Best of the Week
Most Popular
1. Stock Markets and the History Chart of the End of the World (With Presidential Cycles) - 28th Aug 20
2.Google, Apple, Amazon, Facebook... AI Tech Stocks Buying Levels and Valuations Q3 2020 - 31st Aug 20
3.The Inflation Mega-trend is Going Hyper! - 11th Sep 20
4.Is this the End of Capitalism? - 13th Sep 20
5.What's Driving Gold, Silver and What's Next? - 3rd Sep 20
6.QE4EVER! - 9th Sep 20
7.Gold Price Trend Forecast Analysis - Part1 - 7th Sep 20
8.The Fed May “Cause” The Next Stock Market Crash - 3rd Sep 20
9.Bitcoin Price Crash - You Will be Suprised What Happens Next - 7th Sep 20
10.NVIDIA Stock Price Soars on RTX 3000 Cornering the GPU Market for next 2 years! - 3rd Sep 20
Last 7 days
Trump and Coronavirus Pandemic Final US Catastrophe 2021 - 19th Jan 21
How To Find Market Momentum Trades for Explosive Gains - 19th Jan 21
Cryptos: 5 Simple Strategies to Catch the Next Opportunity - 19th Jan 21
Who Will NEXT Be Removed from the Internet? - 19th Jan 21
This Small Company Could Revolutionize The Trillion-Dollar Drug Sector - 19th Jan 21
Gold/SPX Ratio and the Gold Stock Case - 18th Jan 21
More Stock Market Speculative Signs, Energy Rebound, Commodities Breakout - 18th Jan 21
Higher Yields Hit Gold Price, But for How Long? - 18th Jan 21
Some Basic Facts About Forex Trading - 18th Jan 21
Custom Build PC 2021 - Ryzen 5950x, RTX 3080, 64gb DDR4 Specs - Scan Computers 3SX Order Day 11 - 17th Jan 21
UK Car MOT Covid-19 Lockdown Extension 2021 - 17th Jan 21
Why Nvidia Is My “Slam Dunk” Stock Investment for the Decade - 16th Jan 21
Three Financial Markets Price Drivers in a Globalized World - 16th Jan 21
Sheffield Turns Coronavirus Tide, Covid-19 Infections Half Rest of England, implies Fast Pandemic Recovery - 16th Jan 21
Covid and Democrat Blue Wave Beats Gold - 15th Jan 21
On Regime Change, Reputations, the Markets, and Gold and Silver - 15th Jan 21
US Coronavirus Pandemic Final Catastrophe 2021 - 15th Jan 21
The World’s Next Great Onshore Oil Discovery Could Be Here - 15th Jan 21
UK Coronavirus Final Pandemic Catastrophe 2021 - 14th Jan 21
Here's Why Blind Contrarianism Investing Failed in 2020 - 14th Jan 21
US Yield Curve Relentlessly Steepens, Whilst Gold Price Builds a Handle - 14th Jan 21
NEW UK MOT Extensions or has my Car Plate Been Cloned? - 14th Jan 21
How to Save Money While Decorating Your First House - 14th Jan 21
Car Number Plate Cloned Detective Work - PY16 JXV - 14th Jan 21
Big Oil Missed This, Now It Could Be Worth Billions - 14th Jan 21
Are you a Forex trader who needs a bank account? We have the solution! - 14th Jan 21
Finetero Review – Accurate and Efficient Stock Trading Services? - 14th Jan 21
Gold Price Big Picture Trend Forecast 2021 - 13th Jan 21
Are Covid Lockdowns Bullish or Bearish for Stocks? FTSE 100 in Focus - 13th Jan 21
CONgress "Insurrection" Is Just the Latest False Flag Event from the Globalists - 13th Jan 21
Reflation Trade Heating Up - 13th Jan 21
The Most Important Oil Find Of The Next Decade Could Be Here - 13th Jan 21
Work From Home £10,000 Office Tour – Workspace + Desk Setup 2021 Top Tips - 12th Jan 21
Collect a Bitcoin Dividend Without Owning the King of Cryptos - 12th Jan 21
The BAN Hotlist trade setups show incredible success at the start of 2021, learn how you can too! - 12th Jan 21
Stocks, Bitcoin, Gold – How Much Are They Worth? - 12th Jan 21
SPX Short-term Top Imminent - 12th Jan 21
Is This The Most Exciting Oil Play Of 2021? - 12th Jan 21
Why 2021 Will Be the Year Self-Driving Cars Go Mainstream - 11th Jan 21
Gold Began 2021 With a Bang, Only to Plunge - 11th Jan 21
How to Test Your GPU Temperatures - Running Too Hot - GTX 1650 - Overclockers UK - 11th Jan 21
Life Lesson - The Early Bird Catches the Worm - 11th Jan 21
Precious Metals rally early in 2021 - 11th Jan 21
The Most Exciting Oil Stock For 2021 - 11th Jan 21
Financial Market Forecasts 2021: Navigation in Uncharted Waters - 10th Jan 21
An Urgent Message to All Conservatives, Right-Wingers and Patriots - 10th Jan 21
Despite Signs to the Contrary, Gold Price at or Near Top - 10th Jan 21 -
Ultimate Guide On The 6 Basic Types Of Index Funds - 10th Jan 21
Getting Vaccinated at TESCO - Covid-19 Vaccinations at UK Supermarket Pharmacies and Chemists - 10th Jan 21
Cheers for the 2021 Stock Market and These "Great Expectations" - 9th Jan 21
How to Plan Your Child With Better Education - 9th Jan 21
How To Find The Best Casino - 9th Jan 21
Gold Is Still a Bargain Buy - 8th Jan 20
Gold Price Set to Soar as Hyperinflation Looms - 8th Jan 21
Have Big Dreams? Here's How to Pay for Them - 8th Jan 21
Will the Fed Support Gold Prices in 2021? - 8th Jan 21
Stocks trading strategies for beginners - 8th Jan 21
Who is Buying and Selling Stocks in 2021 - 8th Jan 21
Clap for NHS Heroes 2021 as Incompetent Government Loses Control of Virus Again! - 8th Jan 21

