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.


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


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.