Cutting to zero the interest rate the Federal Reserve pays banks to park excess reserves on its books wouldn’t add much stimulus to the economy, Chairman Ben Bernanke said Tuesday. Cutting this rate is “something we’ve considered, and continue to consider, and I don’t rule it out as an action in the future,” Mr. Bernanke said in response to a question at a gathering of the Economic Club of New York. But as a new avenue of stimulus, Mr. Bernanke said it is unlikely that lowering this rate, which currently stands at 0.25%, to zero would do all that much.… “I think it’s wrong to think of this as a major tool that is unused. If it were used it would have some effects that would be marginally constructive,” but it could also impair the functioning of many, very short-term markets. Ultimately, “it’s a relatively small-cost benefit calculation,” and cutting the interest rate on reserves to zero would lower short-term rates by around eight to nine basis points, Mr. Bernanke said.

The committee has talked about lowering interest rate on excess reserves.  We have gone round and round on this issue. I kind of think this might be a time to try that out.

Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said a reduction in the interest rate paid on reserves banks keep with the Fed is one policy tool available should the economy need more stimulus.

“There is some room to reduce that further to incentivize banks to lend,” Kocherlakota said today in response to an audience question after a speech in Minot, North Dakota. “This should be something that we think about” if further easing becomes necessary, even though a cut would have only “minimal effects on the economy,” he said.

Mr. Rosengren said the Fed should buy more mortgage-backed securities and possibly U.S. Treasury securities in an open-ended program, and state that it will continue to buy bonds "until we start seeing some pretty significant improvements in growth and income."

A new program, Mr. Rosengren said, should be "at least of the magnitude that we've had before." The difference, he said, should be that a new program shouldn't set a fixed amount or end-date.

Mr. Rosengren said he wanted to do more than launch a bond-buying program. As an additional step, he said the Fed should gradually reduce the 0.25% interest rate that it pays banks for cash they leave with it on reserve. Other short-term lending rates are lower, such as Treasury bill rates, he noted. "It seems like we're paying too much for people to hold reserves," he said.

He said he didn't expect a reduction in the reserve interest rate to significantly damage short-term lending markets. But because of worries he said he favored only gradual cuts and that he didn't support setting the rate at zero, as the European Central Bank recently did.

In response to a question about the tools available to the Fed,  Fed Chairman Bernanke said, "There are a range of possibilities. And I -- and I don't want to, you know, give any signal that we're choosing one among... The logical range includes different types of purchase programs. That could include treasuries or include treasuries and mortgage-backed securities. Those are the two things we're allowed to buy. We could also use our discount window for -- for lending purposes, but, you know, that's another possibility. We could use communications to talk about our future plans regarding rates or our balance sheet. And a possibility that we have discussed in the past is cutting the interest we pay on excess reserves."
 

"in a world where the Fed pays interest on bank reserves, traditional theories that tell of a mechanical link between reserves, money supply, and, ultimately, inflation are no longer valid. In particular, the world changes if the Fed is willing to pay a high enough interest rate on reserves. In that case, the quantity of reserves held by U.S. banks could be extremely large and have only small effects on, say, the money stock, bank lending, or inflation."

"if the economy improved markedly, inflationary pressures could build. Under such circumstances, the Federal Reserve would need to remove monetary accommodation to keep the economy from overheating and excessive inflation from emerging. It can do this in two ways: first, by raising the interest rate paid on reserves along with the target federal funds rate; and, second, by reducing its holdings of longer-term securities, which would reverse the effects of the asset purchase programs on interest rates."

Dudley said there “should be no anxiety” about whether the Fed’s enlarged balance sheet will cause the economy to overheat. The ability to pay interest on excess reserves “basically allows us to keep credit expansion under control,” he said. Market participants “accept this view,” as long-term inflation expectations are “very well-behaved,” he said.

MBS purchases and treasury securities purchases are one set of tools that we have. The other set of tools that we have are communication tools which essentially tie interest rate decisions to economic conditions or to time.

Those are, with interest rates close to zero, those are basically the two tools that we have, and we need to continue to work on how best to use them and in what combination to use them to achieve our objectives.

I want to close my discussion of FOMC performance by explaining why there is no longer an intrinsic connection between the size of the Fed’s balance sheet and inflation. I’ve mentioned how the Federal Reserve has bought over $2 trillion of government securities. It has funded that purchase by tripling the amount of deposits held by banks with the Fed—what are called bank reserves. The standard reasoning is that this kind of reserve creation is inflationary. Banks are only allowed to offer checkable deposits in proportion to their reserves. Economists view checkable deposits as a form of money because, like cash, checkable deposits make many transactions easier. In this sense, bank reserves held with the Fed are essentially licenses for banks to create a certain amount of money. By giving out more licenses, the FOMC is allowing banks to create more money. And if you took any economics in school you learned: more money chasing the same number of goods—voilà, inflation. Indeed, I think I’m pretty safe in saying that after four years in economics grad school, I’ve uttered this phrase—more money chasing the same number of goods creates inflation—more often than anyone else in this room.

