By Wes Davis of IndexBeating.com
One of the important roles of the Federal Reserve is to control the money supply in an effort to stabilize the business cycle. In doing so, generally the Fed will increase money supply during economic slowdown and decrease it during economic boom. Other things are taken into consideration such as inflation.
As of October 16, 2008 the Fed started to pay interest on the reserves that banks hold. Reserves come in two forms, cash held on-site in the bank’s vault, as well as cash held at the money banks keep on-hand at a Federal Reserve Bank. The Fed stated their reason for implementing this policy was to get rid of the “implicit tax that reserve requirements used to impose on depository institutions.” The Fed can set the interest rate paid on excess reserve held by banks at a different rate but has been kept the same since December 17th. The purpose of this was to encourage banks to keep more cash on reserve because they wouldn’t be forced to pay the opportunity cost of forgoing interest on the capital.
When banks hold more cash on reserves, they have less capital to lend out to consumers. Banks increased cash reserves because they now have the opportunity to earn a return on the cash. Another factor that is causing banks to keep larger reserves, or lend less money, is the deterioration of the credit market.
During October of 2008, the amount of money banks kept in reserves nearly doubled, from $315.5 B to $609.9 B. Below are two graphs showing historical data gathered from the St. Louis Fed’s Economic Research website (www.research.stlouisfed.org). I wanted to show how high the current reserves are with some historical frame of reference. Also, I wanted to focus on how reserves have increased recently, particularly since the beginning of October.
The Fed’s policy change to start paying interest on bank reserves was originally planned to be implemented in 2011 as stated in the Financial Services Regulatory Relief Act of 2006. Part of the Fed’s job is to control money supply to keep the economy growing at a sustainable rate. Because banks are more encouraged to keep excess amounts of cash on reserves as a result of the policy, the Fed is essentially contracting money supply. This seems counterproductive because it mitigates their current attempt to expand money supply during the recession. We are in a credit crisis where consumers have less access to capital, and therefore are spending less. The Fed implementing a policy to encourage banks to keep reserves in excess of the required amount is tightening the available credit for consumers. Although, paying interest is not the only reason or maybe not even the primary reason for excess cash in bank reserves, it is only worsening the credit crisis.
5 responses so far ↓
R McGarry // February 19, 2009 at 12:24 pm |
Wes, this is a very interesting post, and I think the reality that banks are now incentivized to hold reserves rather than be taxed (in the sense that no interest in an inflationary environment is essentially a tax) is an unfortunate side-effect of a legitimate, fair, and logical policy.
Besides the unfairness of taxing banks which clearly needed to be corrected, the true purpose of this policy was to prevent Banks from continuing the policy of lending out excess reserves at whatever rate they could get because the Fed didn’t pay interest. That’s one reason the federal funds rate often crashed late in the day, when banks realized they had more reserves than they needed.
Paying interest on reserves essentially put a floor under the federal funds rate. The Fed could then make loans and purchase assets with little concern for the impact on the federal funds rate, which has clearly been necessary given all of the recent unconvential monetary policy.
Could the reserves more likely be building due to a disfunctional credit market, lack of consumer and private expansionary loan deman, and increased risk aversion of banks? Is this a case of correlation without causation?
Wes // March 3, 2009 at 4:21 pm |
Ryan thank you for the reply, and I apologize for the delay in getting back to you. I agree that the credit market and lack of consumer spending is a major reason why the excess reserves have increased drastically over the past few months. My argument is that the Fed should be taking on a more expansionary policy and by allowing banks to have such huge excess reserves is not helping our current situation. One possible solution that may be a little farfetched is to charge banks to hold excess reserves. This was suggested by Scott Sumner on his blog at http://themoneyillusion.com/ under the post “An Open Letter to Mr. Krugman”.
Index Beating // March 3, 2009 at 4:30 pm |
I think there is too much moral hazard to charging banks to hold cash. It would then better for the bank to always have their money loaned out, even if it is to someone who has no chance of paying it back. This is similar to the effect of Greenspan’s policy of keeping interest rates low on Treasury debt after the 2001 crash, forcing lenders to seek other lending avenues, which turned out to be unqualified mortgage borrowers.
Wes // March 3, 2009 at 4:43 pm |
The banks could loan all that money to the federal government (t-bills) or to the many people who can pay off the debt. I think there are a vast number of people who would like to get a loan but with the tightened credit market, they do not have access to loans at a reasonable rate. The Fed needs to do something about the excess reserves. I am not advocating they start charging interest on the excess, I just wanted to offer one solution from someone else.
Index Beating // March 3, 2009 at 5:05 pm |
The reason they didn’t loan to people who could afford to repay or T-bills was because management was too focused on short term performance, and since riskier loans provide more cash flow in the short term, that is seen as a more desirable move for the bank.
I wish I had a solution to get banks to lend more, unfortunately I have not yet thought of one that does not increase moral hazard for bank management.