26 Dec 2018

BMS Ep. 10: This One Simple Fed Trick Earns the Bankers Billions

Bob Murphy Show, Federal Reserve 27 Comments

You won’t believe what Powell did next! He didn’t know the cameras were still rolling!

27 Responses to “BMS Ep. 10: This One Simple Fed Trick Earns the Bankers Billions”

  1. Tel says:

    Here’s my take… the summary being that the Fed has been able to nuance it, and they are not in such a bad position. I think we are very slowly heading into recession territory but it won’t be spectacular and there won’t be a big crash (I’m going against Peter Schiff on this one).

    From basic ABCT you have a credit fueled expansion, then you have some even that pops the bubble (you can call it a “Minsky moment” although Minsky was not an Austrian, or you can call it a collective realization that this expansion is unsustainable, anyway it suddenly turns around and we have a recession). After that you deleverage for a while, people get their act together, some people pay down debt, others go bankrupt, the garbage projects get weeded out, etc, etc. then you are set to expand again.


    So there’s my graph, and if you look at 1990 to 1995 that’s a classic debt deflation. The green line (mortgages) hits a bottom as a bit of a leading indicator, then the red line (M1) hits a top. In this chart M1 is the closest thing we have to “honest” money, so when the red line is on top what’s happening is debt is getting monetized.

    Compare with the period 1995 to 2000 and the reverse is happening, the blue and green lines are at the top, the red line gets pushed down, it’s all leveraging up. Briefly deleveraged again in the 2000 “dot com” crash, then we have the big mortgage growth with a peak at 2004, and it slides back into the big crash of 2008 and deb deflation.

    What’s it done since 2008? Mortgages get pushed to the bottom again, with that leading indicator as mortgages bottom out in 2010. The red line (M1) is back up the top and it’s a double-peak this time because of QE1 and QE2 but let’s take the peak in late 2011 as the real peak on the red line. Note that the red line has been on the top all the way since 2008 and now in 2018 all those lines are coming together. We are at a similar turning point to where we were in 1995 EXCEPT for some important differences:
    * We have had 10 long years of steady deleveraging and debt monetization.
    * The mortgage curve peaked early (approx 2016) and peaked in a very weak manner (much lower than earlier mortgage booms) so don’t expect housing to do anything spectacular.
    * There has been no credit expansion boom whatsoever.
    * CPI has been unusually low, especially around 2015 but now ramped back up.

    The Fed has a lot of options from here. They could REDUCE the interest they pay on reserves and that bottled up credit would start expanding again. They could also keep increasing the overnight interest rate, which they probably will have to do as CPI picks up.

    Why don’t I expect a big nasty crash? Because there hasn’t been any significant credit expansion to fuel that. We are a long way away from the huge mortgage boom of the mid 1970’s and a long way away from the crazy CPI rates of 1980. There is plenty of room for the Fed to move here. Sure they have a huge balance sheet, but so what? As long as CPI stays under control, the balance sheet can just sit there, or very slowly get eaten away by inflation.

    Paying interest on reserves is one thing that has given them space to move, and as you say in the talk: that money would only have been handed back to the Federal Government as an interest free loan anyway. The banking cartel have jiggered it so they pay a little bit less tax than they usually do, in order to get themselves out of a sticky situation. Can’t say I blame them … maybe it’s looting the treasury but they aren’t the only looters out there by a long shot. If the inflation rate goes above what they pay on reserves then all of the banks are losing money in real terms by holding those excess reserves, and I think we are getting into that situation pretty soon now.

    I predict that before much longer the Fed will open up a little gap between their overnight rate and what they pay on reserves, just enough gap to pump a bit of credit inflation into the market. Maybe 50 basis point gap.

    I also don’t see the Fed as a real cause for concern in the near future… they are doing their job and managing the currency. Other problems like unfunded pension liabilities and general socialist fruit loopery are going to be much more dangerous. Sure it’s a cartel, sure people get rich off of it, but it’s a stable cartel, you know the deal even if you don’t like these guys.

    Sorry to ramble forever, but let’s take a peak at the Australian position: government spending is way beyond our means and government debt going up at an alarming rate. We aren’t the world reserve currency, and we can’t print our way out like you guys can. Our current government are lightweight socialists but they are unpopular and going to be replaced by the Australian Labor Party who are pretty full on spendthrifts and they are going to have us at 100% dept to GDP probably by about 2030 and full scale sovereign debt crisis. Quibbling about the banks not paying their share of tax is going to look totally trivial.

  2. Not agree with this says:

    Not agree with this

  3. Charles DuBois says:

    Thanks! A useful podcast. One, I think important, point. You leave the impression that paying interest on reserves reduces bank lending capabilities. But banks don’t lend reserves. When a bank makes a loan, it adds an asset to its balance sheet (the loan) and a liability to its balance sheet (the deposit from the loan). . This money is created out of thin air with no reference to reserves. If the bank were then to need additional reserves (obviously not the case these days), it would acquire them from other banks with excess reserves or the Fed would supply them.
    Once the loan is made, the bank will typically move some money from excess reserves into required reserves. But since the Fed is paying interest on both required and excess reserves, this change has little impact on bank profitability.
    Hence, the idea that that Fed is “paying banks not to lend” does not appear to be correct. That is, the volume of loans has little impact on the bank’s interest income from its reserves.
    Does this make sense to you? Thanks!

    • Bob Murphy says:

      Charles, your statements about banking sound right to me, except you’re leaving one important thing out: When a bank makes a loan to a customer, it is much more likely that the bank will then be asked to transfer reserves to another institution. E.g. if the bank grants a mortgage and then the person buys a house, the proceeds get deposited in some other bank. So then that bank gets the reserves from the first bank (after interbank clearing operations).

      So yes, in the banking system as a whole, total reserves stay constant (unless the public literally pull their money out in the form of currency), but any individual bank’s reserves are definitely affected by its lending policies.

      • Tel says:

        In the words of Ben S. Bernanke, 2016:

        Does paying interest on reserves prevent banks from lending?

        This claim, made even by some good economists, is puzzling. Before December, the Fed paid banks one-quarter of one percent on their reserves. If the Fed had not paid interest, the return to reserves would have been zero. Accordingly, the only potential loans that would have been affected by the Fed’s payment of interest are those with risk-adjusted short-term returns between precisely zero and one-quarter percent—surely a tiny fraction of the total. In fact, over the last four years bank lending has increased at about a 5 percent annual pace (including around a 7 percent annual rate the past two years), with only residential mortgage lending lagging in the aftermath of the housing bust.


        Which was a reasonable argument two years ago, but since rates have gone up we would have to conclude that the fraction of total potential loans being affected has grown larger.

      • Charles DuBois says:

        Bob. Thanks for taking the time for your response. Appreciated. Good point. While a new loan does not impact overall reserves, it , as you explain, could easily impact the reserves of the bank making the loan and thus reduce that bank’s interest from reserves (also I think – as a possible offset – reducing interest on deposit liabilities).. However, as I think more about it, I’m still doubting that paying interest on reserves reduces bank incentives to make loans. That is, as a practical matter, bank lending rates (Prime rate, etc) move prettty much in lockstep with changes in the interest being paid on reserves. Today the Prime Rate is 5.5. IOR is 2.4. During the 2008-2015 period these numbers were 3.25 and 0.25, respectively. Hence, loan profitability would appears to be relatively unaffected by the interest rate being paid on reserves. Now higher loan rates can impact the demand for loans, but that’s a different issue. So I still don’t see how paying interest on reserves reduces the incentive for banks to make loans. But, being thick-headed, I may be missing somethiing. Thanks for any help.

      • Capt. J Parker says:

        In response to Charles DuBois Dr. Murphy said:
        “your statements about banking sound right to me, except you’re leaving one important thing out: When a bank makes a loan to a customer, it is much more likely that the bank will then be asked to transfer reserves to another institution”

        I don’t think that’s a good way to think about it. When the bank makes a loan it has good reason to believe that the money withdrawn by the borrower will be matched by new deposits just so long as the lending bank is increasing its balance sheet at the same pace as all the other banks. Even if we assume the bank assumes a risk it would need to give up assets earning IOER as a consequence of writing a new loan it still must balance that risk against the risk of having too small a loan portfolio than it would otherwise want and thereby incur an opportunity cost.

