Interest On Reserves, Part I

interest on reserves, financial crisis, Ben Bernanke, quantitative easing, Janet Yellen
The Bridge on the River Kwai

MadnessIn my last post regarding Ben Bernanke's memoir, I took Bernanke's Fed to task for electing to sterilize its pre-AIG emergency lending, thereby making sure that, while it was rescuing a small number of troubled firms, it was also reducing the liquid reserves available to others.  It was doing this, moreover, at a time when increasingly worrisome economic conditions were giving rise to exceptional liquidity demands.  The predictable result was an overall shortage of liquidity, which manifested itself in a collapse of bank lending and spending.

I now turn to an even more mind-bogglingly wrongheaded step taken by Bernanke's Fed in the course of the financial crisis: its decision to pay interest on banks' excess reserves.

The Fed began paying interest on reserves (IOR) in mid-October 2008, just after ending its program of sterilized lending.  That these steps coincided was no accident, for interest on reserves was meant to be a substitute for sterilization, aimed at the same result, namely: that of making sure that the Fed's gross asset purchases did not give rise to any corresponding increase in bank lending.

The Fed resorted to IOR because, by the time of Lehman's failure, it had reduced its Treasury holdings to their practical minimum.  Consequently, when it came to bailing-out AIG, the Fed found itself in a quandary:  the bailout would mean an increase in the overall size of the Fed's balance sheet, and a like increase in the monetary base.  Other things equal, the increase would mean a loosening of monetary policy.  Yet the Fed was determined to avoid such a loosening.

It was to escape from this quandary that the Fed came up with the oh-so-clever idea of rewarding  banks for not lending their otherwise unneeded reserves in the middle of one of the twentieth-century's most severe economic contractions.  You needn't take my word for it.  Here it is from the horse's mouth:

We had initially asked to pay interest [in 2006] on reserves for technical reasons.  But in 2008, we needed the authority to solve an increasingly serious problem: the risk that our emergency lending, which had the side effect of increasing bank reserves, would lead short-term interest rates to fall below our federal funds target and thereby cause us to lose control of monetary policy.  When banks have lots of reserves, they have less need to borrow from each other, which pushes down the interest rate on that borrowing — the federal funds rate.

Until this point we had been selling Treasury securities we owned to offset the effect of our [emergency] lending on reserves (the process called sterilization).  But as our lending increased, that stopgap response would at some point no longer be possible because we would run out of Treasuries to sell.  At that point, without legislative action, we would be forced to either limit the size of our interventions…or lose the ability to control the federal funds rate, the main instrument of monetary policy…[By] setting the interest rate we paid on reserves high enough, we could prevent the federal funds rate from falling too low, no matter how much [emergency] lending we did (Courage to Act, pp. 325-6).

Nor does Bernanke's understanding of the Fed's action differ from that of other Federal Reserve authorities.  In December 2009, for example, Richmond Fed economists John R. Walter and Renee Courtois offered an almost identical account.  The Fed's emergency credit injections, they wrote,

had the potential to push the fed funds rate below its target, increasing the overall supply of credit to the economy beyond a level consistent with the Fed’s macroeconomic policy goals, particularly concerning price stability.

For a  while sterilization solved the problem.  But

following the failure of Lehman Brothers and the rescue of American International Group in September 2008, credit market dislocations intensified and lending through the Fed’s new lending facilities ballooned.  The Fed no longer held enough Treasury securities to
sterilize the lending.

This led the Fed to request authority to accelerate implementation of the IOR policy that had been approved in 2006.  Once banks began earning interest on the excess reserves they held, they would be more willing to hold on to excess reserves instead of attempting to purge them from their balance sheets via loans made in the fed funds market, which would drive the fed funds rate below the Fed’s target for that rate.

There you have it.  The Fed paid banks to hold excess reserves, so that they would quit lending them, in order to make sure that the "overall supply of credit" did not exceed levels "consistent with the Fed’s macroeconomic policy."

And what level of credit supply was it that the Fed was so anxious to not "exceed"?  Perhaps the following chart will give you some idea:


If you are starting to forgive me for using the term "wrongheaded," I have made my point.

When the Fed first started paying interest on reserves, it did so at a rate exceeding the rate at which banks were prepared to borrow from one another in the overnight ("federal funds") market.   Because this was the case, banks more-or-less withdrew from that market, leaving only some GSE's, which had reserve accounts at the Fed but were not eligible for IOR, to participate in it.  The observed average overnight rate for transactions among these institutions — the so-called "effective" federal funds rate — has been consistently below the interest rate on excess reserves:


Needless to say, after most banks withdrew from the overnight market, the overall volume of overnight loans declined substantially.  Remember all that talk about how Lehman's failure led to heightened concerns about counterparty risk, which caused the interbank market to seize-up?  Well, that's not what happened.  Although some large banks had to cut-back on overnight borrowing in response to Lehman's failure, small banks actually borrowed more.  A Liberty Street Economics post, from which the following image is taken, supplies details.


It's possible, of course, that the banks that were flush with excess reserves wouldn't have lent those reserves even if they didn't bear interest, because those banks were also short of capital.  The thesis is at least plausible, since the Fed supplied fresh reserves to capital-starved firms by swapping them for mortgage debt and other illiquid assets.  The exchange reduced the cash recipients' (risk-adjusted) capital requirements, but did so only if they held on to the cash.  As an alternative to having to raise new capital, the swaps were a bargain — and especially so once reserves bore a modest return.

According to Huberto M. Ennis and Alexander L. Wolman, capital shortages did at first  discourage banks that held excess reserves from lending them.  But already by late 2009 some "would have been able to use reserves to accommodate a significant increase in loan demand without facing binding capital constraints." Two years later, the same authors report, "a significant proportion of the reserves held by large banks…could have been quickly used to fund loans without pushing these banks against their minimum regulatory capital levels."

The reserves "could have been" used.  But they weren't.  Why not?  Ennis and Wolman conclude that, for banks that were no longer capital constrained, limited "loan demand was likely the main driving force behind banks’ lending behavior."  But that is just another way of saying that the anticipated return on loans was low compared to the return from not lending — that is, compared to the return on holding reserves.

It remains possible nonetheless that IOR made little difference, because the return on loans would have been below the return on reserves even if the latter bore no interest.  That at least some "natural" interest rates, including the natural overnight rate, became negative during the crisis, and that a few may still be negative today, is the belief of more than a few economists.  That includes authorities in charge of several European central banks.  What's more, it includes Janet Yellen, who in a recent paper observes that "the natural real rate fell sharply with the onset of the crisis and has recovered only partially," and supplies the following chart summarizing extant estimates of the natural ffr:

Negative Natural Rate

If these estimates, or at least some of them, are correct, banks would have withdrawn from the federal funds market by early 2009 even without IOR.

But several caveats are in order.  First, note that the natural ffr estimates turn decisively negative only in late 2008.  This suggests that, if, instead of introducing IOR in the first place, the Fed had allowed its post-Lehman asset purchases to translate into increased bank lending, and especially if it had not sterilized its asset purchases before then, the natural funds rate might never have gone negative.  As I pointed out in my post on sterilization, a collapse in aggregate demand means, among other things, a collapse in the nominal demand for all sorts of credit, and a corresponding decline in market-clearing nominal interest rates.

Second, and no less importantly, while overnight lending rates may have turned negative, not all lending rates did so.  Returning the interest rate on reserves to zero would therefore have encouraged bank lending, even if it failed to encourage overnight lending.   The one qualifier is that, because the supply of overnight funds itself would have remained constrained, banks would still have had a greater than usual need for excess reserves to meet their settlement needs.

Finally, even allowing that nothing short of negative interest on excess reserves would have inspired banks to lend those reserves, it remains the case that IOR was a bad policy, in the sense that abandoning it would at least have been a step in the right direction.

