Interest on Reserves and Monetary Policy. (Session 1: The Reserves Market)

I. INTRODUCTION Monetary policy operating procedures have long been debated within the Federal Reserve and among monetary economists at large. For instance, economists have disagreed about whether a central bank should utilize bank reserves or the interest rate as the policy instrument. For the time being at least, the Fed has settled on an interest rate policy instrument and has announced its current federal funds rate target since 1994. The focus on interest rate policy is reflected in the ubiquitous use of the Taylor rule in monetary policy analysis. Oddly enough, just as the longstanding debate over bank reserves and the federal funds rate was set aside, four developments combined to renew an interest in operating procedures. First, economists began to worry that technological progress in the payments system could threaten a central bank's leverage over interest rates in the future. (1) Second, deflation in Japan led to a zero interest rate policy that stimulated a reconsideration of the nature of monetary policy transmission. Third, Congress considered legislation that would empower the Fed to pay explicit interest on bank reserves. (2) Fourth, during the 1980s and 1990s, many of the world's central banks moved from credit controls to market-based procedures for implementing monetary policy. Today, the world's major central banks implement monetary policy by manipulating short-term interest rates. Yet important differences remain in the procedures by which short-term rates are managed. There is considerable interest in comparing alternatives currently in use and in exploring new procedures that might afford benefits in the future. (3) Motivated by these four developments, this paper highlights the role of interest on reserves in understanding the leverage that central banks exert over interest rates and explores the potential for interest on reserves to improve the implementation of monetary policy. I find that interest on reserves can and should be employed as a policy instrument equal in importance with open market operations. In effect, my paper resolves the historical dispute over bank reserves and interest rate operating procedures by pointing out how a central bank can target both independently. I conclude that a central bank without the authority to pay and vary interest on reserves at a market rate is at a considerable disadvantage in the implementation of monetary policy. Economists, most notably Friedman (1959), have long advocated the payment of interest on reserves at a market rate in order to eliminate the distortions associated with the tax on reserves. (4) To a large extent, the legislation mentioned above was introduced to address the reserve tax. I am proposing something more: that interest on reserves be adopted as an instrument of monetary policy in practice. (5) Some economists have argued that paying interest on reserves might actually impair the ability of a central bank to conduct monetary policy. (6) More recently, however, interest rate rules for monetary policy have been shown to deliver coherent outcomes for the price level and real variables, even in models that ignore the demand for reserves and money completely. (7) These latest findings imply that interest rate rules could achieve broader macroeconomic objectives in much the same way, whether or not interest is paid on reserves. I build up the analytical core of the paper in Section II by reviewing the nature of the zero bound on nominal interest rates. I explain that a central bank can manipulate short-term interest rates either by employing open market operations to manage the interest opportunity cost of holding reserves or by varying the interest paid on reserves. I then explain how a central bank could employ interest on reserves together with open market operations to target independently and productively both short-term interest rates and the aggregate quantity of bank reserves. Section III employs the reasoning developed above to address the viability of interest rate policy in the event that technological progress in the payments system causes the transaction demand for bank reserves and currency to shrink significantly and even to disappear completely. …