There are a couple of interesting, though different points here.

I agree that enabling the Fed to pay interest on reserves is a step in the direction of getting rid of reserve requirements altogether. A number of countries have gone down this route - Canada, Australia, New Zealand, UK, etc. There are arguments to be made in this direction - statutory reserves do not really serve as the cushion they were intended to, since, by definition, they can't be used to pay depositors in the event of a bank run. Thus, they really serve no purpose. Countries that have done away with reserve requirements generally manage risk through capital adequacy requirements. They also generally see greatly reduced actual reserves on deposit at the central bank, so in practice, central bank interest payments on reserves turn out to be almost nil.

What really caught my eye in this post was the following:

"...perhaps the roles of central bank and macroeconomic superhero should be moved to separate boxes on the organizational chart."

This is the important point. I'm not crazy about Paulson's idea of a super-regulator, however, if we're going to end up with one, then I do not believe it should be the central bank. Let the Fed focus on stability in the monetary system and on the lender of last resort function (to banks and ONLY banks) and put the other regulatory functions elsewhere. I can't even wrap my mind around what it would mean for the Fed to assume such a function. Had it had such powers in 2000, would we have seen a TSLF variant where Treasuries were lent with dotcom stocks taken as collateral in an attempt to stabilize the NASDAQ? If we're opening the door to radical regulatory change (not saying whether we should), then perhaps we ought to go even one step further back and rethink the structure of financial markets altogether.

RTD — One way of thinking about bank reserve requirements is that they're like the bank-regulation version of the AMT.

Sure, in theory, they're a barbaric relic. As you say, they ain't about preventing bank runs, and in theory, if banks had perfect risk management models, reserve requirements would simply block useful lending for no good reason.

But like clever tax-avoiders, banks are always at finding ways to lend ever more freely, in an old-fashioned tragedy of the commons. (It is always in each bank's interest to have a freer hand, but widespread loose lending creates widespread failures.) Simple, clear reserve requirements limit the effects of regulatory capture and risk-model cleverness, etc. Banks are deputized with the power to conjure from air funds the government will guarantee as money. Reserve requirements, if designed well, place a regulable upper bound on the public obligations that private banks are empowered to create.

I'm not certain that comprehensive, fixed reserve requirements should make a comeback. But I wouldn't take "great moderation" era experience, in the US or other countries, as definitive proof they are dispensable. The US largely abandoned them, and it worked until it didn't. The same may hold true in the other countries you cite. Or not.

Re the cost of paying deposits, it's important to note that the real price to taxpayers of abandoning required, interest-free reserves isn't the interest that has to be paid, but the free loan that is lost. Holding constant the size of composition of bank deposits, the required interest-free reserves represent a zero interest loan to the public that will rollover perpetually. That is, the reserves are effectively an asset of the public, not of the banks. (Sure the public can't spend them, but taxpayers earn the interest banks don't and can use that to finance an equivalent amount of other spending.)

If, under a interest-paid-reserves-not-required regime reserves drop to near zero (and they would drop to near zero, unless the central bank as a policy choice wants to grow or shrink its balance sheet by borrowing from or lending to banks), the cost to taxpayers is identical to the case where zillions of dollars are deposited and interest is paid. To a first approximation, in either case taxpayers neither earn nor lose money from the arrangement. When there are no reserves, nothing happens. When there are lots of reserves, taxpayers earn interest on the reserves and remit that interest to banks. The "cost" in either case is zero in cash terms, but there is an opportunity cost relative to the alternative policy of requiring reserves and not paying interest them. It's not that paying interest on reserves is costly, it's that not paying interest and requiring reserves is lucrative. Our present arrangement is a tax on banks, worth a few hundred million dollars a year. Paying interest just means cutting that tax, regardless of the quantity of reserves we end up paying interest on (as long as the interest we pay and the interest we save by purchasing Treasuries is comparable).

I agree with you on the last. The headline piece is sprawling and overlong, but one of the main points trying to escape is that there are policy domains in which central bank independence might make sense, and policy domains in which it does not, and that risking taxpayer fund for the purpose of discretionary bailouts is definitely not a function that should be left to central bankers alone.

Thank you very much for clarifing such technicalities to non-experts (but willing to understand) as me.

Keep up the good work!

I don't think there's a balance sheet constrain in the short run for the FED since negative equity is a non-issue. Historically, afaik, the FED has made a profit every year so there are is an implied, relatively large, off-balance sheet asset in the form of the discounted "seignorage" that can cover their risk-exposure to a high degree. Now this could still rightly be seen as paid by the tax-payers since in the end the liabilities of the FED is backed by the states ability to tax. But I don't think it necessarily means a monterization of the eventual losses.

jwh:

It doens't. But it can print to the amount of the swapped assets. Which could be considered sterelized money creation. In order for the FED to be able to print an unlimited amount of money under this sytem it would have to lower rates to stimulate the willingness to hold this new money. Otherwise it will return to the bank, where they'd have to pay interest on it. It could be argued that this actually limits the ability to print money.

jwh & martinb —

So, I guess I didn't explain very well how paying interest on reserves relieves the Fed of its balance sheet constraint. Here's the deal in a nutshell:

1) Mechanically, the Fed always has the power to print all the cash it wants, to buy or lend however it sees fit. (Theoretically the Fed is subject to statutory constraints on what it purchases and to whom it can lend, but it has interpreted those loosely.)

2) However, without the ability to pay interest on reserve deposits, if the Fed it were to exercise its power to print and spend, it would force interest rates down towards zero (and stoke inflation). So, if the Fed wishes to hold its interest rate target, it is de facto unable to just print money to buy what it wants.

3) But if the Fed paid interest on reserves, the Fed could print money to buy stuff while holding an interest rate target. The Fed would buy stuff, but banks would just lend the money back to the Fed at whatever rate the Fed pays. The extra cash becomes "one-time-use" money: it is spent once to buy what the Fed wants, but then disappears back into an account at the Fed, from which it will return only if market interest rates are higher than what the Fed is paying. The Fed can print and spend as much as it wants without forcing interest rates below the "floor" rate.

4) The fact that the Fed has to pay interest on this boomerang cash is not a constraint, so long as the assets that it purchases perform and pay interest comparable to the deposit interest rate. If T-bill rates closely follow the Fed's rate, the Fed can print cash to buy up a bazillion dollars worth of T-bills, even though banks will deposit that cash with the Fed and expect interest payments. The interest the Fed has to pay on a bazillion dollars in cash deposits will be the same as the interest it earns on the T-Bills it has purchased. The Fed just passes the money along.

5) Of course, if it lends those T-bills to banks that then go bust, it might not get interest payments to pass along to depositors. But that's precisely the sense in which letting the Fed expand its balance sheet enables it to expand its risk-taking, which is ultimately backstopped by taxpayers.

martinb — Seignorage is by definition monetization, it is represents the difference between the purchasing power of newly produced money and the cost of production, which represents profit to the currency issuer.

When a central bank prints money to cover a private loss, that is an opportunity cost to the taxpayer. If, given the fact of the loss, there was excess demand for cash in the economy so that money could be printed without driving interest rates below target, the newly printed money could have been used to purchase public debt rather than to make a private party whole. The monetary/inflation implications of both transactions are identical, there are distribution consequences. One option privatizes the seignorage profits while the other captures the benefit for taxpayers.

"I have a kind of random question: What do you do for a living? (I'll explain why I wanna know afterwards, if you don't mind saying.)"

Steve - My degree is in economics and finance, but I work as a technology consultant designing analytical systems for large companies (mostly data warehousing and BI, some forecasting and predictive analytics). Several of my clients have been in the banking and capital markets sector.

This harks back to Andrew Jackson the US bank, and the events leading up to the Fed establishment.

What happens with concentrated or central banking is the need for more and more secrecy because banking becomes more and more unstable to catastrophic runs.

Before the Fed, there were runs on banks, and the effects were geographically and financially limited. Banks essentially lent only to people that they knew, and people put money in banks that they trusted. What is happening now is that banks are too large to fail and need the veil of secrecy to protect them from runs, eg. BofA, Citi, Morgan. On top of that the Fed needs more secrecy to protect it from a run on international confidence, exactly what this bill is intended to protect.

Thinking, the panics before the Fed were all rather limited, but after the Fed we had a national depression. Under current circumstances, unless the fed and other G10 nations are decoupled, we will have an international depression.

Banking must be decentralized to prevent a catastrophe, similar to the compartments on a ship, that can be sealed off to prevent the sinking of a ship if there is one hole. We have one hole, and one compartment. The ship will sink.

Steve:

I know some of my previous comments was a bit rushed but I'd just like to say that the result of any discussion about central bank financies is bound to end up in the realization that the balance sheet of the central bank only is an extension of the states' and what matters is not technical but policy insolvency.

If the loans that the FED has swapped fails on a big scale the question will be if the government is prepared to have a weak central bank or bail it out. If the seignorage is used to rebuild equity you're of course right that it's still paid by the taxpayer. In the end the thing that backs the libalities of the central bank is of course not it's equity but the states power to tax.

This is certainly the big test for the hailed inflation fighting central bank doctrine. Atleast the FED isn't tied by a nominal anchor...

PrintFaster — I wish I disagreed with you. I'm not sure about the secrecy part, but our response to the credit crisis thus far has been to pool risk and centralize it where taxpayers cannot easily to disown it. That strikes me as high risk even in a static situation, since we don't know the scale of the losses. It strikes me as terribly misguided in our real, dynamic situation, as if we always do this, people have every incentive to take on wild risks, harvest the winners and pool the losers, until the scale of losses is catastrophic and can no longer be papered over. I don't trust that regulation will prevent this.

I think it's funny that suddenly the inability to raise interest rates is seen to be a potential problem! This is not only funny because the Fed is pawning off its balance sheet at a rapid pace, but because the only real reason Treasuries have been expensive (and low-interest-rate) is because of the fundamentally paradoxical "recycling" of a handful of central banks into the bonds.

It seems to me that if this central bank recycling dysfunction were addressed, the "problem" if having higher interest rates would certainly go away.

But somehow I doubt the Fed really considers this a "problem" -- they can always blame inflation on external factors. Everyone else does it.

Another point I'd make is that too-low interest rates will likely take care of themselves: we are facing unprecedented looming supply of Treasuries due to the fiscal deficit. It would be pretty amazing if all of these extra hundreds of billions were lapped up by the safe haven play and we could maintain current low interestrates.

Also, the risk of central banks getting out of the dollar -- and hence ceasing their Treasury buying -- seems to be greater than the odds that they will step up their buying from here, and put downward pressure on rates.

I just thought of a corollary to my point about it being seen to always be desirable to provide liquidity to a distressed institution. The additional thought is that sure, central banks might see fit to NOT save some banks.

But then what will bank survival be, other than a mostly politically outcome?

That seems a bad way to run the central sector of a "capitalist" economy.

Steve,

I realize this is relatively small potatoes, but re: the Fed starting to pay interest on reserves, any reason they couldn't do that just on any excess over the reserve requirement and thereby not relinquish the entire "bank tax"?

Steve,
Very interesting post and something I had to check back with other experts (I wrote to Lou Crandall about this and he generally agreed with you except the part about the reverse repo of MBS!).

Without a reserve requirement, as you mention, the Fed cedes control of the money supply to the banks. There is some similarity to the UK where the BOE allows banks to set their own reserves (but enforces them quite strictly).

The one thing that has become quite clear about this crisis is the Fed's coming around to the ECB's way of doing things: broadening the collateral and counterparties, lengthening the term, adding to its arsenal.

The ECB had always maintained through the crisis (note past tense) that this issue was a liquidity issue, not a rates issue. And, they felt they had two instruments to control monetary policy, the rate (a minimum bid rate for their weekly auctions) and cash which they could add or subtract (i.e. through deciding how many of the bids to fill/where to set the marginal rate, when to add or subtract during the maintenance period and whether to do fine-tuning). The collateral is clearly getting worse (Govt GC is sub 4% but the Avg rate at the auction is closer to 4.25% now, so clearly banks are not posting govvies) but this is something that the ECB lets the market decide. They claim they are not taking on more credit risk and there is some element of truth since everything they lend out they get back in reserves anyway.

Of course there are constraints on money supply in order to ensure that EONIA doesn't drift too much from target.

So money supply and level of rates, they are obviously highly correlated but now less so and much more clearly disentangled. Your point here is that the Fed also sees them as completely distinct. And they are having different effects.

