Warning on New Fed "Tool": Interest on Excess Reserves

I have been a long-term critic of Federal Reserve Chairman Ben Bernanke's creation of new Fed  tools to control money supply, especially the Fed's paying of interest on excess reserves (See: Federal Reserve Paying Banks Interest Rate That Is Eight Times Market Rate). These new tools are untested and unstable. During a period of extreme interest rate volatility, it is not clear that the Fed will be able to control monetary policy, without extreme measures that may have severe ramifications on the entire economy.

Caroline Salas at Bloomberg, for the first time that I am aware of in mainstream media, provides in detail the serious problems that may develop because of one Bernanke new tool, the paying of interest on excess reserves:

Federal Reserve officials are staking their inflation-fighting credibility on an untested
tool: the power to pay interest on bank reserves. Congress granted the Fed this ability in 2008, and Chairman Ben S. Bernanke, Vice Chairman Janet Yellen and New York Fed
President William Dudley have all cited it as a main reason why they’ll be able to keep the U.S. economy from overheating after pumping record amounts of cash into the financial system. Raising the rate, currently at 0.25 percent, is intended to entice banks to keep their money on deposit at the Fed instead of loaning it out and stoking inflation.

With the benchmark overnight lending rate trading at 0.1 percent, less than half the deposit rate, it isn’t clear how much control the central bank can exert over borrowing costs by
raising the interest on reserves, said Dean Maki, chief U.S. economist at Barclays Capital. Internal critics also have cast doubt on the tool’s effectiveness.

“There is some concern in markets about whether the Fed will keep inflation under wraps as it goes through this exit strategy,” Maki said in a telephone interview from his New York
office. “It’s unknown exactly what interest on reserves does to the economy.”...

The effectiveness of using interest on reserves, or IOR, as a main policy tool may depend on how closely the federal funds rate, or overnight inter-bank lending rate, follows its
movements. The Fed has kept its target for the fed funds rate at zero to 0.25 percent since December 2008.

“The big unknown is how tight the spread between the IOR and effective fed funds rate will be,” said Dino Kos, a managing director at economic-research firm Hamiltonian
Associates Ltd. in New York. “If the fed funds rate trades at a stable, and preferably narrow, discount to the IOR, then tightening policy through the IOR is doable. But a wide and unstable spread undermines the strategy.”

Kos is a former executive vice president and markets-group head at the New York Fed...

Before the Fed boosts the deposit rate, it likely will use reverse repurchase agreements and its new Term-Deposit Facility to gain more control over the federal funds rate,[Stephen Stanley, chief economist at Pierpont Securities LLC] said...

Stanley said he’s skeptical these transactions can operate at a scale big enough to suck sufficient cash from the system to control the federal funds rate...

While Stanley says Bernanke, Dudley and Yellen’s premise -- that raising interest on reserves should dissuade banks from extending credit -- is valid, policy makers may have to increase rates faster than they’d like because a 25 basis-point jump in the deposit rate won’t deter a bank from making a loan on which it would earn 6 percent interest, Stanley said.

“I will grant the point that Bernanke and others at the Fed have made over and over again, that ‘We have the tools,’ but really what they’re getting at is, in some ways, an academic
question,” Stanley said. “The problem is in thinking through the implications.”

Fed Chairman Ben Bernanke, his pet parrot, Vice-Chairman Janet Yellen, and Goldman's man at the Fed William Dudley, hold the view that everything is fine and under control. (Yes, the same Bernanke,who brought you the greatest economic crisis, since the Great Depression):

Bernanke called interest on reserves “perhaps the most important” tool for tightening credit in July 2009
congressional testimony, and he and his top lieutenants have expressed confidence in the deposit rate’s ability to quash inflation.

Dudley, who is also vice chairman of the FOMC, said in response to audience questions after a Feb. 28 speech that he is “absolutely convinced” raising interest on reserves will prevent a rapid acceleration in prices. “It’s very important that we at the Fed can convince people that this new tool is a viable means of preventing the economy from overheating,” Dudley said. “People should be very, very comfortable that we’re not going to let inflation get out of hand.”...Yellen also emphasized the deposit rate in a Jan. 8 speech defending the central bank’s second round of asset purchases. The Nov. 3 decision to embark on the $600 billion program sparked the harshest political backlash against the Fed in three decades, with Republican lawmakers saying the policy risked causing a surge in inflation.

“I disagree with the notion that the large quantity of reserves resulting from our asset purchases poses some special barrier to removing policy stimulus when the right time comes,”Yellen said. The ability to raise the deposit rate “will allow us to manage short-term interest rates effectively and thus to tighten policy when needed, even if bank reserves remain high."

Bottom line, Bernanke has to be considered a mad man for introducing, in the middle of an economic crisis, such a complex new method of controlling money supply. He didn't see the the subprime crisis coming, he didn't see the way the crisis would expand. He claims he doesn't see the inflation that is knocking at the door of the economy, and yet, he claims he understands perfectly well a major new monetary tool that would likely require huge swings in interest rates, during a period of extreme volatility. Interest rates swings that could create incredible havoc with the economy.

Very scary.

(Thanks2JosephBerkery)