Saturday, 19 September 2015

The Fed's IOER policy is not "paying banks not to lend"

Mainstream media get this wrong all the time. The latest to go down the "paying banks not to lend" rabbit hole is Binyamin Appelbaum in the New York Times. Because he didn't understand how IOER works, he didn't understand the Fed's strategy, and wrote a post that gets it quite seriously wrong. So I've written a Forbes post attempting to set things straight. Here's a taster:
The FOMC has decided not to raise interest rates – for now. But it’s still widely expected that rate rises will come soon, possibly by the end of the year. Some people think that QE should be unwound first, but the Fed’s plan is to raise rates first. The Fed will unwind QE gradually as the securities it has purchased mature. 
This creates a problem. Because of QE, the banking system is awash with reserves. Banks have more cash on deposit at the Fed than they need to settle customer deposit withdrawals (payments), and they therefore don’t need to borrow funds from each other as they would in normal times. Because of this, the Fed Funds rate – the rate at which banks borrow from each other – no longer influences bank behaviour. It has fallen to zero. 
Well, nearly zero. Actually the Fed Funds rate hovers somewhere between zero and 0.25%. This is because the Fed is paying interest at 0.25% on excess reserves (IOER). Paying IOER prevents the Fed Funds rate from falling to zero.

And I go on to explain how rate normalization will work, including the roles of IOER and reverse repos.

Read on here.

Related reading:

Floors and ceilings
Understanding the permanent floor - Scott Fullwiler
Interest rate control during normalization - Simon Potter, Federal Reserve

Image: Industrial magnet, from


  1. You state:
    "... the external effect of raising the Fed Funds rate would be that interest rates to customers, both borrowers and depositors, would rise"

    Since the FED is paying interest on excess reserves, reserves are no longer a cost to banks, that is, before the FED balance sheet expansion, it was costly for banks to acquire reserves, they had to borrow at the federal funds rate from the FED and they passed this cost onto borrowers. Now this is no longer the case, and an interest rate raise is a boon to banks not a cost. Why exactly would they charge more for loans? What am I missing?

    1. You are only looking at one side of the reserve lending transaction. Reserves borrowed are a cost: reserves lent are a gain. One bank's cost is another bank's gain. Therefore it is incorrect to state that reserves are a "cost" for banks. They are equally a source of revenue.

      In normal times, the Fed directly influences the rate at which banks borrow from each other, since some banks will always be short reserves so will need to borrow. But when there are substantial excess reserves in the system, it is not so much that banks need to borrow reserves as that they need to lend them - after all, reserves sitting idle on the balance sheet at zero interest are actually a cost. Consequently the Fed influences the rate at which banks will lend to each other, rather than the rate at which they can borrow from each other. That's the same rate, of course, but influenced from the other side of the transaction.

  2. How would you interpret high beta moves banks stocks around Fed Funds announcements? Given the shallow participation in that market, why do investors and bank executives seem to react to potential shifts in the FF target?

    1. If bank stocks fall at the prospect of FF funds rate rising, that would indicate concerns about the fragility of bank balance sheets. If they rise, then that would indicate anticipation of improved profitability from higher rates - very low interest rates and flat yield curves are deadly for banks.

  3. Matt Usselmann wrote:

    Frances, was that you who Krugman had in mind when he said :

    "Incidentally, this also means that the common claim that QE is a giveaway to bankers is the opposite of the truth; to the extent that journalists with close ties to bankers spread this story, it’s Orwellian. "

    I do not think he meant you when he said that you are a journalist claiming that "QE is a giveaway to the bankers is the opposite of the truth" - but do you know what he means - I do not?

    1. I don't think it's me Krugman had in mind. I have never claimed that QE is a giveaway to bankers. Quite the reverse. QE is deadly for banks because it flattens yield curves, fatally undermining their core business of maturity transformation.

    2. Matt Usselmann wrote:

      Frances, thanks for answering that, and fair point.

      Ok, that means you are not Orwellian, but I suppose that means I am (because I am not agreeing with you; and I claim it is a "give-away to banks", although an unintended one, as "the give-away" is the by-product of QE.).

      Just wanted to check that I understood this right.

    3. You're looking at this far too narrowly--the IOR payment itself is a small part of the picture from any bank's perspective. It's not a giveaway if it hurts banks' abilities to be profitable via flattening yield curves, as Frances mentioned. Further, with QE banks have all these extra assets earning only IOR, which doesn't provide enough yield spread to be profitable against the offsetting liabilities that are also earning on average near the same amount. In normal times w/o QE, banks would only hold much smaller amounts of assets earning the basic money market rate relative to the rest of the balance sheet. I guarantee you that banks would much rather have the pre-2008 world of no IOR and very small quantities of reserve balances to QE, large reserve balances, and IOR.

  4. Matt Usselmann writes:

    "It's not a giveaway if it hurts banks' abilities to be profitable via flattening yield curves, as Frances mentioned."

    So that is a similar argument to Krugman.

    Well, as I said, from the Krugman FRED graph, I cannot detect that net interest margins after QE fell more than before QE. There might be a whole host of other reasons why margins decrease. Another more plausible (?) reason might be that banks have turned down high risk/high reward lending.

    My point is that it is not QE reducing interest margins but perhaps competition. (I have pointed that out twice on Krugman's blog - but it has yet to appear in the comments - the first time I have ever had problems posting anything there) .

    Ok, banks might wish themselves back into an banking environment before 2008, but so would probably a lot of other actors in the economy.

    Now, I still really do not understand who is, according to Krugman, "Orwellian"? My main argument is that QE might have saved the banks' survival, and my two lasts blog posts on my blog are all about that. In addition higher rates will ensure more profitability for banks, we are all in agreement with that.

    So, it the banks ended up with the reserves, it is because it is them who mainly sold (through their bond trading divisions) the bonds to the central banks when QE was on offer. A management decision by the banks, as that was their most profitable route. Others might say, paying over the odds for the bonds is a give-away, and should not have happened. Banks had a choice to sell, and end up with reserves. Or keep the bonds, and have higher yielding assets, as bonds pay more interest than the IOR on offer from the Central banks. They sold. They took the "give away". They sold at a profit.

    So, all in all, banks can now not complain that QE is not a "give-away".

    And what is Orwellian about pointing that out, I still do not know.

    For reference, my posts about why banks sold the bonds, and why banks really still profit and QE is still good for banks.

    1. Matt,

      As there has been considerable consolidation in the banking sector since 2008, which would reduce rather than increase competition, it is hard to see that competition caused net interest margins to fall. But fall they did.

      Banks have indeed turned down high risk/high reward lending, but that was because their balance sheets were damaged and they were under pressure from regulators to de-risk and raise capital levels, not because QE gave them an easier way of making money.

      The banks ended up with excess reserves because NON-BANKS sold gilts to the central banks. The Bank of England specifically avoided buying bonds directly from banks. Banks just intermediated purchases from non-banks and as a consequence ended up with excess reserves.

      You could argue that banks went long gilts during QE in expectation that the price would rise. But banks certainly wouldn't be the only market players doing that.

      I agree that QE, in arresting the sharp asset price falls in 2008-9, did ensure banks' survival. But it has not ensured their recovery. On the contrary, it has made it more difficult, for a number of reasons. Overall, QE is not good for banks. Not by any measure.

      I think you should look beyond banks.

    2. I agree with Frances. I find Matt's understanding of central bank operations and how banks operate to be incorrect, which results in his incorrect conclusions regarding IOR's effects.