I know this is more a macro than a micro-of-the-banking-sector question but shouldn't this all cause further revision of the standard neo-Keynesian framework? Shouldn't this be a reprieve for the (slightly more) monetarist position that supply does matter? Do you see any new economic theory along these directions? Neo-Keynesian models are just so much part of the mainstream canon now.

I know standard RE models which also include level of rates (i.e., Alvarez, Lucas and Weber), use segmented markets to impose the relationship between money and rates, but they too are also quite limited in their applicability.

SRW – thanks for your very thorough response.

Some additional comments (with slight push back):

As things have evolved, much of the precautionary liquidity function has been handled through liquid assets other than balances at the Fed, as well as guidelines/policies for prudent liquidity management (e.g. term extension on liabilities; cash flow matching; etc.). This requires a proper regulatory and supervisory framework, of course.

The broader prudential balance sheet management function has been taken over by rules and regulations for capital allocation and management. The primary constraint on bank balance sheet expansion has become an imposition of capital ratios rather than liquidity ratios.

Given this framework, the need for prudential liquidity in the specific form of Fed balances has declined.

Accordingly, the primary purpose of Fed balances has been their utility as the exchange mechanism for the interbank clearing system. The question that remains from the banking system perspective is what level of Fed balances is needed to ensure the smooth operation of the clearing system.

The answer I think is not much, given improvements in cash management technology and techniques.

The question that remains from the perspective of the Fed is what level of system Fed balances is needed to ensure the Fed's control over the Fed funds rate.

Given the Fed's control over the supply of reserves, the answer is any level that is set as an objective for banks to achieve, that results in banks incurring some penalty if it isn't achieved.

We referred to small positive or 0 balances. In theory, bizarrely, this required number could even be a negative system balance – i.e. a borrowed reserve target for the system. There is no point of course to such an aberrant construct, but the logic does suggest a whiff of artificiality in the requirement for Fed balances as prudential liquidity reserves, assuming prudential reserves are well covered otherwise in the maintenance of liquid assets, etc. in forms other than Fed balances.

As to the reserve multiplier, consider a system that is absolutely continuous in real time, where there is a perfect feedback system (in terms of both information and operational capability) between reserve availability and deposit expansion. I would still maintain that the Fed will supply required reserves, with some marginal excess or deficiency to steer the Fed funds rate appropriately. At the same time, the Fed will consider broader balance sheet developments in the banking system, including deposit expansion, in the context of inflation risks and capital adequacy risks, and take this into account in setting strategy for changing the target Fed funds rate. In other words, to the extent the Fed wishes to influence deposit and balance sheet expansion (apart from capital ratios), it will attempt to do through the strategic management of the Fed funds rate going forward, rather than the blunt withholding of reserves required for the current level of deposits. This is perhaps a fine line, but there is a difference in degree between withholding excess reserves at the margin in order to affect the Fed funds rate directly, and more boldly withholding required reserves for existing deposits in order to affect deposit activity directly. Having said that, while the Fed is looking for an immediate interest rate response when it tightens reserve availability, deposit contraction may well occur as the indirect result of the banks calling in money market type loans. But I think it is the immediate interest rate response more than the induced deposit contraction that is the short term objective of such reserve tightening.

NickF — You ask a lot of good questions, a lot more than I've good answers to. (I am, by the way, just a dog on the internet, with no more claim to authority or expertise than my own voice.)

First: "The collateral is clearly getting worse... but this is something that the ECB lets the market decide. They claim they are not taking on more credit risk and there is some element of truth since everything they lend out they get back in reserves anyway."

I don't think that's quite right. In the aggregate, if the rate at which ECB pays interest on deposits sufficiently high, then the funds it lend return to it. That in itself is a symptom of financial system distress, though. As JKH pointed out early in the discussion, ordinarily, in a "corridor system" central banks would target the midpoint of its corridor, and conduct open market operations until the level of reserves deposited or funds lent at the ceiling was very low.

