Wednesday, January 10, 2018

Yes, IOER Continues to be Bad Political Optics

So the Federal Reserve is reporting that interest on excess reserves (IOER) payments hit $25.9 billion in 2017. This amount is more than double the dollar size of the IOER payments in 2016 as seen below. 

This increase is understandable given the rise in the Fed's short-term interest rate target and the size of its balance sheet. But, as I have noted before, this is horrible optics. For the largest recipients of the IOER payments are large domestic banks and foreign banks. As seen in the figure below, they hold most of the excess reserves and therefore earn most of the IOER payments. 

Put differently, the systematically-important or "too-big-to-fail" banks that were bailed out during the crisis and are still implicitly subsidized by the government as well as foreign banks are the main recipients of IOER. It gets worse. Note in the table above that the higher IOER payments are associated with declining remittances to the Treasury Department. The Fed, in other words, is allocating more funds to big banks and less to the public. This is easy fodder for the "Wall Street vs. Main Street" critics. Because of this, I suspect the IOER in its current form will be increasingly a tough sell to make to Congress.

There is an easy fix to this problem. The Fed can move from its current floor system to a corridor system. Under the latter, the balance sheet can shrink down so that there are few reserve balances in the banking system1. The Fed can still have IOER, but it would be less than short-term market interest rates.2 The IOER would set an floor for short-term interest rates and the Fed's lending rate would be the ceiling for short-term market interest rates. Together this would constitute a corridor system and give the Fed ample control over interest rates. 

Update: To clarify the difference between a corridor and floor system, here is a figure distinguishing the two approaches from the NY Fed. Note in both cases the IOER remains.

1Just because a corridor system would have fewer reserves does not mean it would necessarily be a "scarce-reserve" balance sheet. Reserve scarcity is not about the quantity of reserves, but about their supply relative to their demand. All a smaller Fed balance sheet does is affect the supply of reserves. The Fed can also reduce reserve demand by lowering IOER. Depending on how it adjusts IOER will determine whether there is reserve scarcity. Consequently, observers need to be careful to avoid automatically associating small reserve balances with reserve scarcity.
2In the current floor system, IOER is above short-term market interest rates and is the source of many problems with the system. 

P.S. George Selgin in Congressional testimony today makes the case for the Fed moving to a corridor system. Norbert Michel also makes the case in his testimony. 


  1. Great post.

    Bad optics? In general, regulatory agencies become captured by the regulated (they are ones with an intense interest in the topic, and resources and lobbyists etc).

    Is it too cynical to consider the Fed a creature of the financial industry?

    BTW, cash in circulation is exploding, so the Fed will be unable to reduce its balance sheet below $2.5 trillion or so, as Ben Bernanke has noted.

    "However, today currency in circulation has grown to $1.5 trillion. Because of rising nominal GDP, low interest rates, increased foreign demand for dollars and other factors, Fed staff estimates that, the amount of currency in circulation will grow to $2.5 trillion or more...."

    So will the Fed have to keep paying IOER, even though most of it is cash in circulation?

    You can call for a corridor, but if there is $2.5 trillion in cash out there (and growing at 7% a year) what then?

    1. Ben, cash has historically been the largest part of the monetary base. There has been a secular growth in demand for it that continues to this day. This cash was not a problem before for monetary policy and shouldn't be one going forward. Here is a post; where I touched on some of these points:

    2. Nice treatment,

      Now a laugher question:

      OT but related and a conundrum:

      We are told in monetary policy that “expectations” are very important. The Fed must signal and then the public will “expect” certain levels of inflation.


      For about the last 40 years, conventional US macroeconomists (and the bulk of the financial community) have been predicting (nearly hysterically at some junctures) higher inflation and interest rates ahead, even runaway inflation. They expected, expected, expected, expected, expected higher interest rates and inflation.

      Great Expectations! (sorry, Dickens)

      The Inflation Bogeyman was not just knocking at the door, he had kicked it down and was on the threshold! Armed and loaded for bear! And mean!

      Instead, inflation and interest rates have gone down since 1980 (in general).

      So do expectations matter?

  2. " is an easy fix to this problem. The Fed can move from its current floor system to a corridor system. Under the latter, the balance sheet can shrink down so that there are few reserve balances in the banking system"

    That could take years to achieve at the current rate of selling off assets. Another option would be to do what New Zealand did to get off the floor in 2007. It only paid interest on reserves up to a fixed limit or tier, each bank being allocated a specific tier size. Any amount after that earned 100 basis points less. If the Fed did this it would immediately create a corridor system and reduce the interest that banks are earning.

    On a different matter, isn't a floor system a perfect implementation of Milton Friedman's optimum quantity of money? The moment you set up a corridor by putting some distance between IOR and the overnight rate you get away from Friedman. Are we sure we want to do this?

    1. JP, that is an interesting idea and it must be practical since RBNZ did it. Is RBNZ still on a corridor system? I thought they returned to a floor system?

      The Fed could follow RBNZ's example. But the Fed could also hold IOER fixed until short-term market rates have risen above it. Not sure that would take too long (though the might have to use something like its term deposit facility if it is worried about unencumbering excess reserves). Whatever path we take to a corridor system, I would want it to be transparent and easy to explain to the public.

      Regarding the Friedman rule, it basically says to eliminate the opportunity cost of holding money. For the public that means setting the inflation rate to the opposite of the real rate of interest. For banks holding reserves that would mean setting the IOER equal to short-term market interest rates. Note, though, that is not the case now. IOER is greater than short-term market rates so it is not like we are doing the Friedman rule now.

      Moreover, if we were to do the Friedman rule I think we would want to implement based on the final destination of the Fed's balance sheet. For example, imagine we end up with a corridor system where the Fed's liabilities were mostly currency and there are few reserves. In that case we would want to focus on getting inflation equal to the opposite of the real rate for the sake of the currency holders and not worry about setting IOER to short rates since the reserves would be so few. So we need to first determine whether we want a floor or corridor system and then decide how to apply the Friedman rule.

  3. The economics profession should be concerned about whether bad optics equals 'bad substance'.

    Are you aware of any serious studies that analyse the marginal net interest margin effect on the banking system of IOR?

    1. That is a great question. I would love to hear your take on it. My sense is that IOER should have a direct bearing since it effectively would set the rate of funding costs for banks.

  4. We should "normalize" the rate paid on IOR. What did we pay for 95 years straight? Zero? Sounds good to me. Zero IOR.

  5. Really interesting post,specially the data showing that remittances to the Treasury are declining due to the increase in IOER.

  6. We should "normalize" the rate paid on IOR. What did we pay for 95 years straight? Zero? Sounds good to me. Zero IOR.

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  7. When the next crisis happens, how will the Fed respond? I would think by buying more debt and thereby lowering the federal reserve rate - meaning the IOR will go lower too. Where will the excess reserves go then? And what will be the impact on the economy?