The Great IOR Mystery

| Sat Nov. 13, 2010 11:32 PM PST

I'd like to second this comment from Matt Yglesias:

If the country’s political press could redirect 10 percent of the attention currently being paid to the House Democratic leadership race and the GOP pre-campaign for 2012 to one thing I would suggest the Federal Reserve’s interest on reserves program.

....In late 2008, the Fed for the first time ever said that if banks wanted to hold extra reserves they would get interest payments in exchange for doing so. Then they raised the interest rate. And then they raised it again. Via Scott Sumner, Louis Woodhill makes a very strong argument that this has been a massively underrated factor in producing the recession. The IOR payments led to a steep decline in the velocity of money, which in turn led to a collapse in Aggregate Demand.

Now, I think Woodhill's argument is overstated in two ways. First, the Fed didn't just raise the IOR rate and then raise it again. The IOR rate is based on the fed funds rate, and the Fed raised the IOR rate at the same time that it was reducing the fed funds rate, producing a sort of choppy up and down trajectory for a couple of months in 2008. Overall, though, between October and December of 2008 the nominal IOR rate dropped from 0.75% to 0.25%.

Second, I have my doubts that this was responsible for the great collapse of 2008. Woodhill bases his argument on coincidental drops in stock market prices, but this is fairly weak tea. The stock market was both very volatile and generally falling during this entire period, and the drops following the IOR increases were made up pretty quickly. It's not impossible that the fluctuation in the IOR rate was driving some of the stock market changes, but the evidence is thin. [See update below.]

That said, however, the general argument here seems unassailable: regardless of whether bouncing IOR rates affected the stock market badly in 2008, the fact that the IOR rate today is greater than zero seems very, very strange. As Woodhill says:

The Fed knows that IOR is contractionary. Chairman Bernanke has testified that raising the IOR interest rate is one option for fighting inflation. Two Fed staff economists issued a report in July 2009 ("Why Are Banks Holding So Many Excess Reserves?") that describes how paying IOR at the Fed Funds target rate would stop the "money multiplier" process dead in its tracks.

....In the absence of IOR, there is an incentive for anyone who receives a dollar to immediately pass it on by doing another transaction. There is also an incentive for banks to lend out their excess reserves....The payment of IOR at an "above market" interest rate (which has been the case for the past two years) short-circuits the processes described above. IOR creates a "roach motel" for money — the dollars go in and they don't come out.

In other words, if the IOR rate is zero, banks might as well lend their money and hope to make a profit on it. It's better than nothing. Conversely, if they can earn a safe return on their reserves just by parking them at the Fed, that might seem like the better deal. And so credit tightens and businesses have a hard time getting loans.

Control over the IOR rate, which was given to the Fed in 2006, is an important monetary lever. So why would the Fed announce a quantitative easing program designed to stimulate a weak economy at the same time that it keeps the IOR level set at a mildly contractionary level? It doesn't make sense. Once the Fed has officially announced that it believes the economy is stuck ("Pace of recovery...continues to be slow...high unemployment, modest income growth, lower housing wealth, and tight credit....Employers remain reluctant to add to payrolls. Housing starts continue to be depressed"), why wouldn't it use the IOR lever in addition to the QE lever? Why have them pointing in opposite directions?

I suppose one reason this doesn't get very much attention is that there's nothing much to say about it. The Fed won't comment on it, members of Congress are mostly unaware it even exists, Glenn Beck hasn't devoted a show to it, and there's nothing to say in a news story other than "once again, the Fed has taken no action on the IOR rate." Your editor won't let you write that story very often.

Still, it's a pretty interesting question. Why is the IOR rate still stuck at 0.25% instead of zero? Is it because the Fed believes that lending is constrained by demand and the IOR rate isn't playing a role? Is it because they think providing a steady source of profit for the banking system is still Job 1? Is it because they consider IOR's effect on lending to be pretty trivial at 0.25% and not worth bothering with? Or what? It is indeed mysterious.

UPDATE: My intent in this post was to agree with Matt Yglesias's point about the IOR rate being too high without also implicitly buying into the Louis Woodhill argument that he links to. That's the only reason I spent any time on it at all. However, Niklas Blanchard thinks my skepticism was too mild:

IOR policy wasn’t the driver of the collapse in 2008, inadvertently tight monetary policy was. If you are hardcore about monetary disequilibrium, like I am, then that was the key to the entire recession (contra what was happening with financial intermediation). The IOR policy was just heaping gasoline on a fire, so to speak.

I mostly agree, and I should have been more pointed about this. The great collapse of 2008 was largely driven by economic fundamentals. Regulatory issues played a role in making the collapse worse than it had to be, but it would have happened regardless. Likewise, IOR fluctuations may have affected stock market prices in late 2008 — though even that's not indisputable — but the recession had been underway for nearly a year by that time, the financial system had come close to collapse a month earlier, and the IOR policy, at worst, might have made things slightly worse. The argument that it caused the collapse just doesn't hold water.

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