Time to go negative!

Since the outbreak of the subprime meltdown, the Federal Reserve has shown itself ready, willing, and able to adopt unconventional monetary policies in order to reverse the downturn ushered in by the financial crisis. Recent Fed innovations have included quantitative easing in order to inject more money into the economy, intervention in the debt market to alter the maturity structure of interest rates, and announcing its future interest rate plans in order to make them more effective. These and other novel Fed policies have helped turn recession into recovery.  The recovery remains tentative, however.  In order to put it on a firm footing, the Fed needs to adopt an even more aggressive policy.

In the time-honored tradition of political candidates who are lagging in the polls, it is time for the Fed to “go negative.”

“Going negative” in this context does not mean launching verbal attacks on the values of the Bank of England, Bank of Japan, or the European Central Bank. Rather, it means paying negative interest rates on reserves that banks keep on deposit at the Fed. In other words, the Fed should make banks pay for the privilege of keeping money on deposit—something it has never done before. By adopting this policy, the Fed can increase banks’ incentive to lend and thereby contribute to strengthening the recovery.

Banks are required by law to hold an amount equal to a certain fraction of their deposits in reserves—that is, vault cash and deposits at the Federal Reserve. The most basic reason for this is that it encourages banks to keep sufficient resources at the ready to satisfy depositors who want to withdraw their money.

Historically, the Federal Reserve has not paid interest—positive or negative–on banks’ reserve balances. In October 2008, the Fed decided to start paying banks interest on those balances. The Fed currently pays banks 0.25 percent interest on the balances they hold–both on the amounts that banks are required by law to hold, as well as on any “excess” reserve balances they choose to hold. By paying interest on reserve balances, the Fed gives banks an incentive to leave additional funds on deposit rather than making loans.

Although 0.25 percent might seem like a pretty measly return, in the current environment it is not.

Deposits at the Fed are liquid—they can be called on whenever the bank needs them.  Loans to firms and households are usually not as accessible on short notice. Further, deposits at the Fed are safe.  The Fed has a monopoly in the business of creating dollar-denominated reserves, and so these deposits are not in danger being lost to failure or default. Sadly, the same thing cannot be said for most of the loans that banks make.  Finally, a rate of 0.25 percent is approximately equal to the yield on 2-year Treasury notes.  The fact that the Treasury is considering the possibility of issuing securities with negative yields—that is, securities for which buyers would pay the Treasury for borrowing their money–suggests that a positive 0.25 percent rate is attractive.

How would banks respond if the Federal Reserve began to charge them for the privilege of holding their reserves?

Although banks still might want to hold excess reserves in order to stave off an unexpected outflow of deposits, the incentive to hold these reserves would diminish.  Banks’ interest in finding alternative uses for the money entrusted to them—such as making productive loans—would increase.

What about required reserves?  Banks would still be obligated to hold these, of course, and so they would have to choose whether to hold them in the form of deposits at the Fed or as cash. Given the extra cost–and nuisance–of storing, guarding, and transporting large quantities of cash, banks would almost certainly be willing to pay for the convenience of holding a portion of their reserves on deposit at the Fed.

By giving banks an incentive to lend their deposits, rather than keeping them locked up, the Federal Reserve will encourage more bank lending. Increased bank lending to productive enterprises will give them the means to grow their business and will boost our sluggish economic growth.

Going negative could have positive results.