Market Oracle FREE Newsletter

FIRST ACCESS to Nadeem Walayat’s Analysis and Trend Forecasts

Central Banks Should Stop Paying Interest on Reserves

Interest-Rates / Central Banks Feb 25, 2016 - 05:38 AM GMT

By: MISES

Interest-Rates

Brendan Brown writes: In 2008, the Federal Reserve began paying interest on reserve balances held on deposit at the Fed. It took more than seven decades from the US leaving the gold standard — in 1933 — for the fiat regime to do this and thus revoke a cardinal element of the old gold-based monetary system: the non-payment of any interest on base money.


The academic catalyst to this change came from Milton Friedman’s essay “The Optimum Quantity of Money” where he argued that the opportunity cost of paper money (any foregoing of interest compared to on alternative money-like instruments such as savings deposits) should be equal to its virtually-zero marginal cost of production. Opportunity cost could indeed be brought down to zero if base money (bank reserves, currency) in large part paid interest at the market rate. Under the gold standard, the opportunity cost of holding base money largely in metallic form (gold coin) was indeed typically significant. All forms of base money paid no interest. And the stream of interest income foregone in terms of present value was equal in principle to the marginal cost of gold production (this was equal to the gold price).

Interest on Reserves are Important to Controlling Markets and Imposing Negative Rates

Friedman, however, did not identify the catch-22 of his proposal. If the officials of the fiat money regime indeed take steps to close the gap between the marginal production cost and opportunity cost of base money, with both at zero, then there can be no market mechanism free of official intervention and manipulation for determining interest rates.

That is what we are now finding out in the few years since central banks in the US, Europe, and Japan started paying interest on reserves. (The ECB was authorized to do this since its launch in 1999, while the Fed and BoJ began following the 2008 financial crisis.) Central banks can now bind the invisible hand operating in the interest rate market to an extent almost unprecedented in peacetime. In some cases, central banks have even deployed a negative interest rate “tool” which would have been impossible under the prior status quo where base money paid no interest.

How We Got Here

The signing into law of the Financial Services Regulatory Relief Act in 2006 authorized the Federal Reserve to begin paying interest on reserves held by depository institutions beginning October 1, 2011. On the insistence of then Fed Chief Bernanke, that date was brought forward to October 1, 2008 by the Emergency Economic Stabilization Act. He was in the process of dispensing huge loans to troubled financial institutions but wanted nonetheless to keep interest rates at a positive level (one purpose here was to protect the money market fund industry).