But this connection between bank reserves and inflation is simply not operative right now. Banks have few good lending opportunities, and so they’re not trying to attract deposits. As a result, they are keeping nearly $1.6 trillion of reserves at the Fed in excess of what they need to back their deposits. In other words, banks have the licenses to create money, but are choosing not to do so.

I’m confident, though, that at some point in the future, the economy will improve and banks will once again have good lending opportunities. Some observers are concerned that once this happens, the banks’ excess reserves will serve as kindling for an inflationary fire. This concern would have been entirely appropriate three years ago. But in October 2008, Congress granted the Federal Reserve the power to pay interest on bank reserves. Right now, that interest rate is 25 basis points, or 0.25 percent. By raising that rate judiciously, the Fed has the ability to deter banks from using their reserves to create money, and through this mechanism, the Fed can prevent inflation. The Fed’s ability to pay interest on reserves means that the old and familiar link between increased bank reserves and higher inflation has been broken.

Of course, this requires the Fed to raise the interest rate on reserves in response to changes in economic conditions. You might well ask: Will the Fed raise interest rates in a sufficiently timely and effective manner to keep inflation at 2 percent or a little less? But that’s always been the key question to ask about Fed policy, even when the Fed had a much smaller balance sheet. And that’s my point: Because the Fed can pay interest on reserves, the size of its balance sheet does not, in and of itself, undercut the credibility of its commitment to keep inflation at 2 percent or a bit under. I believe that’s why both survey and market-based measures of expected inflation over the next five to 10 years have remained remarkably stable as the Fed has expanded its liabilities.

Plosser said to reporters after the speech that he “retains an open mind” on the idea of lowering the 0.25 percent rate the Fed pays financial firms on excess reserves.

“Reducing the interest rate on excess reserves at least in my mind would be a more traditional monetary policy action,” Plosser said. The Fed may not want to take such a step because of the uncertain effects from lowering the rate to zero, including possible damage to overnight lending markets, he said.

Lockhart also said the Fed has other options to provide stimulus, such as cutting the interest rate it pays banks for their reserves held at the central bank, although he noted that is a relatively small thing and not a big economic influence.

Rosengren said reducing the interest rate on excess reserves–which is the rate banks get for keeping money in cash–to zero would “make sense.”

The Boston Fed president, who is among the more dovish of Fed officials, said the Fed might need to go beyond the unconventional measures now being considered to spur economic growth.

One idea that might deserve consideration if there is a new shock to the economy or if it fails to pick up, he said, would be setting a ceiling on U.S. Treasury borrowing rates for securities with durations of as long as two years.

“You could peg medium-term Treasurys out for a fixed period of time,” he said. “You could say any security maturing between now and the end of 2013, we won’t allow [the yield] to get above a certain amount of basis points.”

 Note:  Rosengren's view had been different one year earlier.  [Link]

 Even with the federal funds rate close to zero, we have a number of ways in which we could act to ease financial conditions further. One option would be to provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels. Another approach would be to initiate more securities purchases or to increase the average maturity of our holdings. The Federal Reserve could also reduce the 25 basis point rate of interest it pays to banks on their reserves, thereby putting downward pressure on short-term rates more generally. Of course, our experience with these policies remains relatively limited, and employing them would entail potential risks and costs. However, prudent planning requires that we evaluate the efficacy of these and other potential alternatives for deploying additional stimulus if conditions warrant.

This largely paralleled Bernanke's comments in his June 22 press conference.  Bernanke dampened expectations of further asset purchases in the short run in his follow-up testimony to the Senate the following day.

We do have a number of ways of acting; none of them are without risks or costs. We could, for example, do more securities purchases and structure them in different ways. We could cut the interest on excess reserves that we pay to banks. And as was suggested by an earlier question—several earlier questions, actually—Jon’s question about giving guidance on the balance sheet or by perhaps even giving a fixed date, you know, to define “extended period,” those are ways that we could ease further if needed.

But, of course, all of these things are somewhat untested. They have their own costs. But we'd be prepared to take additional action, obviously, if -- if conditions warranted.

The world changes if the Fed is willing to pay a high enough interest rate on reserves... Classical monetary theory would take it as given that the enormous growth of excess reserves of the past few years would spur inflation. But if all those reserves aren't lent out, and all they do is sit at the Fed gathering interest, then the classical conclusion no longer holds water.