Wednesday, October 25, 2017

The neutral overnight rate was probably already less than zero in September 2008.

I have written about how interest on reserves was a contractionary policy implemented in October 2008.  It seems plausible to me that much of the damage to nominal economic activity happened in November and late December 2008 when the Fed had the interest rate on reserves set at 1% along with the Fed Funds target rate, but that the effective Fed Funds rate was less than half that.  This induced banks to deposit hundreds of billions of dollars in excess reserves at the Fed.


During the period between the disastrous September FOMC meeting where the Fed Funds rate was maintained at 2% and the initiation of interest on reserves, banks had already deposited about $150 billion at the Fed in excess reserves.  I had interpreted this as a sort of mitigating fact regarding the contractionary nature of the policy, since this meant that some excess reserves would have accumulated even without interest on reserves, so that the entire $800 billion in reserves accumulated before the Fed finally dropped the target rate to near zero couldn't necessarily be blamed on interest on reserves.

But, I don't think I pointed out the other implication of that early buildup of reserves.  The other implication of those pre-IOR reserves is that already by September 2008, the neutral Fed Funds Rate was below zero, because banks were already willing to park a tremendous amount of reserves at the Fed.  To see the scale of this, note that the measure shown above (in black) isn't just of excess reserves.  It's of all reserves.

It is true, I think, that the gross positions of sales and purchases of overnight Fed Funds are larger than the net reserve position, but that being said, this was a tremendous amount of reserves banks were willing to set aside.

I don't really know anything about the microstructure of the Fed Funds market, so I don't know how the Fed maintained a Fed Funds rate above zero.  Maybe those were reserves lent to banks that other banks considered to be credit risks?  Maybe the defensive draw down of credit lines that happened in late September (blue line) was causing some banks to run short of reserves while others were flush.  Once that draw ended, the Fed Funds rate does appear to have fallen to the level of interest on reserves.  Help me in the comments if you can.

The stated reason for implementing interest on reserves is that it would help the Fed keep control of interest rates, so they could maintain their target rate without having to sell all of their treasury bills.  Not only is that stated reason strange, the policy seems to have failed to achieve even that strange goal.

My main point here, though, is that this is evidence that even while the Fed Funds rate was at 2%, then 1.5%, and then 1% for three months, the neutral rate was surely below zero for the entire period of time, and would have been, with or without interest on reserves.  That neutral rate was surely partially due to the Fed's policy target, so maybe if the Fed had pushed the target rate to 0.25% in September, the neutral rate would have been high enough to require the Fed to inject cash through treasury purchases.  That is, strangely, what they were trying to avoid.


  1. Great post. Way long time ago, I blogged that before the Fed expanded its balance sheet, it first strangely shrank it, heading into the recession.

    As far as I can tell, India is giving printed (digitized) money to its banks, and the market likes it. I do not sense the recriminations that would be attendant in US circles, but I hardly know any Indians….

    Egads, the monetary policy-banking sector connection is complicated enough to give anyone headaches.

    And people sneer at helicopter drops…but I thought a hallmark of democracy was transparency….

  2. Great great post. Bizarrely, it stills seems to be a non-mainstream position. I see people say that we were at the ZLB in Sept 2008 (I don't think the ZLB is that important, but since IOR has been over zero since Oct 2008, we never got to find out if it might). I still wonder what would have happened if the Fed started using negative IOR on 9/15/2008. That's hindsight of course, but I do wonder.