In our recent American Banker opinion piece, Heritage’s Norbert Michel and I argue that, if the Fed is really serious about shrinking its balance sheet, it had better quit paying interest on banks’ excess reserves (IOER) as well. How come? Because the current, relatively high IOER rate is contributing to a strong overall demand for excess reserves, while a shrunken Fed balance sheet will mean a reduced supply of reserves. Reducing the supply of reserves while doing nothing to reduce banks’ demand for them is a recipe for demand-driven deflation, which is a monetary policy no-no.
Predictably (because it has happened every time I write on this topic) our article generated several comments to the effect that we didn’t know what we were talking about, because banks couldn’t possibly prefer the meager 100 basis points they can earn by holding reserves (or something less than that, if they are obliged to pay FDIC premiums) to the far greater amount they can earn by making loans.
The remarkable thing about these criticisms is that they all appear to deny that banks (or some banks, in any event) are in fact sitting on large amounts of excess reserves, and that they are, to that extent, settling for a return on those reserves of 100 basis points or less, instead of swapping reserves for other assets.