Semantics and Key Terms

Currency Wars in the Era of Unconventional Monetary Policies by Menzie Chinn

The Fed Doesn't Ever Have To "Unwind" Its Balance Sheet by Yglesias

From my genealogy*

interest rate on excess reserves (IOER)

On October 3, 2008, Section 128 of the Emergency Economic Stabilization Act of 2008 allowed the Fed to begin paying interest on excess reserve balances as well as required reserves. They began doing so three days later.[3] Banks had already begun increasing the amount of their money on deposit with the Fed at the beginning of September, up from about $10 billion total at the end of August, 2008, to $880 billion by the end of the second week of January, 2009.[4][5] In comparison, the increase in reserve balances reached only $65 billion after September 11, 2001 before falling back to normal levels within a month. Former U.S. Treasury Secretary Henry Paulson's original bailout proposal under which the government would acquire up to $700 billion worth of mortgage-backed securities contained no provision to begin paying interest on reserve balances.[6]

The day before the change was announced, on October 7, Fed Chairman Ben Bernanke expressed some confusion about it, saying, "We're not quite sure what we have to pay in order to get the market rate, which includes some credit risk, up to the target. We're going to experiment with this and try to find what the right spread is."[7] The Fed adjusted the rate on October 22, after the initial rate they set October 6 failed to keep the benchmark U.S. overnight interest rate close to their policy target,[7][8] and again on November 5 for the same reason.[9]

The Congressional Budget Office estimated that payment of interest on reserve balances would cost the American taxpayers about one tenth of the present 0.25% interest rate on $800 billion in deposits:

Estimated Budgetary Effects^[10]

Year	2006	2007	2008	2009	2010	2011	2012	2013	2014	2015	2016
Millions of dollars	0	-192	-192	-202	-212	-221	-242	-253	-266	-293	-308
(Negative numbers represent expenditures; losses in revenue not included.)

0.25% simple interest on $800 billion is $2 billion, not $202 million as shown for 2009. But those expenditures pale in comparison to the lost tax revenues worldwide resulting from decreased economic activity from damage to the short-termcommercial paper and associated credit markets.

Beginning December 18, the Fed directly established interest rates paid on required reserve balances and excess balances instead of specifying them with a formula based on the target federal funds rate.[11][12][13] On January 13, Ben Bernanke said, "In principle, the interest rate the Fed pays on bank reserves should set a floor on the overnight interest rate, as banks should be unwilling to lend reserves at a rate lower than they can receive from the Fed. In practice, the federal funds rate has fallen somewhat below the interest rate on reserves in recent months, reflecting the very high volume of excess reserves, the inexperience of banks with the new regime, and other factors. However, as excess reserves decline, financial conditions normalize, and banks adapt to the new regime, we expect the interest rate paid on reserves to become an effective instrument for controlling the federal funds rate."[14] 

Also on January 13, Financial Week said Mr. Bernanke admitted that a huge increase in banks' excess reserves is stifling the Fed's monetary policy moves and its efforts to revive private sector lending.[15] On January 7, 2009, the Federal Open Market Committee had decided that, "the size of the balance sheet and level of excess reserves would need to be reduced."[16] On January 15, Chicago Fed president and Federal Open Market Committee member Charles Evans said, "once the economy recovers and financial conditions stabilize, the Fed will return to its traditional focus on the federal funds rate. It also will have to scale back the use of emergency lending programs and reduce the size of the balance sheet and level of excess reserves. Some of this scaling back will occur naturally as market conditions improve on account of how these programs have been designed. Still, financial market participants need to be prepared for the eventual dismantling of the facilities that have been put in place during the financial turmoil" [17]At the end of January, 2009, excess reserve balances at the Fed stood at $793 billion[18] but less than two weeks later on February 11, total reserve balances had fallen to $603 billion. On April 1, reserve balances had again increased to $806 billion, and on February 10, 2010, they stood at $1.154 trillion.[19] By August 2011, they had reached $1.6 trillion. 

open market operations (OMO)

hot-potato effect

monetary base

Floor System (from Waldman)

Under the floor system, a central bank sets the monetary base to be much larger than would be consistent with its target interest rate given private-sector demand, but prevents the interbank interest rate from being bid down below its target by paying interest to reserve holders at the target rate. The target rate becomes the “floor”: it never pays to lend base money to third parties at a lower rate, since you’d make more by just holding reserves (converting currency into reserves as necessary). The US Federal Reserve is currently operating under something very close to a floor system. The scale of the monetary base is sufficiently large that the Federal Funds rate would be stuck near zero if the Fed were not paying interest on reserves. In fact, the effective Federal Funds rate is usually between 10 and 20 basis points. With a “perfect” floor, the rate would never fall below 25 bps. But because of institutional quirks (the Fed discriminates, it fails to pay interest to nonbank holders of reserves), the rate falls just a bit below the “floor”.

If “the crisis ends” (whatever that means) and the Fed reverts to its traditional approach to targeting interest rates, Krugman will be right and I will be wrong, the monetary base will revert to something very different than short-term debt. However, I’m willing to bet that the floor system will be with us indefinitely. If so, base money and short-term government debt will continue to be near-perfect substitutes, even after interest rates rise.

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* a work in progress