for a number of reasons. First, when money is measured as M2, only a small portion of it is reservable and thus only a small portion is linked to the level of reserve balances the Fed provides through open market operations.  Second, except for a brief period in the early 1980s, the Fed has traditionally aimed to control the federal funds rate rather than the quantity of reserves.  Third, reserve balances are not identical to required reserves, and the federal funds rate is the interest rate in the market for all reserve balances, not just required reserves.  Reserve balances are supplied elastically at the target funds rate.  Finally, reservable liabilities fund only a small fraction of bank lending and the evidence suggests that they are not the marginal source data for the most liquid and well-capitalized banks.  Changes in reserves are unrelated to changes in lending, and open market operations do not have a direct impact on lending. 
Therefore, Cullen agrees with the Fed that the banks lending behavior is not guided by excess reserves.

Third, in the same article above, Cullen discusses the money multiplier and the velocity of money, both explained here.

Cullen says that the money multiplier is not valid as long as reserves are not loaned, and quotes the Fed:
All of these points are a reflection of the institutional structure of the U.S. banking system and suggest that the textbook role of money is not operative. While the institutional facts alone provide compelling support for our view, we also demonstrate empirically that the relationships implied by the money multiplier do not exist in the stem from the demand side, and that a better test for the lending channel is to check whether bank loans are financed by reservable deposits.  Our findings suggest that this is not the case.
The money supply is not being increased or decreased while all the money goes to reserves. since 2008. Printing money does not increase inflation or velocity of money or the multiplier or economic activity.

However, the market monetarists believe that velocity of money can be affected by central bank policy. In fact, the market monetarists believe that the Fed actually hurt the economy in 2008, by constricting the money supply through payment of IOR to the big banks. 

So, at the blog, the Money Illusion, Scott Sumner said this in opposition to inflation targeting:

The interaction of the supply of base money and velocity (or the Cambridge k) determines NGDP.  The central bank controls the supply of money, and the demand for base money is mostly determined by nominal interest rates, but also tax rates (as currency is held for tax evasion.)  When not at the zero bound, they aren’t close substitutes.  Nominal interest rates are strongly and positively correlated with the output gap, and with expected NGDP growth.  That means expected future base growth has a strong and positive impact on current interest rates (when not at the zero bound.)  If the central bank does NGDP level targeting, then the specific NGDP growth path chosen is by far the most important determinant of nominal rates, and hence velocity.  Output gaps are determined as in other natural rate models, by unexpected changes in NGDP.  (Notice we use NGDP growth where other models use inflation.)
So, the debate is not solved. Cullen Roche makes the case that payment of IOR does have much to do with the volume of lending, while the market monetarists say that the Fed hurt lending, both in the economy and with interbank lending, starting with the payment of interest on the excess reserves. It is a debate for economists to figure out. But certainly, something is restraining lending by the big banks. Comments are welcome! 


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