Accordingly, the Federal Reserve Board amended its regulation D so that the interest rate paid on required reserves and on excess reserves would be at levels tied (according to distinct formulas at the start) to market rates. An official communiqué explained that the new procedure would eliminate the opportunity cost of holding required reserves (and thereby “deregulate”) and help to establish a lower limit for the Federal Funds rate, becoming thereby a useful tool of monetary policy.

This was useful indeed from the viewpoint of rate manipulators: by setting the rate on excess reserves the Fed could now determine the path of short-term interest rates and strongly influence longer term rates regardless of how the supply of monetary base was growing relative to trend demand. By contrast, under the gold standard and the subsequent first seven decades of the fiat money regime, interest rates in the money market were determined by forces which brought demand for base money into balance with the path of supply as set by gold mining conditions or by central bank policy decision respectively. A rise in rates meant that the public and the banks would economize on their direct or indirect holdings of base money and conversely.

Back Before the Fed Paid Interest on Reserves

Yes, under the fiat money system the central bank could effectively peg a short-term rate and supply whatever amount of base money was needed to underwrite that — but the consequential growth of supply in base money was a variable which got wide attention and remained an ostensible policy concern. Right up until the Greenspan era, the FOMC implemented policy decisions by directing the New York Fed money desk to increase or reduce the pace of reserve growth and changes in the Fed funds rate occurred ostensibly to accomplish that purpose. This old method of determining money market interest rates under a fiat regime — in which banks’ need for reserves was minute given deposit insurance, a generous lender of last resort, and too-big-to-fail — depended on the banking industry enduring what was essentially a tax on its deposit business, which was then magnified by fairly high legal reserve requirements. Thus, it is not surprising that the original impetus to paying interest on reserves, whether in the US or Europe, came from the banking lobby. There was no such burden under the gold standard even though the yellow metal earned no interest. Banks in honoring their pledge to deposit clients that their funds were convertible into gold had to visibly hold large amounts of the metal in their vaults or at hand in a reserve center. Actual and potential demand for monetary base by the public is more limited under a fiat money regime than under the gold standard as bank notes are hardly such a distinct asset as gold coin from other financial instruments.

More Problems with Friedmanite “Solutions”

Friedman, when he advocated eliminating the opportunity cost of base money under a fiat regime, hypothesized that this could occur under a long-run declining trend of prices rather than by the payment of interest. The real rate of return on base money could then be in line with the equilibrium real interest rate. This proposal for perpetually declining prices would also have been problematic, though. The interest rate would fluctuate, and in boom times be well above the rate of price decline. In any case, the rate of price decline would surely vary (sometimes into positive territory) in a well-functioning economy even when the long-run trend was constant (downward). The equilibrium real interest rate would be below the rate of price decline sometimes (for example, during business downturns), meaning that market rates even at zero would be too high. That situation did not occur often under the gold standard where prices were expected to be on a flat trend from a very long-run perspective and move pro-cyclically (falling to a low-point in the recession from which they were expected to rise in the subsequent business expansion, meaning that real interest rates would then be negative).

What Can Be Done?

So what is to be done to escape the curse? A starting point in the US would be for Congress to ban the payment of interest on bank reserves. And the US should use its financial power with respect to the IMF to argue that Japan and Europe act similarly within a spirit of G-7 coordination such as to combat monetary instability. We have seen in recent years how rate manipulation and negative rates are made possible by the payment of interest on reserves, and are potent weapons of currency warfare. Yes, the ban in the immediate would force the Federal Reserve to slim down its balance sheet so that supply and demand for base money would balance at a low positive level of interest rates. The Fed might have to swap its holdings of long-maturity debt for T-bills at the Treasury window so as to avoid any dislocation of the long-term interest rate market in consequence. That, not the Yellen-Fischer “rate lift off day and beyond,” is the road back to monetary normalcy.

Brendan Brown is an associated scholar of the Mises Institute and is author of Euro Crash: How Asset Price Inflation Destroys the Wealth of Nations and The Global Curse of the Federal Reserve: Manifesto for a Second Monetarist Revolution. See Brendan Brown's article archives.

http://mises.org

© 2016 Copyright Brendan Brown - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules