Monetary Freedom: Bernanke’s Reason for Paying Banks Not to Make Loans

Bernanke’s Reason for Paying Banks Not to Make Loans

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I was reading Steven Williamson’s opinion on Bernanke’s recent Jackson Hole speech. In it, he said that the only way the Fed can implement policy is by manipulating the interest rate paid on reserves. Williamson then said that Bernanke’s speech last year explained why that wouldn’t happen.
It is really pretty shocking.
Moreover, such an action could disrupt some key financial markets and institutions. Importantly for the Fed’s purposes, a further reduction in very short-term interest rates could lead short-term money markets such as the federal funds market to become much less liquid, as near-zero returns might induce many participants and market-makers to exit. In normal times the Fed relies heavily on a well-functioning federal funds market to implement monetary policy, so we would want to be careful not to do permanent damage to that market.
So, the reason for interest on reserves is to allow brokers on the Federal Funds market to make money and stay in business. The Fed’s excuse for keeping these folks in business is to make sure that they are there to help to Fed use its preferred operating procedure after economic conditions return to the way they were in the past.
The Fed wants to do things in familiar ways, and so it is making sure that there is plenty of business for certain money market brokers on Wall Street.
In my view, if banks don’t want to do as much interbank lending and borrowing, then brokers in that market should shift to doing other sorts of money market transactions. And then, if interbank lending markets pick back up, then they should shift back. The Fed shouldn’t try to keep interest rates up to protect their friends.
If the Fed believes that federal funds are not liquid enough for the federal funds rate to mean much, then the Fed should quit using the federal funds rate as a target.
Or, of course, it could give up on interest rate targeting.