        So, I think Mr. DuBois has an excellent point. It is far from clear that IOER directly incentivises banks not to lend. It may do so but that will depend on what kind of asset mix between lower yield (and lower risk) interest bearing reserves and higher yeild (and higher risk) loans the bank desires.

  4. Charles DuBois says:

    Sorry. In my fourth sentence, I meant “You leave the impression that paying interest on reserves reduces the incentive for banks to loan”. (I did not mean capabilities).
    To reinforce my overall point, the volume of bank lending is a function of the demand for loans, credit standards and loan profitability. My understanding is that loan volume has little or nothing to do with the level of reserves or the level of interest being paid on reserves.
    Since the idea that “paying banks not to lend” is central to your discussion, what say you to my point?
    That is, am I missing something important? Thanks much for any help.

  5. Tel says:

    Not sure how long this pastebin stays visible. https://pastebin.com/HGfyzzJ9

    From: William Arkin
    Date: January 2, 2019 at 11:32:20 AM PST
    To: Bill Arkin

    Subject: My goodbye letter to NBC

    January 4 is my last day at NBC News and I’d like to say goodbye to my friends, hopefully not for good. This isn’t the first time I’ve left NBC, but this time the parting is more bittersweet, the world and the state of journalism in tandem crisis. My expertise, though seeming to be all the more central to the challenges and dangers we face, also seems to be less valued at the moment. And I find myself completely out of synch with the network, being neither a day-to-day reporter nor interested in the Trump circus.

    Not sure if this guy is easy to get hold of but could be a red hot interview for some eager anti-war podcaster. Particularly this bit:

    Somewhere in all of that, and particularly as the social media wave began, it was clear that NBC (like the rest of the news media) could no longer keep up with the world. Added to that was the intellectual challenge of how to report our new kind of wars when there were no real fronts and no actual measures of success. To me there is also a larger problem: though they produce nothing that resembles actual safety and security, the national security leaders and generals we have are allowed to do their thing unmolested. Despite being at “war,” no great wartime leaders or visionaries are emerging. There is not a soul in Washington who can say that they have won or stopped any conflict. And though there might be the beloved perfumed princes in the form of the Petraeus’ and Wes Clarks’, or the so-called warrior monks like Mattis and McMaster, we’ve had more than a generation of national security leaders who sadly and fraudulently have done little of consequence. And yet we (and others) embrace them, even the highly partisan formers who masquerade as “analysts”. We do so ignoring the empirical truth of what they have wrought: There is not one country in the Middle East that is safer today than it was 18 years ago. Indeed the world becomes ever more polarized and dangerous.

    As perpetual war has become accepted as a given in our lives, I’m proud to say that I’ve never deviated in my argument at NBC (or at my newspaper gigs) that terrorists will never bedefeated until we better understand why they are driven to fighting. And I have maintained my central view that airpower (in its broadest sense including space and cyber) is not just the future but the enabler and the tool of war today.

    I’m really looking forward to this interview. You have to hold of this guy before Tom Woods does … not that this is a competition or anything … but a whimpy 30 minute show wouldn’t do it justice.

  6. Bob Murphy says:

    In response to Charles, Capt. Parker, and Tel:

    First, I agree that the IOR rate of 25 basis points in the beginning, wasn’t a big deal. That’s why I personally didn’t cite that when making excuses for why I was wrong about price inflation; I don’t think the policy early on could have had a huge impact, in the grand scheme. However, as the rate goes up, it does have a big effect.

    On the matter of other interest rates moving in tandem, right, that’s the point. If a bank can earn a guaranteed 2.2% from the Fed, it would insist on earning more if lending to a private sector client. That is obviously going to restrict lending, in the sense that private sector borrowers won’t want to borrow as much, the higher the interest rate. If I say to my brother, “Hey, if you’re thinking of selling your car, just keep in mind I’ll give you $100,000 for it,” then it would be silly to deny that I am paying him to not sell his car to others.

    Finally, suppose there are 20 big banks serving the public, all with equal sizes of clienteles. If a bank makes a loan to John Brown, its customer, then there is a 95% chance that when he spends that money, it will end up in one of the 19 other banks. The fact that John Brown owes the first bank money doesn’t automatically cause the bank to get more deposits.

