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Why the Federal Reserve wants to drain excess reserves

I wrote a post yesterday (The Fed’s exit strategy) to explain the mechanics surrounding Monday’s Federal Reserve announcement that it is offering CD accounts to banks. The Federal Reserve does not control the demand for credit and therefore cannot increase aggregate demand by increasing bank reserves.  This is an important point because it colors how you view the potential for inflation as a result of Fed action.  I see little need for immediate inflation concerns because there is huge amounts of excess capacity.

Normally, the Federal Reserve controls the supply and demand of reserves to maintain its target interest rate above the interest rate on reserve balances. However, when interest rates are at zero percent, excess reserves pile up.

The Economist does a much better job of explaining this in a post yesterday at the Free Exchange blog (emphasis added where the Economist dispels the reserves-lead-to-credit view of the world):

The misperception has only grown with yesterday’s announcement that the Fed would offer “term deposits” to banks as a way of draining some of the excess reserves its emergency operations have created. The move has been widely reported as aimed at keeping banks from lending the reserves out, which would spur inflation…

the volume of reserves has almost no significance for the growth of bank lending and inflation.

For the Federal Reserve, as with most central banks, reserves ordinarily serve only one purpose: to help it establish a target interest rate. In ordinary times, some banks have more reserves than they need and lend them to those that have too little. The rate on those interbank loans is called the Fed Funds rate. If the Fed wants a higher Fed Funds rate, it drains reserves. If it wants a lower one, it adds reserves. The quantity of reserves, per se, is irrelevant to the Fed. It’s the interest rate that affects spending and it’s spending that drives both the demand for credit and, ultimately, inflation.

I hope that makes more clear that reserves are not creating lending but rather that demand for credit creates reserves. So why is the Fed looking to keep these excess reserves from making their way into the system if not to prevent them from being loaned out and stoking inflation?  Again, The Economist is on point here:

The Fed could announce a federal funds target of 3% but the tsunami of excess reserves now out there swamps any conceivable demand, so the Fed funds rate would be guaranteed to remain stuck at zero. The target would be meaningless.

The solution is twofold. First, the Fed can pay interest on those reserves, and if that interest rate is high enough, it will put a floor under the federal funds rate. But that may not be perfect. So, the second solution is to drain or otherwise immobilise those excess reserves so that banks won’t want to, or can’t, lend them in the Fed Funds market. That’s the purpose of the term deposits, of the long-term reverse repos, and of other Rube Goldberg solutions yet to be dreamed up by Brian Madigan, Brian Sack, and their fellow propeller heads at the Fed. It makes perfect sense for the Fed to figure out today how it will go about raising the Fed Funds rate eventually, but it doesn’t mean (or at least I hope it doesn’t) that it’s about to do it.

So, there you have it – this is a mechanical issue to allow the Fed to target interest rates if and when it raises rates which it is unlikely to do as it is on hold for an “extended period.” The Federal Reserve can’t successfully target rates unless it can control the supply and demand of reserves. 

It is that last phrase “control the supply and demand of reserves” which is most telling here. In my view, the the Federal Reserve’s use of unorthodox policies is a sure sign of a dysfunctional credit system. But it is also a sign that command and control tactics to manage interest rates don’t really work.

Source

The truth about all those excess reserves – Free Exchange, The Economist

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

6 Comments

  1. Brick says:

    Potential for inflation is right, but since there are a number of sources of inflation this may or may not have an effect on inflation expectations. The sources of inflation to my way of thinking are money supply and credit availability which is the area covered in your post, significant wage rises which are not likely in the immediate future, final product taxation which are also unlikely to rise across the board, production costs linked to material prices which may rise as parts of the world recover, currency devaluation which also may or may occur, over supply of debt which most likely will happen.
    Getting back to the substance of your post I agree that reserves build up is probably a result of lack of credit being extended and it would be nice if those reserves could be frozen or released slowly into the economy as it recovers. I am not totally convinced locking reserves into longer term deposits will work. You need to compensate banks for not being able to remove those reserves at short notice, so there will be a cost to the FED of doing this. Now you can just magic money for that cost out of thin air as central banks like to do, but this also has implications for interest rates and reserves. Set the rate wrongly and things will get counter productive very quickly.There is a lot more to explore here than appears on the surface.
    The aim of course is for the FED to gain greater control, but I am guessing that banks and investors will not want to play ball. Set the long term rate too low and all those reserves end up in a bubble sending maybe oil prices sky high.Set it too high and banks will stop lending and just park all their money at the FED. What will complicate matters is the looming Basel II capital requirements for banks and the drain of negative convexity hedging on treasury debt as the FED pulls its rug of support from under agency debt.Basically I think the FED has too many balls in the air for them not to make a misstep, especially since they have a blind spot for things coming from outside the US.

