Two Tales of Unintended Consequences of Monetary Policy – Tale 1

by Nicolás Cachanosky and Andreas Hoffmann

Even when a policy is successful in achieving its desired ends, we have to consider its unintended and unforeseen consequences, resulting from cumulative market adjustments to policy changes that make it hard to judge the overall outcome of a policy in our complex economy. The Federal Reserve and European Central Bank’s monetary policy responses to the 2008 financial crisis offer two tales of major unintended consequences. This post discusses unintended outcomes of the U.S. Federal Reserve’s crisis policies. In our next post, we address ECB policies.


One of the major challenges the Fed faced during the 2008 financial crisis after Lehman was allowed to fail, was the loss of confidence in the financial markets and the resulting increase in money demand that led to a decline in the money multiplier. The scenario was even more delicate from the Fed’s perspective due to the presence of a number of financial institutions the Fed considered too big to fail.

To avoid bank runs that would make any bailout decision ineffective, the Fed decided to provide liquidity to the banking system via emergency lending operations on a large scale. Doing so, the Fed concealed which banks were insolvent and which were not. The Bernanke-Fed did not follow Bagehot’s principles in lending to solvent banks only.

The monetary expansion required for this “bail-out” strategy might have led to serious inflationary pressure. To avoid this outcome, the Fed adopted policies, known from emerging markets central banks, to limit the monetary expansion. Offering interest on excess reserves (IOER) the Fed aimed to absorb surplus liquidity from the banking system via monetary policy operations on the liability side of its balance sheet. Banks that keep the newly created reserves at the Fed, rather than lending them out, receive an interest rate payment on these reserves. The new policy allowed for easy and safe bank profits, allowing the Fed to increase both the money supply and money demand (by the banks).

The main intention of this policy design was to improve the liquidity situation of banks and prevent inflationary pressure. Although the Fed successfully dealt with liquidity problems, its policies backfired unintentionally along several lines:

First, given the level of uncertainty, paying interest on excess reserves led to an increase in money demand of the banking system that exceeded expectations of Fed policymakers. Banks began hoarding ever-increasing amounts of reserves at the Fed.

Second, credit was not extended to businesses anymore. The artificial increase in money demand was even larger than the increase in the base money. According to market monetarist Scott Sumner, “the Fed, terrified of inflation, kept interest rates too high for too long—causing NGDP to fall even further.” If monetary policy effects had been expansionary overall, NGDP should have increased in 2008. Thus, Fed stimulus has not had the wanted effects on consumption and investment.[i] Indeed, the recovery from the financial crisis is among the slowest in U.S. economic history.

Third, the Fed’s crisis policies, especially the lengthening of its balance sheet, complicate monetary policy today and in the near future. If investment opportunities arrive that are more attractive than holding reserves at the Fed, the Fed will have to increase interest on reserves (IOER), which may become costly, to prevent excessive credit creation or allow banks to extend lending. A new credit boom might be the consequence in the latter scenario.

This commentary is cross-posted at Sound Money Project and ThinkMarkets

[i] Offering interest on reserves is a way to sterilize the monetary expansion (market-based). It tends to increase interest rates. However, note that the remuneration rate for excess reserves is pretty low. That banks have a hard time to find and finance investment projects with expected returns above 1 percent points to great problems in the U.S. economy (regulation, policy uncertainty, fiscal issues, structural distortions) which cannot be fixed via easy monetary policy.

7 thoughts on “Two Tales of Unintended Consequences of Monetary Policy – Tale 1

  1. I want to make one comment on a very good post. The authors observe that paying interest on excess reserves led to an increase of money demand of the banking system that exceeded expectations of Fed policy makers.” That may, indeed, be an unintended consequence of paying interest on reserves.

    But it may also be that there was an independent increase in demand for liquidity by banks. It could be a manifestation of the general increase in money demand. It may also be the consequence of regulatory actions to get banks to hold liquidity reserves. About half the excess reserves at their peak were held by foreign banks. We don’t know what foreign banking regulators may have been requiring. If this hypothesis is correct, then the reserves aren’t economically “excess.” Jerry Jordan has written a lot about this, including at Sound Money.

    The demand for these reserves began declining before the Fed embarked on hiking rates. It has continued declining as interest on reserves has increased, the opposite direction predicted in the simple IOR model. There seem to be independent demand shifts at work. The decline has been led by foreign banks. So, again, we aren’t sure what is going on.

    The bottom line is there is more research to be done. This post is a good start.

  2. Dear Jerry,

    thanks for your comment. Let me try to answer both points you make without trying to resolve the issue.

    Your first point questions whether or not money demand would have increased without IOER. I agree that it is plausible that, for example, in times of uncertainty banks may want to hold additional liquid assets. They might want to hold reserves at the Fed as a buffer. Perhaps regulation provided additional incentives to hold very liquid assets. But it should be more attractive to hold reserves at the central bank relative to other liquid assets when the reserves are remunerated. I fully agree that we do not know how important each factor was.

    The second point, however, does not seem counterintuitive to me. I agree that it is demand shifts. It’s the same picture we get when the Fed is chasing inflation. The recovery and decline in uncertainty made it less attractive to hold reserves at the Fed. A decisive increase in the remuneration rate would have increased the demand for reserves again. But the Fed has started to hike rates timidly, fearing to damage the economy.

  3. We agree on the first point. On the second point, I was just reporting a fact. The quantity of excess reserves has been declining in the face of rising rates paid on reserves. As I said, we don’t know why.

    Just to spice things up, under the new operating procedures, the Fed is no longer conducting monetary policy. Payment of interest on reserves (and on reverse repos) is a transfer payment from U.S. Taxpayers to banks and other financial institutions. That is a fiscal action, not monetary policy.

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