    • Charles DuBois says:

      Thanks Bob for the response. You note that higher interest rates are “obviously going to restrict lending”. Agreed. I made the same point. But the reduced incentive to borrow is coming from the borrowers, not the lenders. Your original point was that the Fed , by paying IOER, is reducing bank incentives to lend. Since the banks maintain their margins by increasing their loan rates, their incentive to lend is apparently not impacted. But, with higher IOER, loan volume is lower, all else equal, as you explain. So, unless I am mistaken, it seems higher IOER is a negative for the banks, not a benefit. That, I believe, was my point.

      Of course, this is what the Fed is trying to do by increasing their Fed Funds target – cool off the economy a bit by reducing borrowing activity at the margin.
      P.S. I think the analogy to your $100000 car example would be for the Fed to be increasing IOER significantly above the Fed Funds rate – with the banks still pricing their loans based on the Funds rate. This would reduce bank incentives to lend – which was your point. But that is not what is occurring. Thanks.much.

      • Bob Murphy says:

        Charles I don’t really get your position. Suppose a hotel normally rents out 1,000 rooms a night, at $50/night. I come in and say, “I will rent as many rooms as you want to rent to me, at $75/night.”

        In the new equilibrium, the hotel will obviously raise its rates to $75/night. At the higher price, maybe the public only rents, say, 300 rooms a night, rather than the original 1,000. I pick up the other 700 myself, per my agreement with the hotel.

        Are you saying:
        (A) I have nothing to do with reducing the hotel’s room rental to the public?
        (B) I am somehow hurting the hotel?

        • Charles DuBois says:

          Hi Bob. Thanks. Yes, in your hotel example, you have everything to do with reducing the public’s rental activiy and you are obviously not hurting the hotel. Agreed.
          Because of your offer, the hotel has little incentive to rent rooms to the public.

          In contrast, if you and I were running a bank and we can create a loan for 5.50 % (with IOER at 2.4%) versus earlier days when we would create a loan for 3.25% (with IOER at 0.25%) – our incentive to make a loan has not decreased. I don’t think you would tell me “No, don’t make the loan – we are being paid 2.4%”. So it’s different than the hotel example. That is, we may make fewer loans at a higher rate – I think analageous to the hotel renting out fewer rooms to the public. But our incentive to make loans has not changed – different than the hotel example.

          Perhaps I can attempt to reconcile our viewpoints by noting that, loans or no loans, I think a bank would be making more money at IOER at 2.4% than when IOER = 0.25% (keeping deposit rates the same). So, yes, you could rightly say the banks are being helped by the Fed paying IOER. My only point was that the incentive to make loans has apparently not changed – in contrast to your view that “banks are being paid not to lend”. .

          No need to respond. If you still think I am all wet on this issue – that’s fine and that could very well be the case as I obviously don’t get it. We should leave it at that.

          I know we are all busy and you have been gracious with your time and thoughts. Thanks!

          • Bob Murphy says:

            Last one from me, Charles: You don’t think that raising the risk-free rate banks can earn, from 0.25% to 2.4%, might have something to do with why the standard rate went from 3.25% to 5.5%?

            In the hotel example, suppose I don’t even use the rooms, so the hotel doesn’t have to clean them afterwards. In contrast, they need to service the rooms (including replacing the coffee, towels, sheets, toilet paper) when the public rents them. So I offer to pay $75 per night, but the hotel insists on getting $95 per night from everyone else. It’s the same logic as in my original hotel example, except the hotel charges a premium to the rest of the customers because they impose more costs (are “riskier guests” than I am).

            • Charles DuBois says:

              Hi Bob. Thanks.
              You say: “You don’t think that raising the risk-free rate banks can earn, from 0.25% to 2.4%, might have something to do with why the standard rate went from 3.25% to 5.5%?”.
              Of course, Agreed. The change in the risk-free rate had everyhing to do with the change in the standard rate. Banks price their loans relative to T-bills, Fed Funds, Libor, etc. I thought that was part of the point I was making.