More importantly the borrowers (who by definition have cash needs) and the depositors (who have excess cash) are mostly different institutions. The central bank cannot use the returned deposits as a security against the loans. Should one of the borrowers default and surrender collateral that turns out to be trash, the deposited reserves are still a liability of the ECB that would have to be honored. I need to learn more about how the ECB works, but one way or another I gather that seignorage gains are shared among member-state governments. Should a bank default on the ECB, those gains would have been captured by the defaulter or its creditors, and would represent a cost to European taxpayers.

I've just skimmed through the Alvarez, Lucas and Weber paper. It's an ambitious little thing, isn't it? I'd need to think a whole lot more to have much to say on the broad issues you bring up. But it's worth noting that throughout this comment thread, we've basically assumed a segmented model at least superficially similar to the one in the paper. That is, we assume that there are banks and the rest of the world, and central banks target interest rates by matching cash supplied to bank cash demand, and that in equilibrium that somehow affects inflation in the broader economy. The model in the paper suggests that when interest rates are very sensitive to money growth, pegging an interest rate might be a more effective way to hold inflation constant than targeting money growth directly. But the model itself is monetarist by construction — money-growth and inflation track one another over times, it's just that interest-rate targeting best minimizes short-term fluctuations.

The model tells a nice story, but it was constructed to tell a story. I'd have to think a lot harder to decide if I think it captures reality or just rationalizes a practice. All that said, I'm not sure I have very much to say about broad disputes between neo-Keynesianism and monetarism, except that I'm skeptical of a lot of things that we've mostly taken for granted for the purpose of this discussion. It may not be true that control over cash interest rates is sufficient to control price inflation. "Money" may be a less special asset than we think.

One of the earliest posts on Interfluidity was an attempt to capture my intuition about moneyless money supply. (You have to click through the "Read more" link to see anything interesting.) If you buy my reasoning in that post, then all assets are to some degree money, and what central banks are up to is trying to offset the losses in value with increases in liquidity in order to hold the total "moneyness" in the economy roughly constant.

SRW-

I appreciate your penetrating feedback, but I get nervous when smart people say “you've lost me”. Also, I'm afraid I'm expanding on my points more than responding adequately to yours. So toward the end of this comment, I've attempted some responses more targeted to your points. The overall result is quite lengthy - sorry about that.

I'll begin with a simple example for a $ 0 system reserve requirement with a corridor.

Requirements are $ 0 for the system and for each bank in it.

Suppose Fed funds trade below target and the Fed wants to steer it back to target (I'll assume some actual rates below, but it's not necessary here).

The Fed attempts this by tightening actual system reserve balances to the level of $ (1).

This means the excess reserve position is also $ (1) because the required reserve position is $ 0.

Suppose all banks manage their cash exactly as they're supposed to, with one lone straggler – Bank A -who doesn't.

So we assume all non-A banks will have exactly met their $ 0 requirement by the end of the day.

Suppose A's only transaction for the day is a new loan for $ 10.

(Assume the borrower pays that money to another bank in some other transaction. The example assumes all these other banks have flattened their Fed accounts by the end of the day.)

A's balance at the Fed, as a result of the newly extended loan, drops from (yesterday's) $ 0 to $ (10) today.

Bank A attempts to fund this shortfall in the Fed funds market.

Bank A is short $ 10 in reserves. The system by assumption is only short $ 1. This means there must be $ 9 in reserves held by non-A banks in excess of what they require to square their Fed accounts. The example assumes those banks do flatten their accounts, which means Bank A will only be able to attract $ 9 in new reserves through the funds market. But A doesn't know this. So it continues to bid for Fed funds in search of that final dollar, which doesn't exist. As Bank A proceeds to have difficulty attracting the final dollar it needs to cover its Fed account, it bids up the Fed funds rate. If the target funds rate is 2 per cent, but it previously traded at 1.875 per cent, assume A's activity moves the market back to 2 per cent. Bank A fails to find the last dollar it needs in the funds market and goes to the window for $ 1 at a rate of 2.25 per cent, say. The Fed is happy. Mission accomplished – the funds rate trading level has moved back to the target level. Bank A isn't particularly happy due to the stigma of the window, but that's life.

We could also invert the problem to an example of the Fed supplying positive excess reserves: 2.125 per cent Fed funds trading rate, a Fed injected system excess of $ 1, a new customer deposit for A of $ 10, $ 9 in fed funds sold by A at 2 per cent, and a final balance at the Fed of $ 1 dollar, on which the Fed pays $ 1.75 per cent (more on corridor interest rate economics below in response to your points).

