The BoJ has started helicopter drops

Oddly, some economists think that helicopter drops are either beyond the capacity of central banks or highly unlikely. Neither is true – they have already started.

It is now clear that the Bank of Japan is engaging in helicopter drops. Helicopter drops are transfers to the private sector financed by the creation of money (bank reserves) under the direction of the central bank. This is the definition that Milton Friedman uses when discussing actual practical policies in a liquidity trap (in his AER presidential address in 1968) – although he does not use the term “helicopter”. I only differ from Friedman by designating institutional responsibility to the central bank – he does not discuss who should direct the policy, but deems it “monetary policy” because it is financed by base money.

The recent innovation in monetary policy by the Bank of Japan is a clear case of a helicopter drop. Here’s why: central banks, due to quantitative easing (QE), have created huge levels of bank reserves. Bank reserves are essentially electronic money which the banks hold at the central bank. The central bank determines the stock of reserves, usually by purchasing assets (QE).

Because the stock of reserves is so high, central banks pay “interest on reserves” (IOR) to influence market interest rates. For example, when the US Federal Reserve Board raised interest rates in December, it raised the IOR to ensure market rates rose in line with their new target. If the IOR remained below the target Fed funds rate, market rates would never reach target because banks could lend reserves to each other at a rate close to the IOR.

For this reason, it is assumed that when the central bank changes its target interest rate, it will change the IOR in line with its target – just as the Fed has done.

But the BoJ has clearly broken ranks, and made a helicopter drop to banks. It has also shown how easy this is to do. It has done so by introducing three distinct interest rates on reserves: required reserves – which banks must hold – these are paid zero, and are relatively small in quantity; existing reserves – these are now paid 10bps; and a new third tier – a “policy balance” which will be paid minus 10bps. To be clear, the income banks derive from reserves held at the BoJ has been substantially insulated from negative interest rates. Using the BoJ’s terminology, the ‘basic balance’ of existing reserves which pays 10bps, totals ¥210trn. Zero interest rates will be paid on ¥40trn. Only ¥10trn-30trn will receive negative rates. Also – importantly – it appears that this balance of ¥10trn-30trn will be fixed at these levels, despite QE creating ¥80trn of new reserves annually. New reserves will receive zero interest. So QE may well increase the profitability of banks (if the BoJ buys negative yielding JGBs and then pays zero) – a further transfer to the banking sector.

The helicopter drop is the transfer payment that the BoJ is making to banks on their existing reserves, which is unnecessary in conventional monetary policy: it is neither a regulatory requirement nor an interest rate which affects market rates. It is in fact a transfer payment to the private sector (in this case, the Japanese banks) financed by the BoJ – i.e. a helicopter drop.

And the Bank of Japan is explicit about this – it has introduced the new tier of reserves – a “basic balance” – to support the profitability of financial intermediaries.

The BoJ can increase its helicopter drop by raising the IOR on this balance.

So, helicopter drops have started. Now let’s make them transparent and sensible.