              So I still don’t get it. To go back to my example:
              If you and I were running a bank and we can create a loan for 5.50 % (with IOER at 2.4%) versus earlier days when we would create a loan for 3.25% (with IOER at 0.25%) – our incentive to make a loan has not decreased. I don’t think you would tell me “No, don’t make the loan – we are being paid 2.4%”.
              That is, we may make fewer loans at a higher rate, but our profit incentive to make the loan has not changed – assuming the loan has equivalent risk. You apparently say that banks have less incentive to lend with IOER. The profit incentive seems the same to me. That was my only point. Maybe I am mssing something? .

              Your other comments all seem on the money – if you will forgive the pun.
              The hotel example, etc., seems to be saying that IOER is providing risk-free income to the banks. Agreed. But that was not my point.

              I guess we just think about the issue slightly differently. That’s OK. Thanks.

              • Bob Murphy says:


                I don’t understand why you are using a different interpretive framework for the hotels vs. the banks. In the hotel example, if I offer them $75/night for a room they don’t use, then the equilibrium hotel rate for the public rises to $95/night. Then the hotel “doesn’t have any incentive to stop renting rooms to the public.” Yet the number of rooms the public rents, goes from 1,000 down to 300, because demand curves slope downward.

                You had no problem saying there was a definite sense in which my policy caused the drop in hotel rooms being rented to the public. So, if the Fed’s IOR policy causes the equilibrium regular loan rate to rise to 5.5%, and at that rate the public borrows less from the banks, then why do you resist saying the Fed has paid banks to reduce the amount of loans they make to their customers?

              • Dan says:

                It seems to be a semantic issue. He mentioned in a previous comment:

                “Now higher loan rates can impact the demand for loans, but that’s a different issue. So I still don’t see how paying interest on reserves reduces the incentive for banks to make loans.“

                He’s looking at it as the higher rates reducing the demand for loans, but not reducing the amount of money the banks want to make. As far as I can tell. It’s the only way I can figure out where the trouble is here because you’re explanation and analogies seems perfectly clear to me.

              • Bob Murphy says:

                Dan (and Charles), right, I picked up on that line from the beginning. Sorry if I could have / should have been clearer. The whole point of me bringing up the analogies with my brother selling a car, and then the hotel renting out rooms, was to show why dismissing the role of price hikes and demand curves as “a different issue” was an unusual move.

              • Dan says:

                Yeah, I’m with you. I think you’re point has been clear as day. I just think he’s seeing you say one thing but hearing it as another. I think when you say it reduces the incentive to loan to their customers, he’s hearing that it makes them want to make less money or something.

                Maybe if Charles considers why banks don’t make loans at 4% instead of 5.5% he’ll see it more clearly. The incentive to make loans is the same. The incentive to make loans to customers is certainly lower though. Otherwise they wouldn’t have raised their rates in the first place.

        • Tel says:


          3. Why is the payment of interest on reserve balances, and on excess balances in particular, especially important under current conditions?

          Recently the Desk has encountered difficulty achieving the operating target for the federal funds rate set by the FOMC, because the expansion of the Federal Reserve’s various liquidity facilities has caused a large increase in excess balances. The expansion of excess reserves in turn has placed extraordinary downward pressure on the overnight federal funds rate. Paying interest on excess reserves will better enable the Desk to achieve the target for the federal funds rate, even if further use of Federal Reserve liquidity facilities, such as the recently announced increases in the amounts being offered through the Term Auction Facility, results in higher levels of excess balances.

          They openly admit that right now, a huge excess of empty hotel rooms exists … so they are trying to prevent bum falling out of the market rate of hotel rooms by paying for the empties.

          At first glance this might sound like an irrational thing to do … but I’m willing to make a case for why it actually makes sense (even for hotels) to organize themselves this way (especially when operating an industry cartel).

          • Bob Murphy says:

            Tel wrote:

            They openly admit that right now…

            Just to be clear, they were writing that back in the fall of 2008 (or soon thereafter). This is what I said in the podcast. They flooded the market with liquidity to bail out the investment banks holding “toxic assets,” and that was going to push the fed funds rate below their target at the time. So they instituted IOR to be able to prop up the fed funds rate higher than what mere supply and demand in the loanable funds market would imply.

