Quantitative easing is often described as printing lots of new money and using it to buy back government debt. It sounds too good to be true. And so far all this money printing has resulted in relatively little inflation. Even if central banks had raised rates a little earlier, the recent rise in inflation could have been prevented.

But when something is too good to be true, it usually gets caught. For the most part, central banks were not actually “printing money”. Rather they were buying long-term bonds paying 2% interest with newly issued interest-bearing reserves, which paid almost no interest at the time. Central banks essentially manage the world’s largest hedge funds. Offering short-term loans at low rates and long-term loans at high rates.

But that carry trade remains profitable as long as the short-term rate is lower than the rate on the previously issued long-term bond. If short-term interest rates rise sharply, the huge profits made by central banks over the past 13 years will turn into losses. So perhaps it is fair that the central bank now incurs some losses.

But not everyone wants central banks to pay out the money. here Economist:

Another option is to find a way for central banks to pay lower interest on reserves. A recent report by Frank van Laerven and Dominique Cadic of the New Economics Foundation, a British think-tank, called for interest payments on only one reserve, rather than the whole lot, to influence their decision-making. The ECB and the Bank of Japan already have such a “tiered” system. It was designed to protect commercial banks from the negative interest rates they had imposed in recent years.

Banks using tiered to avoid paying interest would be taxed in disguise when their cost of funds rises. Banks, considered collectively, have no choice but to hold reserves force-fed into the QE system. Forcing them to do so without reason would be a form of financial repression that could damage banks’ ability to lend. It will “shift costs [of rising rates] in the banking sector,” former Bank of England deputy governor Sir Paul Tucker told parliament in 2021.

Maybe I’m missing something, but I’m having trouble following their logic. It is difficult to see how banks could be motivated to maintain their large holdings of excess reserves if the reserves do not earn interest while other risk-free assets such as T-bills earn positive interest rates. In 2007, short-term interest rates in the US were around 5% and thus banks held only small amounts of excess reserves. Today, excess reserves are now about 1000-times greater than before the Fed began issuing IOR in 2008.

There is a reference to a tiered system in Japan and Europe, but this involves payment senior Interest rate on infra-marginal reserve holdings (This is zero interest instead of negative interest rate on marginal holdings.)

It’s a bit misleading to suggest that banks, as a whole, are somehow “obliged” to keep injected reserves through the QE program. One problem is that banks may make deposits less attractive and part of the reserves will flow out as currency. But even if you assume a world without currency, where 100% of the monetary base is bank reserves, it’s still misleading to suggest that banks are forced to hold excess reserves because the central bank injects them into the system.

Here it is useful to recall the difference between the nominal supply of bank reserves and the actual demand for bank reserves. The central bank determines the nominal stock of reserves, while the commercial banking system determines the actual stock of reserves.

To be sure, central banks can induce commercial banks to hold a very large stock of reserves – even in real terms – if they are willing to pay enough IOR. But if you assume that no interest is paid on most bank reserves, why would banks choose to hold a large stock of excess reserves?

If all banks try to get rid of excess reserves at once, it will cause changes in the prices of goods, services and assets. Eventually, the price level will rise high enough so that banks hold their actual stocks of desired reserves. But when you consider that excess reserves in America are about 1000-fold greater than in 2007, the necessary price level increase will likely be very large. (How big it is is hard to say, as there have also been some regulatory changes since 2007 that have increased banks’ reserve requirements.) I suspect the UK will face similar problems.

Ultimately, someone has to pay the cost of financing the public debt. If the central bank buys back government debt in QE programs, there are three options:

1. The central bank has to issue IOR indefinitely, which is expensive.

2. Impose an implicit tax on the banking system with regulations requiring banks to hold large amounts of reserves that do not bear interest.

3. Impose an inflation tax on the public by not requiring banks to hold large amounts of reserves, but without paying interest on those reserves.

I fail to see the rationale for taxing banks during periods when QE is causing central bank losses. As an analogy, imagine if the Prince of Monaco visited the casino in Monte Carlo every time. Some days he ends up winning money. Another day will be his loss. Now suppose that on days when he had bad luck the prince imposed one this Casino tax equal to his losses. It doesn’t seem right!

Central banks are essentially running a giant hedge fund. Why should commercial banks pick up the tab when central bank bets turn sour?

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