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I'm going to need some help with this one, fellas. It's being reported that the FOMC is considering raising the level of interest paid on excess reserves as a means to keep banks from lending and forestall inflation. I'm sorry, but as a student of the Austrian school of economic theory, my mind just doesn't work that way. I'm going to need a dyed-in-the-wool Keynesian to sort this out for me.

Here's the problem (as I understand it): after letting the beast of excess liquidity off the chain, the Fed is finding that they can no longer effectively manipulate the economy with the Fed Funds Rate. They're concerned about rising inflation because the banks have access to so much (Fed provided) liquidity. The Fed wants to be able to curb bank lending, so the plan is to offer a better rate of interest on excess reserves to convince the banks to leave their excess reserves on deposit at the Fed instead of lending them out.

Here is where it gets squirelly for me. The Fed either gave these excess reserves to the banks through the purchase of worthless toxic assets, or the Fed loaned these excess reserves to the banks at the ridiculous rate of 25 basis points. In either case, the Fed has basically given away the money. Now the plan is to pay the banks even more to prevent them from loaning the money out?

First of all, the banks aren't lending money as it is. Not in any meaningful way, anyway. I guess I can accept that the powers that be are content to see a jobless recovery, despite the damage that does to a significant portion of the American population. But this proposal has the potential to go way beyond killing inflation. It could put a hammerlock on the economy and keep us at marginal GDP growth indefinitely.

Wouldn't a better policy be to just bite the bullet and raise the Fed funds rate to something respectable like 3%? Yes, it would cause a great deal of short term pain, but you don't go on a coke bender in a Shanghai brothel and expect to feel fine in the morning.

I'm being serious here, guys. Somebody explain the advantage of this proposed plan to me. Please.

Comments (17)

  • tandaradei's picture

    Well, it seems that you understand it perfectly. If you ask me, the Feds goal is to recapitalize the banks - faster. This is currently being done by the means of Fed Funds Rate - US Treasuries arbitrage. Maybe the central bank thinks this is going to slow, so they will offer a higher rate on reserves than the USTs yield, as to push more money into the banks.

    There is no inflation threat coming anytime in the future - capacity utilisation is low (with rampant overcapacity), there is source for demand in sight, the banks arent lending because there simply no one creditworthy left standing. The inflation argument seems to be a smokescreen.

    "Wouldn't a better policy be to just bite the bullet and raise the Fed funds rate to something respectable like 3%?". Why not 10%? Or 5,5%? Or 19%? Seriously, how does one know? Maybe ZIRP is the correct answear, why not? We will never know until we have a market to determine that.

  • jnl83's picture

    The short answer is it changes the risk premium between risky and risk-free assets.

  • stk123's picture

    The idea here is that banks will leave more money with the Fed (above the amount required, hence called excess reserves), because they will be able to collect interest on that money.

    For example the Fed has about $1tn in excess reserves vs. $2.2tn at the start of 2007, if it starts paying interest on that $1tn in excess reserves then the more banks will leave their money with the Fed instead of lending it out to other banks over night. This will drain liquidity out of the system because although the Fed will have to pay interest ($10bn for every $1tn in excess reserves for every 1%), it will probably attract a lot more money into the excess reserve fund than it pays out in interest. It doesn't mean anything if the Fed pays out $10bn in interest if it is able to attract an additional $1tn in excess reserves.

  • roel_1's picture

    The point is that higher reserve holdings reduce the money multiplier. Banks lend money to the public and then receive it again as deposits, which they again lend.....etc. Money which they deposit at the Fed cannot be 'multiplied' in this fashion and therefore if banks hold more reserves at the fed broad money supply decreases (and through the quantity equation eventually inflation is reduced).

    However, as you said it doesn't make a lot of sense. First banks are not lending enough and there is a deflation risk, now the Fed wants to restrict lending to curb inflation.

    My guess would be this: even though we're witnessing a monetary expansion of unprecedented size, it has little effect on either consumer price inflation or employment. The extra liquidity is resulting in (foreign or domestic) asset price inflation (bubbles!). Now the Fed is trying to reduce this risk. Normally it would do this by raising rates but given the current fragile situation it prefers using the backdoor.

    In other words, by rewarding excess reserves Bernanke is trying to avoid making the same mistake as his predecessor (creating bubbles), while still leaving the funds rate unchanged and thus avoiding panic in the market!

  • oab729's picture

    @jnl83: tell me if i got this right
    1) increases excess reserves lowering money supply
    2) making risk free assets less attractive and riskier assets more so
    For example, if you can earn 3%, simply holding onto money, you're not going to invest in anything below 3%. So instead, to increase your yield you take on riskier debt

    But increasing credit increases lending right? Yes, it does, but you're not increasing credit, you're shifting credit towards riskier assets while also increasing reserves.

    Now here's where I'm confused... why would you want your banks to take on more risk?

  • Edmundo Braverman's picture

    Thanks guys. I agree with all of the above points, I just think there's a simpler way to achieve the same ends.

    I find it hard to believe that the market is dumb enough to ignore a back door solution and avoid a panic by taking this route. The point about fractional reserve banking is well taken also. Perhaps a common sense curb on the money multiplier would achieve the same result without costing the taxpayer interest on money the taxpayer has lent out (in other words, paying the borrowers to carry off the money). Maybe instead of 9:1 fractional reserve banking, a 3:1 curb or even 5:1 curb would work better.

    Ultimately, though, I have to believe this 6-point plan is closer to the real solution:
    http://defenseofcapitalism.blogspot.com/2010/01/re...