For my part, I do not doubt that, whether negative IOR would have been ideal or not, positive IOR played an essential part in the vast post-2008 accumulation of bank excess reserves  — an accumulation that proceeded in lock-step with the Fed's large-scale asset purchases, thereby allowing the Fed to add trillions to its balance sheet, without contributing a jot to bank lending:


Here is where I must part company with some of my Market Monetarist friends.  For while those friends hold, as I do, that IOR was counterproductive, and that Fed asset purchases might have been far more effective in boosting recovery without it, they have tended nonetheless to defend the Fed's large scale asset purchases ("quantitative easing").  I think this was a mistake, both because it meant accepting the Fed's own dubious (and hardly "monetarist") theories about how LSAPs were supposed to aid recovery despite the non-lending of added reserves, and because it overlooked the very real adverse effects of those purchases, including the sacrifice of ordinary means for monetary control that they entailed.

There are, I realize, some who argue that IOR isn't really equivalent to paying banks not to lend, and that it is therefore not to blame for their having accumulated so many excess reserves.  Their arguments are, if anything, even more screwy than the logic — which those arguments manifestly contradict — underlying the Fed's decision to resort to IOR in the first place.  But this post is long enough, so I'll turn to these arguments in Part II.


As it happens, just as I am completing this post, Janet Yellen is holding a press conference announcing what she regards as the Fed's first steps toward the "normalization" of monetary policy that has become a policy desideratum in the wake of the Fed's highly abnormal marriage of IOR and large-scale asset purchases.  Of what do these steps consist?  First, the Fed will raise its federal funds rate target by a quarter of a percentage point — a meaningless gesture, given  (as Yellen herself understands) that the target was already above the "natural" funds rate before the hike.

Second, the Fed plans to double the rate of interest on excess reserves.


  • Walker Todd

    Well done.–Walker Todd

  • Bill Bergman

    Great article. Some related credit extensions by the Fed were doing some very interesting things in late September and into October 2008. See peak funds overdrafts at

  • Kevin Erdmann

    Thanks for another great post.

    Maybe you will find this useful. Here is a post where I put together a timeline in late 2008. I think the fact that the disastrous Fed meeting came the day after the Lehman failure has allowed the Lehman failure to take on an oversized role in the perceived factors in the crisis. The graph in my post suggests that, not only was the September meeting a disaster, but, as you document here, there was a considerable time after that meeting where IOR was implemented and then pushed up – going above the effective fed funds rate for much of the rest of 2008, and attracting large amounts of excess reserves.

    In the graph, we can see that equity prices didn't react that much to Lehman, or even to the September meeting, but that most of the decline, in equities at least, happened in October and November, coincident with the rising IOR rate.

    • George Selgin

      Thanks for these observations, Kevin. My impression is that, the more closely one looks at the timing of events during the crucial period of Sept.-Oct. 2008, the more inclined one will be to blame the Fed, not for having failed to rescue Lehman Bros., but for just about everything else it did during that interval.

      • Mr Selgin, my question is why? Why did they allow the economy to tank? They may have decided to shake out weak hands in industry, and in real estate investing, all to make money for their buddies at the bottom. I like looking at conspiracy and it could be a doozy. The original housing bubble was a conspiracy, with Greenspan saying you could get a "better deal" with an adjustable mortage.

  • Thanks for a great post, George.

    I'm not sure if you quite captured the MM view of LSAP/QE. I know Scott's view is that the massive QE was a sign of the failure of the Fed's interest rate targeting regime, and that under NGDPLT, much less asset purchasing would have been required because under NGDPLT, it's much more clear what the Fed's endpoint is — all that's needed is to convince the market that the Fed was serious about reaching the endpoint. I think the quotes in the AEI article you linked to (implying that MM's support QE) were a bit cherry-picked. The MM view is that money was way too tight in 2008, so insofar as QE means money is looser than no QE, then sure, QE is better than no QE. It's sort of like asking 100 doctors, if you're starving to death, is it a good idea to eat a giant bowl of whipped cream. Well, it's not very healthy, but it sure beats starving. And then concluding that doctors support eating giant bowls of whipped cream.

