This is a companion piece to our article entitled No Exit -- The Real Danger of the Fed's Easy-Money Policies. We recommend you read that one first.
Some Federal Reserve members have recently emphasized the effect of paying interest on excess reserves (IOER) and the ability to raise that rate if necessary. The purpose of paying IOER is to keep the large amount of excess reserves (a result of all the monetization) from becoming inflationary as would happen if it were lent into the general economy. It seems to us that the problems we outlined in the prior article are not solved by the Fed continuing to pay or even raise the IOER paid to banks because it would not preclude the need to raise rates economy-wide (via raising the Fed funds rate and/or reversing QE purchases) should inflation start to become an issue.
It’s hard to fathom that paying interest on excess reserves is the magic bullet that some would make it out to be. It’s more likely just a clever way to keep the money printing party going for a while longer and it’s quite possible that the excess reserves are in fact an additional risk unto themselves. Interestingly, Philadelphia Federal Reserve President Charles Plosser recently expressed serious concerns about relying on the IOER when he made the following statments:
"Inflation is going to occur when excess reserves of this huge balance sheet begin to flow outside into the real economy. I can't tell you when that's going to happen."And if IOER does seem to work, can it go on forever? Imagine also that QE continues and interest rates start to rise and the Fed is forced to pay a higher rate on an increasing amount of excess reserves. At some point, the interest that needs to be paid becomes a very large figure unto itself. Where’s the exit from dumping ever-higher interest payments into the banking system? Can they and our currency maintain credibility if the Fed keeps printing and printing to buy government bonds and then prints more to pay interest on excess reserves to keep them from circulating?
"When that does begin if we don't engage in a fairly aggressive and effective policy of preventing that from happening, there's no question in my mind that that will lead to lots of inflation."
"How fast will we have to do that [raise the IOER]?" "How rapid will it have to go up? We don't have a clue. Raising the IOER where you have a trillion and half or two trillion dollars in reserves, we have absolutely zero experience with it."
"We have the tools to do it, but we don't know the consequences of the tools…. If the IOER doesn't work and we have to sell assets, MBS [mortgage backed securities], how will that affect housing? Will we be able to unwind from this at a pace that doesn't disrupt the economy?"
If IOER is really a long-term answer, why limit the QE program to 40 billion per month? If they can print an unlimited amount to pay interest on the reserves that would pile up, then there’s no problem, right?
If it were truly a panacea then Germany would be on board and Europe would be printing freely to buy all of the high interest government debt of troubled Euro area countries to keep those borrowing costs down.
The whole thing reminds us of the real estate bubble’s last legs. There, home prices got to the point where many couldn’t afford to buy using traditional methods. Without rising real estate prices, the system would be in trouble, so bankers got “creative.” The only way to keep the game going was to offer buyers interest-only loans and subprime loans. When even the interest-only payment was too much for a buyer to afford, they were offered option ARM loans where the borrower actually paid less than even the interest that was owed on the debt. All of these were “creative financing” schemes that allowed the bubble to grow bigger and last longer than it should have under normal circumstances.
IOER may allow the game to go on for a while longer. Meanwhile, our debt mounts, the Fed’s balance sheet becomes larger, and our entire system becomes ever more dependent on low rates. But we are not at all convinced that IOER is a true Exit. Eventually, what’s unsustainable stops, and allowing imbalances to grow further and further out of whack gives us time to hope for a solution, but generally only serves to increase the pain in the end.