  • In reply to Edmundo Braverman
    stk123's picture

    Edmundo Braverman:
    ...The point about fractional reserve banking is well taken also. Perhaps a common sense curb on the money multiplier would achieve the same result without costing the taxpayer interest on money the taxpayer has lent out (in other words, paying the borrowers to carry off the money). Maybe instead of 9:1 fractional reserve banking, a 3:1 curb or even 5:1 curb would work better...

    I don't know if I understood correctly, but are you suggesting that we change the Reserve Requirement Ratio (RRR) from 10% to 33% or 20%?

    I had a professor who used to say that changing the RRR is like flipping an on/off switch on the economy (read: too drastic) and therefore the Fed only uses the Fed Funds Rate and Discount Rate to implement Monetary policy.

    E.g. I don't know what is the amount of reserves held at the Fed, but let's assume that it is $1tn (at 10%RRR) now if you raise that to 20%, banks will now have to hold $2tn in reserves at the Fed. Each dollar lent out by a bank has a multiplier effect of approximately 5x, meaning that if we forced banks to throw in an extra $1tn into the reserve fund it would (overnight) suck $5tn out of the money supply. Needless to say, that would be a disaster.

  • In reply to jnl83
    chifin's picture

    jnl83:
    The short answer is it changes the risk premium between risky and risk-free assets.

    I agree with the common sense money multiplier approach, but could someone offer some clarification on this ^

  • In reply to Edmundo Braverman
    tandaradei's picture

    Edmundo Braverman:

    Ultimately, though, I have to believe this 6-point plan is closer to the real solution:
    http://defenseofcapitalism.blogspot.com/2010/01/re...

    Yep, this seems just about right. However, it'll never happen - banks have enough influence on the legislative process to assure that. It'll always be disregarded as ultra-free-market-radicalist speech.

    I also think roel_1 might've hit jackpot here - stopping asset price inflation. The Fed will simply PAY the banks to refrain from speculation in the financial markets, and avoid inflating bubbles. Makes sense - the wider public probably wont notice, and the banks will be happy.

  • Banker88's picture

    I think the Fed should abolish itself. Neither Bernanke nor any other group of individuals can guess the correct interest rate to "fix" the economy. Interest rates should be set by supply and demand like any other good. Why should the American people get 0% interest on their deposits while banks can loan out at whatever rate they desire?

  • nucci3220's picture

    It is all politics - they are attempting to spin it a way that makes "economic sense" but for anyone that knows the least bit about economics these proposals are the worst thing right now. The voters will like it because you are taxing wall street and/or going after their profits...

    Barry and company need to focus soley on jobs at this point - with unemployment at 10% (actual closer to 20%) the economy needs growth - growth needs capital. The low rates are in place to improve the risk/reward profile for lending institutions, which it does - an upward sloping yield curve is how these banks make money.... One poster made the arguement that banks are just not lending because there are no "credit worthy borrowers" - this is only true in the short term, past lending problems in the forefront - soon banks will realize that lending has to open up for the entire economy and their business to expand significantly. Remember also that banks only make money off of these low rates if they lend/invest....

    What would be the real trouble is if we maintain this level of unemployment and then see inflation - the better solution is to put the rates at a higher level, lower payroll, personal, and income taxes to increase capital to the main streeet economy, cut government spending, use the remaining tarp funds to lower the deficit (strengthen the dollar), and allow banks/companies to fail for their bad decisions... remember in the depression economists thought the world would end when other industries (i.e. steel in some regions) were hurting - free markets sent these jobs/productions to other countries who now use US finanial services and consulting services - its a life cycle and in a free market system, if it makes sense to have something it will be created where others have failed... I doubt we will ever see a time when lending/financing/investing is not needed - so if ANY bank fails someonoe will pick up that business - this is why banks like PNC have gone from regional to national players and banks like HCBK continue to roll on.....

  • In reply to nucci3220
    tandaradei's picture

    nucci3220:
    (...) the economy needs growth - growth needs capital.

    This is a necessary, but not sufficient condition. You also need demand, and for the last 20+ years the source for it was the US consumer base, financed by increasing leverage. But now the consumer is tapped out, scared, worrying about his retirement account and paying down debts. If there is no new demand source (like China, had it let its exchange rate float) or a breaktrough technology (like Internet) giving productivity a boost - I don't see the economy going anywhere, but south.

    nucci3220:
    (...) soon banks will realize that lending has to open up for the entire economy and their business to expand significantly.

    Firstly, to do business (ie lend money) banks would need to see projects worthy of financing - are there any? Cars, education, housing, internet start-up ipo's, leveraged buyouts and more - all done. Whats left? Secondly, they would need someone ready to take on more debt, and such people will be hard to find, as consumers are struggling to pay off their existing burdens, or find a job, and business see demand going down, not up, and don't really need more capital.

    nucci3220:
    Remember also that banks only make money off of these low rates if they lend/invest....

    Or if they just borrow at 0,5% from the FED and buy risk-free treasuries at 3%. And if the FED increases rates on reserves they wont even have to do that - it will be a one-stop-shop!

  • jnl83's picture

    Some clarification on my earlier comment:

    Assuming the return on the risky asset is the same, now the spread between a risky asset and a riskless asset is less, so banks will have less incentive to invest in the risky asset to chase yields.

    This is just another tool for the Fed to control the amount of money in circulation (i.e. money lent out by banks, multiplier effects and such), in addition to open market operations, setting overnight fed funds rates, TALF, etc.

  • jnl83's picture

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  • Revsly's picture

    Jack: They’re all former investment bankers who were laid off from that economic crisis that Nancy Pelosi caused. They have zero real world skills, but God they work hard.
    -30 Rock