    But this is just a quibble.


    Kenneth Duda
    Menlo Park, CA

    • George Selgin

      " The MM view is that money was way too tight in 2008, so insofar as QE
      means money is looser than no QE, then sure, QE is better than no QE."

      Right. But this is precisely the position I disagree with. At some point, a little easing isn't worth the price of a vast increase in the Fed's balance sheet. The gains were not great: if the economy was starving, there is not much evidence that QE gave it much sustenance. The proof is in the NGDP pudding. (Comparisons with Europe are poor counter-evidence at best.) The costs are still accruing and will accrue for some time yet.

      I believe, in short, that QE was a mistake given the circumstances, though I would have favored it if I believed it would prove effective in boosting spending. Had there been no IOR, in other words, I would have favored it; but then the Fed would not have had to buy so many trillions.

      These are, Ken, differences that (I hope) do not separate us much. I consider the MM position reasonable enough, but it is a matter of how we gauge the hard-to-measure costs connected to having a massive Fed balance sheet weighed down by unsaleable assets.

      • Got it. Your position makes perfect sense. I have no idea how to compare the costs of an excessive balance sheet with the costs of modestly tighter monetary policy. Thanks for the response.


  • Yes, this payment on reserves, the IOR seems dumb, but it was not the cause of the crash Toxic loans bundled up into securities were a cause for the crash. However, one has to wonder why the Fed wanted to slow lending. Did they just want the houses back? Did they want housing to bottom and then make money for their rich borrowers who bought up those houses with cash? Or were they afraid of the economy overheating when the banks had bet on low floating rates. That bet failed at the beginning of the Great Recession as the chart here shows:

    • George Selgin

      I hope I never supplied any grounds for anyone to think that I blamed the crash of the subprime market, which started in 2007, on a policy begun in the last quarter of 2008!

      • You didn't. 🙂 But the question remains, why did they do it? Also, Mr Selgin, how much, dollar wise in long bonds is needed as collateral for the derivatives markets? Apparently the bonds are in short supply.

    • Kemo Spear

      Flagged for posting a link to your personal blog.
      Never trust anyone who posts links to their personal website and tries to pass it as "fact". The "chart" posted by Mr. Anderson was created by himself (he has admitted it), so it can not be trusted.

      • You are a sick stalker who knows nothing about this subject, Kemo. The chart has been vetted by professional editors.

        • Kemo Spear

          So, Gary, do you continually post lies for free or do you get rewarded? Oh, that's right, you constantly post links to your personal blog to get hits and to get paid. So, you DO get rewarded for posting lies. Gary, please, just who are these "professional editors" that you speak of that vetted your drivel?

          See, here is the thing, you could have posted a link to the web page (I tried it, guess what Einstein, you CAN copy & paste the URL). you could have done a right click on the image, saved it and then reposted it here, but you did not. Instead, you created your own chart. You have been caught in so many lies, Gary, why, oh why should anyone trust you now? You though it wise to call me a moroff, yet you are too stupid to do a copy & paste of a URL (something a 6 year old kid could do). Give it up Gary. Your a liar who was caught in a lie, and at this point, anything else out of your mouth is a lie.

          • You are embarrassing yourself, Kemo. You sign up for an account at FRED, and it is up to you how to use their data. Creating charts can show a comparison between two or more trends in economics. My chart clearly showed that the recession was triggered by the LIBOR line crossing the Swaps line, and banks quickly realized that they could not do business as usual. You do not have to be an economist to create a legitimate chart. I have commented on economic issues at Business Insider and other publications besides publishing my own blogs.

