Selgin on IOER and TNB

George Selgin has a nice piece on TNB and IOER, which I missed when it came out in September, but it's still relevant.

(HT a correspondent. TNB is "The Narrow Bank" which I wrote about here; IOER is interest on excess reserves. The Fed pays banks interest on reserves, which are accounts that banks hold at the Fed.) 

As George points out, TNB's model is to take money from, large corporations or money market funds, invest that money at the Fed as interest-paying reserves, and give as large an interest rate back to the depositors as possible. (Well, that's what their model will be if their suit against the Fed  winds through the US legal system before the next crash, which is unlikely, These customers can't get large enough insured deposits at regular banks; that TNB invests entirely in reserves make it impossible for TNB to fail so its customers don't need insurance. TNB doesn't want to let you or me give them money because that opens them to an immense amount of costly regulation.

The puzzling question is, how can TNB make money at that.?TNB takes money, invests it with the Fed, and the Fed in turn buys US treasuries. How is that better than TNB simply operating a money market mutual fund that invests directly in Treasurys?

The answer is, that for most of the last decade, the Fed has paid more interest on reserves than comparable treasury rates. Yes, "money" pays higher interest than "bonds," an inversion of classic monetary theory. Since money is more liquid, how can this survive? The answer is, because only banks can access this kind of "money." TNB was going to upend that.

Just why does the Fed pay more interest on reserves than comparable treasuries?  This is, like it or not, a nice little subsidy to banks, who get about 0.2% more on their reserves than anyone else can get.

Where does that 0.2% come from? You and me. George explains vividly

Just how is it that the Fed's IOER payments could allow MMMFs to earn more than they might by investing money directly into securities themselves? Because the Fed has less overhead? Don't make me laugh. Because Fed bureaucrats are more astute investors? I told you not to make me laugh! No, sir: it's because the Fed can fob-off risk — like the duration risk it assumed by investing in so many longer-term securities — on third parties, meaning taxpayers, who bear it in the form of reduced Fed remittances to the Treasury. That means in turn that any gain the MMMFs would realize by having a bank that's basically nothing but a shell operation designed to let them bank with the Fed would really amount to an implicit taxpayer subsidy. There Ain't No Such Thing As A Free Lunch... As it stands, of course, ordinary banks are already taking advantage of that same subsidy.

This is good, and I conclude that the Fed should keep a large balance sheet, flood the economy with liquidity as Friedman said it should, and run a tight corridor system paying no more on excess reserves than comparable Treasury rates.  Here we part company.

George seems to agree with the Fed though, that this subsidy is an integral part of the interest on reserves scheme, and that TNB will undermine the whole project of a large balance sheet and targeting interest rates directly via interest on reserves and later, the discount rate. I disagree.

The explanation, in a phrase, is that, were it to gain a charter, TNB could cause the Fed's present operating system, or a substantial part of it, to unravel. 

What would happen, then, if TNB, and perhaps some other firms like it, had their way? That would be the end, first of all, of the Fed's ON-RRP facility and, therefore, of the lower limit of the Fed's interest rate target range that that facility is designed to maintain.

Let me explain a bit more slowly. The Fed does not just want to peg the short term interest rate. For obscure reasons, it wants the Federal funds rate (the rate at which, these days, about $10 gets lent from one bank to another overnight) to wander between an upper and lower band. 

OK, normally central banks who want a "corridor" offer to pay a low rate, say 1% on any amount of money,  and lend any amount of money at a higher rate 2%.  Nobody will bother borrowing at more than 2%, when they can get 2% from the Fed, and nobody will lend at less than 1%, when they can get that from the Fed. Presto, the central bank now controls the interest rate, between 1% and 2%. Or, 1.499% and 1.5001%, if it wishes. 

Our Fed, again for obscure reasons, wants the amount it pays to be the upper bound, not the lower bound. So it pays more than a market rate to banks, and pays money market funds about 0.2% less (money market funds can invest at the Fed, that's what ON-RRP is, but they get a lower rate than banks), and the Fed keeps the whole thing 20-25 basis points above treasuries.

 (BTW,  When the Fed wants to push rates down under current procedures, it's going to have to invert this whole business, and lend money at lower rates than markets offer. Get ready for screaming opeds of rage.)

Whew. OK, George is right. This lower bound business will come falling down if TNB is allowed to operate, and will take over the entire ON-RRP business, since it can offer the same service and 20 more basis points. But so what?

So what's wrong with viewing this as a small ( 0.2% x $2 trillion = $4 billion) subsidy to banks, easily remedied by paying the same rate on IOER as treasuries?  As George asks:

So what if the Fed's leaky "floor-type" operating system lacks a "subfloor" to limit the extent to which the effective fed funds rate can wander below the IOER rate? Why not have the Fed pay IOER to the money funds, and to the GSEs while it's at it, and have a leak-free floor instead? Besides, many of us have money in money funds, so that we stand to earn a little more from those funds once they can help themselves to the Fed's interest payments. What's not to like about that?

My question exactly. Here George really seems to endorse the Fed's fears: 

... the Fed would face a massive increase in the real demand for excess reserve balances that would complicate both its monetary control efforts and its plan to shrink its balance sheet.

But the Fed has total control over its balance sheet. It can simply refuse to buy or sell, and then reserves are what they are. Banks have to get them from other banks. When supply is vertical, "massive demand" means that prices have to change. OK, either Treasury rates go up 20bp, or IOER goes down 20bp. I don't see the explosion.

Moreover, answering "What's not to like about that?''

Plenty, actually. Consider, first of all, what the change means. The Fed would find itself playing surrogate to a large chunk of the money market fund industry: instead of investing their clients' funds in some portfolio of Treasury securities, money market funds would leave the investing to the Fed, for a return — the IOER rate — which, instead of depending directly upon the yield on the Fed's own asset portfolio, is chosen by Fed bureaucrats.

The first just isn't true. Once IOER is no more than Treasury rates, money market funds that invest in Treasuries pay the same as IOER. Again, quantities don't have to change because prices can move.

The last sentence is the one that I really think underlies it all. George doesn't like interest rates being "chosen by Fed bureaucrats."

But George,  The point of an interest rate target is for the central bank to set interest rates.  

Yes ,in good old monetarist times, one thought the Fed should set the money growth rate at 4%, and leave interest rates to markets.  I harbor some related thoughts -- I would like the Fed to set the price level, and leave interest rates to markets. (I'll explain how to do that some other day). 

But nothing under discussion here gets the central bank out of setting interest rates. Today, the Fed is targeting interest rates.  The interest on excess reserves is set by Fed bureaucrats, and in a corridor the "market" only gets to pick up the last 20 basis points. In a corridor system, the Fed is targeting interest rates, just 20 basis points lower. In the old (1982-2008) operating procedures, paying no interest on reserves, but setting interest rates by rationing reserves, Fed bureaucrats were setting interest rates.

If we want to talk about the Fed getting out of interest rate setting altogether... well, that is an entirely different issue that these little changes in operating procedure say nothing about.



from The Grumpy Economist http://bit.ly/2Sylrbn