Although the Fed doesn't use open market operations in its administered corridor, it still requires a method for controlling the level of excess reserves in the system. Since the funds rate will be highly sensitive to any system excess (or deficiency), the level of excess (or deficient) reserves needed for tactical interest rate operations will be very small relative to the size of the Fed's balance sheet. Such reserve adjustments are easily facilitated using transfers of funds between the government's deposit account at the Fed and its accounts in the rest of the banking system.

In this example, I've assumed no aggregate changes in the banking system deposit base or corresponding reserve requirements. But if the reserve requirement is $ 0, there is no sensitivity to this in terms of system reserves. When the reserve requirement is $ 0, it is a fixed requirement - hence the disappearance of sensitivity to changes in the deposit base. The examples show the difference between required reserves of $ 0, versus actual (excess) reserves of $ (1) or $ 1 respectively, and effect of that difference on interest rates.

But the entire exercise of a $ 0 reserve requirement seems pathological. Why would we consider this to be a reserve requirement at all? The question itself invites the point that needs to be made about the positive balance reserve requirement system currently in place. The Fed is supplying excess or deficient reserves for the purpose of marginal Fed funds rate influence. Holding balances at the Fed is not terribly useful or meaningful for precautionary liquidity reserve management. Fed accounts are required as part of the funds clearing mechanism, which in turn allows the Fed to adjust the interest rate at which such funds clear. In other words, it is not the size of the specified level of balances held at the Fed that is important, but the idea that banks become disciplined to target the level that is specified, or incur a penalty interest rate. Banks need good reserve management for cost efficiency purposes and the Fed needs it to control interest rates.

Finally, consider the ultra-pathological case of a “negative system reserve requirement”. (This is just to reinforce the interpretation of causality, not to suggest that this case is practicable or reasonable.) Instead of $ 0, suppose A's individual requirement as a share of the system requirement is $ (1). We can just do a linear transformation of the balances in the above examples. E.g. in the Fed tightening scenario, Bank A ends up with $ (2) in its Fed account and goes to the window for $ 1. Causality unchanged, QED. This ultra-pathological case should again illustrate that it is the effective management toward the required reserve level (efficiency of funds clearing) rather than the level itself (precautionary reserve value) that is the essence of the Fed funds system. I believe this is consistent with the secular decline in the actual positive reserve balances that the Fed has required to be held.

The (theoretical) aspect of continuity is only relevant in a system with positive reserve balances that are a function of the deposit base. It's moot in the case of a fixed reserve of $ 0, or the pathological fixed negative reserve. With perfect continuity, the Fed reacts to changes in the deposit base by changing the required level of system reserves. Banks continue to compete for their share of those reserves. The Fed will continue to manage the excess or deficient reserve setting according to where Fed funds are trading relative to the existing target rate. Thus, the setting of the differential excess reserve position is independent of this continuity characteristic. It depends only on the level that funds trade at. Banks continue their deposit expansion activity knowing that required system reserves will be supplied continuously, apart from excess reserve adjustments that respond to a temporarily aberrant funds rate level relative to the target rate or a change in the target itself. That is a matter of judgment for both the Fed and the banks' expectations for the Fed. Banks may well take such expectations into account in their deposit strategies, but rational banks won't adjust their deposit strategies for fear that the Fed will not ensure that required reserves are available. Concerning the case of a change in the target funds rate, it is important to note that the Fed does not undertake a cumulative permanent withdrawal of required reserves if it increases the target rate. The rate change is a quick announcement following by a trading response and Fed reversion to the objective of managing deviations of the actual rate from the new target through the excess reserve setting. Target interest rate increases do not require a cumulative contraction in supplied reserves. They require only the resetting of the discipline of achieving the level of required reserves in the context of the new interest rate environment.