          • George Selgin

            KS, you won't be stalking Gary, or anyone else, on this site any longer!

          • Kemo Spear

            It is an open public forum. I am just calling Mr. Anderson out for lying. If you have an issue with that, then that is on you. But, keep in mind, you are justifying Mr. Andersons lies. He makes clams, I asked him to back them up, which he has not.

  • JP Koning

    "Finally, even allowing that nothing short of negative interest on excess reserves would have inspired banks to lend those reserves, it remains the case that IOR was a bad policy, in the sense that abandoning it would at least have been a step in the right direction."

    Let's say that nothing short of negative interest on excess reserves would have inspired banks to lend those reserves. Wouldn't IOR be a good policy? How else to implement a negative rate on reserves without first legislating the ability to pay/debit interest on reserve? If so, it wasn't IOR that was a bad policy; it was positive IOR that was bad.

    So come the next crisis, George, do you think negative interest rates will be the way to go? A lot of free bankers I read seem to be paranoid about the phenomenon of negative rates.

    • George Selgin

      You misunderstand me, JP, and I take the blame. I mean that _positive_ IOR was bad policy; I am not here criticizing the decision to create the new tool.

      And yet…given the irresponsible manner in which the Fed has employed its new instrument thus far, I cannot but conclude that it may, in fact, be wiser to deprive the Fed of that tool altogether than to risk having it continue to misuse it.

  • SMIA061948

    I am not an economist, but as soon as I heard about IOR (early December of 2008), I published the following article, warning that IOR would crash the real economy:

    To this day, the Fed does not seem to realize that paying IOR at a rate above the short end of the Treasury yield curve renders conventional monetary policy completely impotent. To keep the value of the dollar stable, the Fed has to be able to adjust the total amount of dollar liquidity in the world. With IOR, all their QE accomplishes is to make 1:1 exchanges of one cash equivalent (bank reserves) for another (Treasury securities).

    By the way, "lending" is not the issue. The money multiplier (and NGDP) is the issue. Without IOR, the banks would have used their excess reserves to buy Treasuries.

    The Fed's (and the economics profession's) obsession with interest rates is bizarre. The Fed should simply target commodity prices. Commodity prices relate directly to the real value of the dollar, while interest rates have only a tenuous and variable connection with the real value of the dollar. And, there is no "zero bound" problem with commodity prices.

    Of course, to be able to target anything, the Fed must stop paying IOR.

    • George Selgin

      "By the way, "lending" is not the issue. The money multiplier (and NGDP)
      is the issue. Without IOR, the banks would have used their excess
      reserves to buy Treasuries."

      I admit to sometimes using "lending" as a shorthand to mean "acquiring interest-earning assets." But by buying Treasuries the banks would also generate new deposits, and eventually this would inspire them to increase their loans as well. The increase in the multiplier would not simply involve an increase in bank's Treasury security holdings.

  • Max

    Something that nobody (outside of finance) seems to know about is that the law authorizing the Fed to pay IOR forbids paying an above-market interest rate. But they've been doing that continuously since 2008, as your second chart shows. This is a misuse of public funds, and not a small one. There's no defending it, but the Fed hasn't had to defend it.

    (I'm not saying this is what the Fed initially set out to do. I think they were operating on the theory that IOR would place a floor on interest rates. But when it failed to do so, they didn't change course).

  • B Cole

    I like this post. However, I think QE also work by stimulating spending. That is, people who sold bonds to the Fed then could place an immediate claim on other assets, goods and services.
    QE was $4.5 trillion—different in scope and scale from earlier OMOs.
    I suspect QE boosted demand for goods and services, and was successful on that level.
    Remember, if a bondseller sold into QE for the purpose of, say, buying a new car, the Fed provided the money. No one else bought the bonds, thereby giving up immediate claim on goods and services.

