We are paying one-fourth of one percent so it's obviously a very, very low rate of interest. The rationale for not going all the way to zero has been that we want the short-term money markets like the federal funds market to continue to function in a reasonable way because if rates go to zero there will be no incentive for buying and selling federal funds, overnight money in the banking system, and if that market shuts down ... it'll be more difficult to manage short-term interest rates, for the Federal Reserve to tighten policy sometime in the future. So there's really a technical reason having to do with market function that motivated the 25 basis points interest on reserves.What would happen if the IROR on reserves went to zero? Would the fed funds market shut down? Currently there is a massive quantity of reserves in the system, but nevertheless there is an active federal funds market (though much less activity than in normal times). Why? Even though the system is awash in reserves, Fannie Mae and Freddie Mac don't receive interest on their reserve accounts, and therefore want to lend. A surprising feature of financial markets currently is that the effective fed funds rate (currently at 0.18%) is lower than IROR (0.25%) - there is something inhibiting arbitrage here, as without that the effective funds rate should be 0.25%. Now, if the IROR goes to zero, then the GSEs no longer have an incentive to lend overnight. Maybe the fed funds market essentially shuts down then. Presumably this is what Bernanke is alluding to, though he is not being explicit. But why do we care if the fed funds market shuts down? After all, it would shut down because it's not needed. Is it going to be costly to start it up again once the Fed starts to tighten? Do fed funds traders get out of practice, or what? I don't think this makes sense. Surely there is plenty of scope, if the Fed wants to, to subsequently tighten. It can do this in one of two ways: (i) Conduct open market sales of assets, until the fed funds rate rises above zero; (ii) Raise the IROR.That being said, it would have a bit of an effect on monetary policy ...
(and) we'd certainly consider that as one option.
Now, what would be the effects of a decrease in IROR to zero? As Bernanke says, not much. Reserves would become slightly less attractive to banks, and in the course of trying to shed them, the price level would rise by a small amount, reserves would fall, and the quantity of currency (in nominal terms) would rise.
