Martin Feldstein tries to answer the question: “Why has the Federal Reserve’s printing of so much money not caused higher inflation?” and comes up with a seemingly obvious answer – because the Fed pays interest on excess reserves. Like many others, Feldstein sees the payment of interest on excess reserves (IOER) as a “fundamental” change in Fed policy. The reality however is that the payment of IOER is a necessary prerequisite for any regime in which the Fed wishes to sustain a positive Fed Funds rate in the presence of excess reserves. IOER is a red herring and there is simply no way in which the Fed can generate inflation by tinkering with it.
The easiest way to understand this is to look at all the possible configurations of the Fed Funds rate and IOER. Ignoring the ludicrous scenario in which IOER is greater than the Fed Funds rate, there are three other configurations:
- Fed Funds and IOER are both equal to 0%.
- Fed Funds is above 0% and IOER is equal to 0%.
- Fed Funds is equal to 0% and IOER is below 0%.
In the first configuration, payment of interest on reserves clearly does not matter. If the Fed Funds rate itself is at zero, then clearly banks have no incentive to try and get rid of excess reserves.
The second configuration is often invoked as a scenario that could generate inflation. But if the Fed Funds rate is above 0% and IOER is 0%, then there can be no excess reserves in the system. If the central bank wants to sustain a positive Fed Funds rate, it must either pay interest on reserves or mop up all excess reserves. If there are any excess reserves, the Fed Funds market rate immediately falls to 0%. And we’re back to configuration 1 where both the Fed Funds and IOER are equal to 0%. To put it differently, if IOER is equal to 0% and the Fed Funds rate is above 0%, there cannot be any excess reserves in the system.
The third configuration is more interesting. Even if we have hit the zero-bound, why can’t the Fed enforce a negative IOER to force banks to try and get rid of their excess reserves and trigger the monetarist ‘hot potato’ effect? If the central bank charges a small negative rate on reserves, the effects will be negligible. Banks will pass on this cost to deposit-holders in the form of negative deposit rates or extra fees. In the absence of any alternative liquid and nominally safe investment options, most depositors will pay this safety premium.
But what if the Fed charges a significantly negative interest rate on reserves? For example, what if it costs 5% to hold excess reserves? In a world where all money is electronic, this may just work. But in a world where bank depositors possess the option to take their cash out in the form of bank notes, highly negative interest rates on reserves are impossible to enforce. In other words, if IOER is -5%, then you and I can earn a higher interest rate of 0% by simply taking our money out of the bank and holding currency instead.
To summarise, there is no avalanche of inflation coming our way no matter what the Fed pays out as interest on excess reserves.