    • SD3

      Yet what you describe is not 'generating new demand' where it previously did not exist, nor 'contribute to economic growth'.
      It's nothing more than pulling future demand into the present. I.e., a car purchase "now", instead of next year. So when 'next year' rolls around, we're guaranteed to be "down" one new car purchase that might otherwise have happened.
      It's 'fake' prosperity. Unfortunately, now it's time for the wheels to fall-off that fake prosperity.

      • Benjamin Cole

        SD3: I do not follow. Okay, so people who sold into QE3 got digitized cash. I guess they were going to sell anyway (in a globalized market no less). QE just means no one else gave up an immediate claim on assets to buy the $4.5 trillion in bonds the Fed bought.

        Georeg Selgin says the impact of QE was limited. You say it did a fast-forward on demand. Actually, then I respond, "Really? Then QE should have been bigger and earlier!"

        Some people say QE was inert, as bond sellers just put the money into commercial banks and the banks sat on it. Although even this scenario results in a nice tax cut, and lowered indebtedness for future generations.

        Egads, if QE fast-forwards demand, we have a long road of prosperity ahead. There is another $10 trillion or so outstanding in federal debt we can liquidate through QE. (The public already owns many trillions through FICA trust funds. The amount of federal debt truly outstanding is about $10 trillion now). Maybe we can run deficits and QE that too.

        China has been doing QE for decades, Japan is doing it now with some success, the ECB is doing it. Where is the inflation? I see nothing but a relief in tax burdens and some stimulus.

        They talk about the QE bazooka, but I wish the Fed would go to QE heavy artillery.

        I still see no downsides in QE. I see the potential for inflation, but none yet, and I am a fan of moderate inflation anyway.

        I say the purpose of macroeconomics is prosperity. Other goals are secondary.

    • George Selgin

      "That is, people who sold bonds to the Fed then could place an immediate claim on other assets, goods and services." Yes. But the effect was very limited under the circumstances, and the cost was a vastly bloated Fed, the complications from which are only now beginning to be fully appreciated.

      • Benjamin Cole


        1. Why was the effect of QE "very limited"? I think it was stimulative. Although I am not a supporter of IOER, I doubt the banks would have done much lending anyway (at least after the recession started). Banks like to lend on collateral, and that usually means real estate. Real estate was going down. I think QE allows the Fed to bypass the banks and stimulate the economy directly. The old way was federal deficits and Fed accommodation. I like QE better; smaller federal government, and no debts on future generations. In fact, one could argue for more QE—perhaps FICA tax cuts financed by the Fed buying Treasuries and placing them into the FICA trust funds.

        If the effect of QE was limited, should it have been larger, more aggressive and open-ended, with closure base on results, and not a pre-announced time table? (i.e., QE1 and QE2).

        2. So the Fed has a large balance sheet. So what? It has traded digitized cash for bonds. The bond-sellers had immediate claim on assets and goods and services after they sold to the Fed, and did what they did. No one seems to know what bond sellers did with the $4.5 trillion they got from the Fed through QE. We saw equities and property rallies, and some GDP growth, But, far as I know, no one surveyed bondholders in the QE period and asked them, "When you sold your bond, what were your plans? What did you do with the money?"

        The Fed's large balance sheet strikes me as a positive, in that it funnels interest payments back to the Treasury, thus lowering taxes (ceteris paribus). What is not to like? (I confess unease if Congress ever figures out they can print money and get away with it).

        BTW, I think China's PBoC has done QE for decades to finance infrastructure development. So, China has decades of rapid growth and now has 1.5% inflation.

        What are the downsides of a large Fed balance sheet? It has the option of selling, rolling over, or enlarging. Is the stress of a large balance sheet a loss of psychic income for some?

