Mike Shedlock

Alan Blinder, a professor of economics and public affairs at Princeton University and former vice chairman of the Federal Reserve, is back at it.

In an Op-Ed in the Wall Street Journal Blinders says "Don't only drop the interest rate paid on banks' excess reserves, charge them."

Please consider The Fed Plan to Revive High-Powered Money.

Unless you are part of the tiny portion of humanity that dotes on every utterance of the Federal Open Market Committee, you probably missed an important statement regarding the arcane world of "excess reserves" buried deep in the minutes of its Oct. 29-30 policy meeting. It reads: "[M]ost participants thought that a reduction by the Board of Governors in the interest rate paid on excess reserves could be worth considering at some stage."

As perhaps the longest-running promoter of reducing the interest paid on excess reserves, even turning the rate negative, I can assure you that those buried words were momentous. The Fed is famously given to understatement. So when it says that "most" members of its policy committee think a change "could be worth considering," that's almost like saying they love the idea. That's news because they haven't loved it before.

Not long ago—say, until Lehman Brothers failed in September 2008—banks held virtually no excess reserves because idle cash earned them nothing. But today they hold a whopping $2.5 trillion in excess reserves, on which the Fed pays them an interest rate of 25 basis points—for an annual total of about $6.25 billion. That 25 basis points, what the Fed calls the IOER (interest on excess reserves), is the issue.

Unlike the Fed's main policy tool, the federal-funds rate, the IOER is not market-determined. It's completely controlled by the Fed. So instead of paying banks to hold all those excess reserves, it could charge banks a small fee, i.e., a negative interest rate, for the privilege.

At this point, you're probably thinking: "Wait. If the Fed charged banks rather than paid them, wouldn't bankers shun excess reserves?"

If the Fed turned the IOER negative, banks would hold fewer excess reserves, maybe a lot fewer. They'd find other uses for the money. One such use would be buying short-term securities. Another would probably be lending more, which is what we want.

Mike Shedlock

Mike Shedlock is a registered investment advisor representative for Sitka Pacific Capital Management.
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