During economic downturns, the Federal Reserve typically uses monetary policy (generally, lowering interest rates) in order to help spur economic growth. The problem is that we are in a period of extremely low (or even practically zero) interest rates. Given that, it might seem that the Federal Reserve is sort of like a baseball team with no bullpen. Once the starters are out of gas, what do they do, just give up? Not exactly some economists would argue. Particularly economist Scott Sumner on his blog TheMoneyIllusion.
Banks, being regulated institutions, are required to hold a certain amount of their deposits as reserves. The Fed then pays interest on those reserves. High interest rates on reserves give a bank an incentive to keep reserves high, even above the amount required by regulation. Low interest rates on reserves discourage holding reserves beyond the required amount.
Therefore, since many people seem to agree that it should be the policy of the government at this time to encourage banks to lend and to discourage them from simply holding on to cash, what should be the policy of the government towards reserves? Here is economist Sumner:
One easy step would be to stop paying interest on reserves. These interest payments increase the demand for reserves, and are thus deflationary...then why not go one step further and charge an interest penalty on excess reserves?No complicated scheme for purchasing assets that nobody knows how to value. I mean, most of the TARP money is spent and I have yet to see the green glow of a toxic asset emanating from Tim Geithner's desk. No capital injection along with a personalized note from Rep. Barney Frank asking if the nation's major financial institutions could start lending money again, pretty please.
It's a straight forward proposal. No pleading, no appealing to the better angels. No carrots. All stick. The Fed simply tells banks we don't care whether or not you sit on your money, but we are not going to pay you to do so. In fact, we are going to start charging you for making us watch this big pile of money just sit there. You don't want to lend it, fine. But why should we store it for free, at least under current conditions.
Sumner concedes this amounts to 'unconventional' monetary policy, but hey, these are unconventional times. He also notes, with (barely) disguised glee, that others may be coming around to this suggestion.