  • N H

    I read this after hearing the interesting discussion on Econtalk. I found the analysis of the Fed's response pretty convincing, but I wanted to ask a more general question about the grounds of the objection to IoR.
    Is the objection to IoR in this article more about the intent and timing of the Fed's introduction of IoR, rather than being against IoR in principle? I was under the impression that other central banks have always remunerated at least a portion of reserve balances, or at least begun to do so long before the crisis, and certainly not in response to it.
    Without a central bank, well-run banks would still seek to hold liquid assets as some form of reserve, and so earn a return of some description. So it is not obvious to me that it is necessarily peverse for central banks to provide a risk-free return on reserve balances. Indeed, the idea that any theoretical economic argument could justify a particular arbitrary fixed nominal rate (which is what zero is) seems surprising to me.
    I suppose physical cash has a zero nominal rate of return, but this feels like an increasingly less important benchmark, so I think I would be surprised if a theoretical objection could be mounted on these grounds.

    • George Selgin

      "Is the objection to IoR in this article more about the intent and timing
      of the Fed's introduction of IoR, rather than being against IoR in

      Yes. For some reason my attempts to be clear on this point have failed me. It is the Board's decision to set a rate above the ffr, and to do so in the middle of a downturn, that I object to. But I also think it better to confine interest payments to required reserves.

  • Fireplace 1

    Is this analysis taking into account global cash flows? There would be serious limitations to this analysis if its components are limited to the domestic economy. The USD is now the world's only reserve currency. The U.S. is now seen by the big money as the last safe haven. The ME has been destabilized, and it is spreading to Europe. The Euro is doomed and wealth is fleeing on any boat that it can find. This is a form of a reverse Marshall Plan. This is exacerbated by the Fed's increase in rates which is necessary to save pensions and savers. Banks no longer borrow short and lend long. It is now done by the Fed which is investing only in g0vernment bonds and MBSs, unproductive enterprises. Productive enterprises are being starved. History has shown that ALL g0vernments ALWAYS default on their obligations. Foreign inflows from the wealthy are propping up the domestic economy and creating bubbles, like cash deals for real estate. The regulatory environment and wealth inequality are also creating a perfect storm. It is uneconomical to make smaller loans. The surveillance state's main purpose is to track down assets for tax collection. Is faith warranted in the same regulators who allowed the 2008 melt down to occur?

  • jw


    Extending the Econtalk comments. Please reference the first chart in this week's commentary by John Hussman here :

    I am sure that you will find his comments interesting, but one rarely finds such a stable relationship in economics as his interest rate to monetary base per dollar of nominal GDP chart.

    My question is: leaving aside Hussman's analysis of the Fed's virtual move to increase rates, if this relationship is to hold, and the Fed continues to refuse to reduce the monetary base, then the only way to raise rates is to increase the denominator of the x-axis, which is to dramatically increase NGDP.

    Since real GDP can't be increased that quickly, productivity doesn't grow very fast and it takes time to build facilities and equipment and make processes more efficient, especially in a service economy, doesn't that mean that the N in NGDP has to rise extremely quickly?

    This is just one of my inflation phobias, the other being the lack of power that the Fed has over the money center banks. If the banks decide to lend out the excess reserves at a 10% reserve ratio, there are $25T in potential loans available (numbers adjusted from the Econtalk post, but still huge). If the Fed tries to retract the reserves, a TBTF bank would fail and that is currently impossible for them to conceive of, so they will be forced to grant new reserves.

    I would appreciate your thoughts.

  • Joch C.

    How does this Feb. 2016 quote from Ben Bernanke fit into this conversation and compare to what Ben said in his book?

    "Does paying interest on reserves prevent banks from lending?

    This claim, made even by some good economists, is puzzling. Before December, the Fed paid banks one-quarter of one percent on their reserves. If the Fed had not paid interest, the return to reserves would have been zero. Accordingly, the only potential loans that would have been affected by the Fed’s payment of interest are those with risk-adjusted short-term returns between precisely zero and one-quarter percent—surely a tiny fraction of the total. In fact, over the last four years bank lending has increased at about a 5 percent annual pace (including around a 7 percent annual rate the past two years), with only residential mortgage lending lagging in the aftermath of the housing bust." Ben Bernake Feb. 2016