  2. GraueEminenz says:

    “I see little need for immediate inflation concerns because there is huge amounts of excess capacity.”
    That is a common Keynesian fallacy – inflation (Latin “inflare” to inflate) is already there, it’s the amount of money that exists. That someone cannot or does not want to increase prices, whether out of whim, or because he thinks it’s a good strategy if one has “excess capacity”, has nothing to do with inflation, nor would it be DEflation if he lowers prices for the same reasons. The RESULT of inflation is money devaluation and that is following unevenly but eventually across the board. If you need to recoup the cost of rebuilding your worn-down production line over time you will always try to do so at “tomorrow’s” prices, as it’s them you have to pay to refurbish your factory (maintenance, change, expansion, whatever).
    So even with excess capacity you would, if you were economically sound, raise prices in a depression if you’d anticipate price increases, which will inevitably follow TODAY’s inflation. IF IT’S NOT DONE it’s not a sign of subdued “inflation” as you use the term, i.e. price depression but rather it shows that owners see the depression so bad as not to try to recoup their outlays as they figure they won’t be able to use the capital in the mid-term future to profit from.
    So, in short: what you’re describing is a fire-sale of gigantic proportions due to not only economic but, equally so, mental depression and discouragement across the business community, at least those sectors that would not, as some parts of the military-industrial complex (Eisenhower) tend to profit from freshly created money in states’ hands.

    • What are you talking about? I am not a Keynesian. Do some research before
      you write comments projecting your thinking onto others. When I say
      inflation in that sentence, I am referring to consumer price inflation. The
      only way we are going to get consumer price inflation in a world of debt
      deflation is via commodity prices or currency devaluation. And since the
      Chinese are not playing ball, it is left to commodity prices.

      Austrian economics would tell you that.

      Sent from my mobile telephone

      • GraueEminenz says:

        Sorry, I did not insinuate you ARE a Keynesian. But you talk like one when you use inflation synonymically to price INCREASE. The latter is a (possible) effect of the former, and both are not he same as little as a father is the son. So, in the world of scientific economics there is no such thing as consumer price inflation, since there is no price inflation, only increase or decrease. Prices rise, they don’t inflate, dinghies do and the monetry base.
        Increases in prices NORMALLY, i.e. if the money base is not expanded by fiat money “printing”, result from ONLY two sources:
        a) the increase in demand/decrease of supply resp. (ALL OTHER things being equal) OR
        b) the increase of cost, all other things being equal, i.e. if these costs can be added to the price without harming sales. If they can not, production, i.e. supply, will eventually cease and some kind of substitution will take place.
        So when there’s no such thing as consumer price inflation then your article needs at least be rephrased. But after rephrasing you would still drive at the same point, which is what’s wrong with your argument: since consumer prices don’t increase, you hold the view there’s nothing to worry. And what I said is that inflation HAS HAPPENED already, i.e. the multiplication of the monetary base and that the logical result will eventually be the general rise in prices, but that it will always happen unevenly which is why a price index is an unscientific way to look at the effects of inflation or else they wouldn’t have focused on the CPI and missed the housing bubble, which was wjere inflation took its toll LAST TIME. NEXT TIME though will be more general.

  3. demandside says:

    Very cogent explanation. Thank you. It displays how very much at sea the Fed is. Blundering around in the dark because it won’t take off its blinders.

    Inflation in consumer prices, or deflation in consumer prices, for that matter is not a problem. It is the deflation in asset prices that is crippling any investment going forward. Real assets, that is, not financial assets (which seem to be in a bubble of their own, perhaps for their liquidity or maybe it is just because there is lots of zero interest funding for positions).