I could reformulate again the ultra-pathological case by noting that banks currently run intra-day short positions in their Fed accounts as a matter of course. There's no mathematical reason why such short positions couldn't become an end of day target, or that the Fed couldn't set a system short position as the required level for system balances (see more on this in my response to your points below).The fact that today's target Fed balances are positive is only a reflection of a somewhat artificial deposit ratio calculation that bears little relationship to the way in which banks manage their overarching liquidity strategies, and little relationship to the natural flexibility they have in managing the level of balances in their Fed accounts. The Fed account is merely an important detail in a much bigger liquidity management function for banks, where precautionary liquidity levels are managed through other asset-liability techniques. And again, I'm not suggesting that it makes sense for Fed account reserve requirements to become short positions. The point merely illustrates the nature of the Fed's interest rate management techniques and their relationship to required Fed balances as being essentially detached from any real characteristic of prudential liquidity reserves.

Finally, on some of your specific points:

“In a world without reserve requirements, where regulation focuses on balance sheet capital rather than precautionary liquidity, in what sense is there any kind of reserve target, positive, negative or zero?”

Liquidity management is still extremely important in its own right, and a vital complement to capital management. It's just that Fed balances are merely the cash management front end interface for liquidity management. They don't represent in any way the core strategy for precautionary liquidity. This requires stocks of liquid assets such as t-bills and precautionary term extension of liabilities. This larger liquidity management aspect will be a huge issue in the full post-mortem on Bear Stearns and for the future for the regulation of investment banks. Investment banks really have operated in a different liquidity management paradigm than commercial banks. That said, and on a tangent well beyond this comment, there is a pressing need for a more robust intellectual interface between liquidity and capital management frameworks. Just consider the intensity of the internet debate regarding the distinction between the two in the case of Bear Stearns.

“Even with a reserve requirement of zero, banks that have to borrow reserves for endogenous uses do end up paying a penalty in the form of the discount/ceiling rate spread (or interest premium on auctioned funds). Right now this penalty is quite small, but it needn't be in general. So even with a reserve requirement of zero, the central bank could manage rates by providing less cash than banks endogenously require, forcing an adjustable level of borrowed reserves that would end up implying an interest rate.”

Agreed, I think.

“If the central bank were to set a negative target, would that imply two lending rates, so that banks could inexpensively borrow up to the targeted level, then pay a penalty rate to borrow more? Weird, but I can see how this would work.”

This idea was intended as an intuitive illustration, but your question helps me think through the detail. Assume the banking system operates with a required negative balance at the Fed, i.e. a short position, which is a long position from the Fed's perspective. The Fed earns some specified rate on that long position. I'll refer to this rate as the “required borrowing rate”, as opposed to the discount rate. The constraint on the required borrowing rate is that it must be consistent with corridor rates that constitute penalties as borrowing and lending rates. The upper corridor rate is the discount rate, which applies to banks that fail to meet their short position requirement and therefore must borrow from the window. Failing to meet their short position requirement means that these banks end up with short positions that exceed their required (i.e. allowable) short positions. The lower corridor rate is a rate which applies to banks that exceed their short position requirement, and therefore have surplus funds to deposit with the Fed. Exceeding their short position requirement means these banks end up with short positions that are less (in absolute terms) than their required short positions, or that are outright long positions. The upper and lower corridor rates should straddle the target fed funds rate so that the upper and lower halves of the corridor are symmetric, allowing the Fed unbiased flexibility to steer wandering funds rates toward target. Therefore, the lower corridor rate should probably mirror the discount rate in terms of its spread against the target Fed funds rate. I used a lower corridor rate of 1.75 per cent in the earlier example, relative to a target funds rate of 2.00 per cent, and an upper corridor discount rate of 2.25 per cent.

Most interestingly, the “required borrowing rate” could be any rate that exceeds the lower corridor rate. This causes the lower corridor rate to be a penalty when banks with excess balances (relative to required short positions) deposit these balances with the Fed. It results in a negative interest margin on surplus balances held at the Fed. The required borrowing rate isn't necessarily bound by a necessary relationship to the discount borrowing rate, since the discount rate is always a penalty rate so long as it exceeds the Fed funds rate. But it probably makes the most sense to set the required borrowing rate equal to the Fed funds rate itself, with a symmetry that makes the intended penalty costs in either direction equal. With such a construct, the case of a negative required reserve doesn't affect corridor interest rate economics or the Fed's ability to control the actual funds rate under the corridor mechanism.

