Way back in March 2011, I had an article at Mises.org critiquing three “exit strategies” people had discussed for the Fed. The first was paying higher interest on excess reserves. Here was my analysis:
The option that Bernanke himself frequently mentions is the Fed’s ability to offer higher interest rates on excess reserves. Currently, if a commercial bank keeps its excess reserves parked at the Fed, the balance grows at an annual percentage rate (APR) of 0.25 percent, or what is called 25 “basis points.”
Now suppose (either because of rising price inflation or because of a healthy recovery) that the prime rate — what commercial banks charge their best clients — rises from its current level (3.25 percent) to, say, 10 percent. (This isn’t farfetched; the prime rate was higher than 10 percent in the late 1980s.)
Faced with earning a completely safe 0.25 percent by keeping their money parked at the Fed, versus earning a very (but not perfectly) safe 10 percent by lending to their most stable customers, many banks would begin drawing down their excess reserves, thus starting the inflationary spiral. To check this, the Fed could also bump up the yield it pays, to (say) 7.25 percent. By maintaining the spread between the two rates, the Fed could bribe the bankers to keep their money locked up at the Fed.
In any event, Bernanke’s favored “tool” of raising the interest rate on excess reserves is the epitome of kicking the can down the road. In the beginning, the higher payments would simply reduce the Fed’s net earnings, meaning that it would remit less money to the Treasury. Thus, the federal deficit would grow larger, meaning that taxpayers would ultimately be the ones paying bankers to not give them loans.
But at some point, if the process continued, the Fed would have exhausted its income from other sources. For example, on a balance of $1.2 trillion, if the Fed had to pay 7.5 percent interest, that would translate into $90 billion in annual payments to the banks. (The Fed earned about $81 billion in net income in 2010, of which it remitted $78 billion to the Treasury.)
To be sure, nothing would stop Bernanke from making such payments. He isn’t constrained by income statements; Bernanke laughs at the shackles holding back lesser men. He could simply bump up the numbers in the Fed’s computers in order to reflect the growing reserves balances of the commercial banks if they kept their funds with the Fed.
But this would hardly “solve” the problem of excess reserves. Rather than facing a $1.2 trillion problem, the next year the Fed would face a $1.21 trillion problem, and so on. The excess reserves would grow exponentially.
In a running argument with Paul Krugman, Interfluidity’s Steve Waldman recently wrote:
Cash and (short-term) government debt will continue to be near-perfect substitutes because, I expect, the Fed will continue to pay interest on reserves very close to the Federal Funds rate…This represents a huge change from past practice — prior to 2008, the rate of interest paid on reserves was precisely zero, and the spread between the Federal Funds rate and zero was usually several hundred basis points. I believe that the Fed has moved permanently to a “floor” system…under which there will always be substantial excess reserves in the banking system, on which interest will always be paid (while the Federal Funds target rate is positive).