            It would be like if they flooded the hotel market with new rooms (somehow), and began paying hotels for empty rooms, in order to prop up the room rate.

            • Tel says:

              Yes, fair point… I should not have said “right now” although very likely the same thing still applies today.

              Has it been 10 years already? Sheesh, what happened?!?

            • Charles DuBois says:

              Dan, Bob. Repeating this from below – fixing some typos, etc.
              Thanks much for the insights and clarification! – and your patience. Sorry about that . It was primarily semantics, as Dan noted. Bob says ”The Fed has paid banks to reduce the amount of loans they make to their customers” This is the end result. Agreed.

              I was focused on the apparent profitability of the loan (not volume) . If I were, say, a loan officer, I would still have the same incentive as before to make the loan and increase the bank’s profits – but less opportunity. So the Fed has, in effect, paid the bank to reduce their loan book.

              Anyway, as a practical matter, given the level of excess reserves, the Fed has no choice in the IOER matter if they want to achieve their target Fed Funds rate. Or at least that is my understanding. Bob touches on this above.


  7. Bitter Clinger says:

    Dr. Murphy you make everything so complicated. I listened to your podcast twice, the second time taking notes. While I don’t disagree with what you said or the point you are trying to make, I believe it is not really a problem. This is problem is as I have pointed out in the past. From Wikipedia:

    The financial position of the United States includes assets of at least $269.6 trillion (1576% of GDP) and debts of $145.8 trillion (852% of GDP) to produce a net worth of at least $123.8 trillion (723% of GDP)[a] as of Q1 2014.

    In the number system we use (to quote David Hume) there is a property called Divergence. Stokes’s theorem states that unless there is a source or a sink the divergence of any system must be zero. In mechanics this is interpreted, as the sum of the forces on an object must be equal to zero unless the body is undergoing acceleration. This for Harold’s benefit is a-priori knowledge. Because I see my investments as assets while the people I invest in see them as debts, the sum of investments and debt must be equal to zero. Obviously we don’t owe foreigners the $150 Trillion so whom do we owe it to if we cannot book it as an asset?

    Let us look at how the discount window works. If I deposit $3,000 in my Wells Fargo account they pay me half a percent interest. They take that $3,000 and hold it as a reserve with the Federal Reserve and make 2.4% interest and it allows them to borrow at the discount window $100,000 at 3% interest to loan to some poor sap at 5% interest. To summarize the cash flows after one year:

    Sap owes Wells …..…….. $105,000
    Wells owes Fed ……… …..$103,000
    Wells owes me ………………$3015
    Fed owes Wells ………………$3072

    The question is not necessarily where does Wells get the $2,928 to pay back the Fed but where does the Sap get $5,000 to pay back Wells? A while ago you all laughed at the Malthusian who was taking about the power of compounded interest. This system has been running for 105 years. Later in the same article it points out:

    Interest payments on debt by US households, businesses, governments, and nonprofits totaled $3.29 trillion in 2008. The financial sector paid an additional $178.6 billion in interest on deposits.[14]

    How much has to be lent out to get $3.29 Trillion in interest and what interest rate do you use? I had a $300K loan (a seven-year ARM) at 2.8% (but increased over time to 3.625%) that I invested in tax-free municipals at 4.67%. Lets say that the banks are “on average” charging 3%, obviously people then owe over one hundred Trillion dollars. What interest rate are they charging depositors on their deposits to only pay them $178 Billion?

    An acquaintance of mine works for the Federal Reserve. His role, when I knew him, was building the systems for the clearing of checks. I confronted him with my views of how the Federal Reserve was charging interest on the money it was creating and how it could never be paid off and he confessed it was true. Obviously, more is owed than is created. He went on to say not to worry, as long as the Fed provides that we have the right kind and amount of money in circulation, the rest are just numbers. He then laughed at me and said I sounded like a motorboat, as I stuttered, “but, but, but, but, but”

    This paying of interest on reserves was instituted in the Bush administration in the hopes that it would prop up interest paid to depositors without raising the interest rates on loans. How well it worked (works?) is in dispute as you point out. But you have to admit, $40 billion is nothing more than a rounding error.

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