Should The Federal Reserve Cut Interest Rates To Zero?

The Wall Street Journal – Alan Blinder: How Bernanke Can Get Banks Lending Again
If the Fed reduces the reward for holding excess reserves, banks will have to find something else to do with their money, like making loans or putting it in the capital markets
Fortunately, there is more the Fed can do. I have two out-of-the-box suggestions to make, one in today’s column and another in a companion piece soon. The simpler option is one I’ve been urging on the Fed for more than two years: Lower the interest rate paid on excess reserves. The basic idea is simple. If the Fed reduces the reward for holding excess reserves, banks will hold less of them—which means they will have to find something else to do with the money, such as lending it out or putting it in the capital markets. The Fed sees this as a radical change. But remember that it paid no interest on reserves before the 2008 crisis and, not surprisingly, banks held practically no excess reserves then. In early October of that year, Congress gave the Fed authority to pay interest on reserves, which it promptly started doing. When the Fed trimmed the federal funds rate to its current 0-25 basis-point range in December 2008, it also lowered the interest rate on reserves to 25 basis points, where it has been ever since. My suggestion is to push it lower in two stages. First, test the waters by cutting the interest on excess reserves (in Fedspeak, the “IOER”) to zero. Then, if nothing goes wrong, drop it to, say, minus-25 basis points—that is, charge banks a fee for holding their money at the Fed. Doing so would provide a powerful incentive for banks to disgorge some of their idle reserves. True, most of the money would probably find its way into short-term money-market instruments such as fed funds, T-bills and commercial paper. But some would probably flow into increased lending, which is just what the economy needs.

Comment

Negative interest rates, as Alan Blinder suggests, is a bad idea for two reasons.

1. The ECB recently did this and money market funds are closing down.  If  the money fund industry is dismantled, it will make the exit strategy all but impossible.  It would also throw the markets into chaos as transactional balances have no home.  If your money market fund closes, what do you do with the balances you use to pay bills?  Do you buy Facebook shares?
2. The U.S. has 8,000 banks, many of which are community banks.  If the Federal Reserve charges for excess balances, many of these shaky banks could go bust.  The Federal Reserve is already sensitive to the idea that they regulate for the benefit of the big banks.  Implementing  policy that drives community banks out of business will not go over well.

The Financial Times – Futures brokers count cost of zero rates
The Peregrine case has reinforced doubts about the integrity of futures markets and set in motion expensive reforms.  But very low interest rates are potentially more costly for the brokers known legally as futures commission merchants. Processing orders and handling cash for traders, they are the backbone of the futures market and their troubles threaten to become the troubles of the market as a whole.  Both the Peregrine case and the issue of low rates relate to customer funds. At Peregrine, chairman Russell Wasendorf Sr confessed to embezzling millions, according to a statement authorities say he typed before trying to kill himself. He awaits trial.  With interest rates the problem is less headline-friendly than fraud and more intractable.

Source: Bianco Research