OPINION
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July 22, 2012, 6:09 p.m. ET
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How Bernanke Can Get Banks Lending Again
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If the Fed reduces the reward for holding excess reserves, banks will have to find something else to do with their money, like making loans or putting it in the capital markets.
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By ALAN S. BLINDER
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The U.S. economy could use another boost, and it won't come from fiscal policy. Can the Federal Reserve provide it?
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Chairman Ben Bernanke keeps insisting that the central bank is not out of ammunition, and in a literal sense he is right. After all, the Fed has not yet exhausted its bag of tricks. It is still twisting the yield curve. It can purchase more assets. It can tell us that its federal funds target interest rate will remain 0-25 basis points beyond late 2014. It can even nudge the funds rate down within that range. The operational question is: How powerful are any of these weapons?
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Let's start with Operation Twist, which was recently extended through the end of this year. The Fed seeks to flatten the yield curve by buying longer-term Treasurys and selling shorter-term ones. And it's probably succeeding—a bit. But Federal Reserve activity in the Treasury markets is modest compared with the vast volume of trading.
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Realistically, the U.S. yield curve is probably influenced far more by daily developments in Europe. In any case, the Fed will be out of short-term Treasurys to sell by December.
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The logical next step would be more quantitative easing—QE3—or, as the Fed likes to call it, more large-scale asset purchases.
Purchases of what? There are two main choices. One is Treasurys. But does anyone really think that lower U.S. Treasury rates are what this country needs?
The U.S. economy could use another boost, and it won't come from fiscal policy. Can the Federal Reserve provide it?
.
Chairman Ben Bernanke keeps insisting that the central bank is not out of ammunition, and in a literal sense he is right. After all, the Fed has not yet exhausted its bag of tricks. It is still twisting the yield curve. It can purchase more assets. It can tell us that its federal funds target interest rate will remain 0-25 basis points beyond late 2014. It can even nudge the funds rate down within that range. The operational question is: How powerful are any of these weapons?
.
Let's start with Operation Twist, which was recently extended through the end of this year. The Fed seeks to flatten the yield curve by buying longer-term Treasurys and selling shorter-term ones. And it's probably succeeding—a bit. But Federal Reserve activity in the Treasury markets is modest compared with the vast volume of trading.
.
Realistically, the U.S. yield curve is probably influenced far more by daily developments in Europe. In any case, the Fed will be out of short-term Treasurys to sell by December.
.
The logical next step would be more quantitative easing—QE3—or, as the Fed likes to call it, more large-scale asset purchases.
Purchases of what? There are two main choices. One is Treasurys. But does anyone really think that lower U.S. Treasury rates are what this country needs?
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Mortgage-backed securities (MBS) are a better choice, the idea being to reduce mortgage rates by shrinking the spread between MBS and Treasurys. But mortgage rates are already falling toward 3.5%. With 10-year expected inflation around 2.1%, can a 1.4% real interest rate be deterring many prospective home buyers? No, they are shut out of the market by the unavailability of credit. Posted rates are low, but try getting a mortgage.
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The third available weapon is what the Fed calls "forward guidance"—that is, indicating (please don't say promising!) that the 0-25 basis points funds rate will be maintained for years to come. The Fed's current guidance (please don't call it a pledge!) extends "at least through late 2014." While that's pretty far into the future, the Fed could stretch it to 2015, 2016 or 2025 for that matter.
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In rational models, the yield curve should flatten a bit every time the Fed pushes that date out further. But the key words here are "rational" and "a bit." To most bond traders, two and a half years is already an eternity. Would they really respond much if 2015 replaced 2014?
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This brief analysis paints a pretty grim picture: The Fed has three weak weapons, one of which will be exhausted by year's end.
.Fortunately, there is more the Fed can do. I have two out-of-the-box suggestions to make, one in today's column and another in a companion piece soon.
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The simpler option is one I've been urging on the Fed for more than two years: Lower the interest rate paid on excess reserves. The basic idea is simple. If the Fed reduces the reward for holding excess reserves, banks will hold less of them—which means they will have to find something else to do with the money, such as lending it out or putting it in the capital markets.
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The Fed sees this as a radical change. But remember that it paid no interest on reserves before the 2008 crisis and, not surprisingly, banks held practically no excess reserves then. In early October of that year, Congress gave the Fed authority to pay interest on reserves, which it promptly started doing.
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When the Fed trimmed the federal funds rate to its current 0-25 basis-point range in December 2008, it also lowered the interest rate on reserves to 25 basis points, where it has been ever since.
.My suggestion is to push it lower in two stages. First, test the waters by cutting the interest on excess reserves (in Fedspeak, the "IOER") to zero. Then, if nothing goes wrong, drop it to, say, minus-25 basis points—that is, charge banks a fee for holding their money at the Fed. Doing so would provide a powerful incentive for banks to disgorge some of their idle reserves. True, most of the money would probably find its way into short-term money-market instruments such as fed funds, T-bills and commercial paper. But some would probably flow into increased lending, which is just what the economy needs.
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The Fed has steadfastly opposed this idea for years. Why? One objection is true but silly: Lowering the IOER might not be a very powerful instrument. No kidding. Are there a lot of powerful instruments sitting around unused?
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The other objection is that making the IOER zero or negative would push other money-market rates even closer to zero than they are now, thereby hurting money-market funds and otherwise impeding the functioning of money markets. My answer two years ago was that we have more important things to worry about. My answer today is that it has mostly happened anyway: U.S. money-market rates are negligible.
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It is noteworthy that the European Central Bank just jumped ahead of the Fed by cutting the rate it pays on bank deposits to zero—and European money markets did not die. Denmark's National Bank went even further, dropping its deposit rate to minus 20 basis points. Yet the Little Mermaid still sits in Copenhagen harbor.
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The Fed's hostility toward lowering the interest on excess reserves is almost self-contradictory. When Mr. Bernanke lists the weapons the Fed plans to use when the time comes to tighten monetary policy, he always gives raising the IOER a prominent role.
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His reasoning is straightforward and sound: If the Fed makes holding reserves more attractive, banks will hold more of them. Why doesn't the same reasoning apply in the other direction?
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But suppose it doesn't work. Suppose the Fed cuts the IOER from 25 basis points to minus 25 basis points, and banks don't lend one penny more. In that case, the Fed stops paying banks almost $4 billion a year in interest and, instead, starts collecting roughly equal fees from banks. That would be almost an $8 billion swing from banks to taxpayers. There are worse things.
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Mr. Blinder, a professor of economics and public affairs at Princeton University, is a former vice chairman of the Federal Reserve.
.Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved
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