“Still, with non-positive reserve requirements, the system begins to break down as bank money requirements go to zero. If we abandon ATMs entirely for plastic and private interbank settlement networks became the norm, the Fed would lose rate-setting traction as bank demand for Fed money disappeared. Presumably this possibility would be regulated away, but that would mean, in a way, a de facto reintroduction of reserve requirements. If the Fed enforces a monopoly on interbank clearing, and participation therein requires transactional balances, that's just a reserve requirement by the backdoor, albeit without the fiction of being defined as some fraction of bank deposits.”

Whoa! I've been referring only to balances held at the Fed, which are the inter-bank clearing component of the monetary base. Banks do hold currency inventory for precautionary liquidity purposes. I hope I didn't infer they don't need to do this. The degree to which they do depends on the evolution of the payments systems for customers. I would classify the economic importance of these currency inventories as something that belongs in a bank's larger liquidity management framework, apart from any interconnection it may have with Fed mandated Fed account reserve requirements. There is no necessary connection between the formulation of a required Fed balance (as stipulated by the Fed) and the formulation of a required currency inventory (logically determined by some economic inventory model). If the Fed wants to connect these things via reserve regulations, so be it. But the connection isn't necessary. Currency inventories to satisfy customer demand have nothing to do with the economics of clearing interbank balances through the Fed or the Fed's control of interest rates (“Orders” or “returns” of currency between the Fed and the banks do affect system Fed balances and individual bank positions, but such flows are integrated into the sterilization process.)

“In the last paragraph, are you basically arguing that even in a textbook fractional reserve world, the Fed would choose to target interest rates rather than quantity? I wouldn't argue with that, except to say that in such a world, wouldn't the two approaches actually be equivalent? It "feels" blunter to target deposit contraction or expansion, but if there really were "a perfect feedback system... between reserve availability and deposit expansion" my sense is that the two approaches would pretty much be the same.”

Although it seems intuitive, I don't believe so. Causality depends on differentiability, but not on continuity. Causality refers to the Fed's propensity to supply required reserves in response to deposit expansion or contraction. Differentiability refers to the Fed's ability to make marginal adjustments in the form of excess or deficient reserves, in order to affect interest rates through bank competition to sell or buy Fed funds. The size of this marginal adjustment is independent of either the size of required reserves or the continuity with which the level of the requirement changes. Continuity refers to an increase in the frequency of the Fed's response in specifying required reserve levels as a function of a changing deposit base. Perfect continuity doesn't invert or neutralize this causality, because banks expect the Fed to accommodate changes in system reserve requirements induced by changes in system deposit balances continuously. They may expect the Fed to change the funds target rate for a variety of reasons, but this is a fundamentally separate operation and decision. The Fed won't change the target rate with an extraordinary change in the reserve setting per se. They'll just announce it. There may be some excess reserve noise or anticipatory funds rate noise around the time of a change in the target rate, but the underlying causality of reserves supplied in response to deposit changes doesn't change. The key is the provision of an excess or deficient reserve differential relative to what the Fed deems appropriate to move the actual funds trading rate toward the target. They might allow the trading rate to begin to move toward an expected new target prior to the precise time of the target change, but this is just a circumstantial modification in the actual/target rate relationship. The matching of the required relationship between deposits and reserves might become continuous, but the decision on the excess reserve position is independent of this underlying continuity. The economics around the differential alone motivate the iterative interest rate adjustments desired by the Fed.

The crux of the cause of our monetary mismanagement, esp. since 1965, is the assumption that the money supply can be managed through interest rates, specifically the federal funds rate ("bracket racket"). As any monetarist knows, it is impossible to control properly the money supply through the manipulation of interest rates.

We should have learned the falsity of that assumption in the Dec. 1941-Mar. 1951 period. That was what the Treas. - Fed. Res. Accord of Mar. 1951 was all about.

The Fed's technical staff either never learned, or forgot, how Roosevelt got his "2 percent war". This was achieved by having the Fed stand ready to buy (or sell) all Treasury obligations at a price which would keep the interest rate on "T" bills below one percent, and long-term bonds around 2-2 1/2%, and all other obligations in between.

This was achieved through totalitarian means, involving the control of total bank credit and the specific rationing of that credit. Plus there were controls on prices and wages that kept the reported rate of inflation down.