Massive, long-term excess reserves are the anomaly that resulted from deviation of historic Fed monetary policy that began in 2008. From 1913 to 1971 the Fed targeted a dollar fixed weight of gold to determine the economy’s required base money, cash and reserves. From 1971 to 2008 the Fed targeted the federal funds rate. The Fed also briefly targeted Friedman’s monetary aggregates during this period which ignited the great inflation of the 70s. After the 2008 financial crisis, the Fed abandoned specific targets for creation of base money. Bernanke’s Fed implemented his long-held academic belief that the Fed could have prevented the Great Depression by injecting liquidity. Bernanke summed up his November 8, 2002 speech celebrating Friedman’s ninetieth birthday with exactly this sentiment:
“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
With the onset of the financial crisis in September 2008, Bernanke’s Fed put his “we won’t do it again” promise into action. The Federal Reserve Bank of St. Louis working paper describes the Fed’s actions through 2012.
“The Fed’s next major policy actions did not occur until Lehman Bros. filed for bankruptcy protection on September 15, 2008. The Fed responded by injecting massive amounts of credit into the market, mostly through its lending facilities. Between September 15, 2008 and January 2009 the monetary base doubled. In mid-March 2009 the FOMC initiated what is commonly referred to as quantitative easing (QE1), announcing that it would purchase up to $1.75 trillion in mortgage-backed securities, agency debt, and longer-dated Treasuries. QE1 was followed by QE2, the purchase of an additional $600 billion in longer-term Treasuries, and Operation Twist, the purchase of $400 billion in longer-term Treasuries while simultaneously selling the same amount of short-term Treasuries. These actions were intended to stimulate aggregate demand by reducing longer-term yields.”
QE3 followed in September 2012 with the $40 billion per month open-ended bond purchasing program of agency mortgage-backed securities. The Fed expanded this to $85 billion per month in December 2012. When Fed QE purchases were finally halted in October 2014, the Fed’s balance sheet sat at $4.5 trillion, up from $0.8 trillion at the beginning of the crisis. Excess reserves exploded in tandem with the Fed’s balance sheet from a nominal $2.0 billion in 2008 to $2.6 trillion. Today, excess reserves are $2.0 trillion while the Fed balance sheet remains at $4.4 trillion.
The Financial Services Regulatory Relief Act of 2006 authorized the Fed to pay interest on reserves (IOR) beginning in 2011. Congress passed this act as regulatory relief for banks. Its intention was to compensate banks for their regulatory requirement to hold required reserves against loans. There are administrative costs that accrue to banks for holding required reserves. It is dead money required by regulation that otherwise banks could put to use earning income. Banks pass this cost on to depositors, so the intent was to relieve a “tax” on depositors. As a result of the cost of holding reserves, banks traditionally keep reserves to the minimum required by law. The last time banks held significant excess reserves was during the Great Depression. Banks held excess reserves as a cushion against the economic instability that resulted from the onset of the Great Depression. This was a natural result of the time. There was no abnormal increase in the monetary base during the Great Depression since the U.S. was on a gold standard.
The Economic Stabilization Act of 2008 moved the date forward from 2011, and the Fed began paying interest on reserves on October 6, 2008. While the intent of the 2006 Act was regulatory relief, IOR immediately gained a new purpose under Bernanke’s QE policy. IOR compensated banks for holding reserves beyond required reserves. Where previously banks were financially punished for holding excess reserves, the Economic Stabilization Act of 2008 changed the dynamic. Banks are now rewarded with interest payments from the Fed on all reserves, including excess.
There are two notes of interest. First, the original law in 2006 was never meant to reward banks for accumulating excess reserves. Relief from regulatory burden was the law’s intent. Second, the 2006 law specifically stated that the Fed is allowed to pay interest “at a rate or rates not to exceed the general level of short-term interest rates.” The Fed’s own experts treat the federal funds rate as a proxy for the level of short-term interest rates. An immediate result of QE and the driving of interest rates toward the zero bound is that the federal funds rate quickly fell below the IOR floor. The Fed does not control lending in the shadow banking system. The shadow banking system consists of nonbank financial institutions outside the scope of federal regulators. This lending drove the funds rate below the Fed’s desired IOR floor. By paying IOR above the level of short-term interest rates, the Fed has consistently been in non-compliance with Congressional regulatory law.
Excess reserves allowed the Fed to conduct its aggregate demand stimulus experiment. Global central banks imported the Fed’s QE policy as their own. Fed asset purchases drove interest rates across the yield curve toward zero. Global negative interest rates are now an accepted norm. The intended demand stimulus never arrived. Instead we got falling GDP, income inequality, capital misallocation, the decline of the middle class along with their standard of living, unsustainable debt, secular stagnation, and a political revolt.
IOR and the accumulation of excess reserves allowed the Fed to create its liquidity injections without runaway inflation. Essentially what the Fed did with QE was create money out of thin air and then paid banks not to lend it. Combined with the Dodd-Frank regulatory morass that punished lending, banks were happy to earn free money from the Fed for holding excess reserves. The runaway inflation predicted by the market’s run-up of gold to $1900 never materialized. Excess reserves remain locked out of the economy and gold fell back to its current equilibrium level.
Beyond the failed demand-side stimulus and contracting economy, the other side-effect of excess reserves is the Fed’s inability to normalize monetary policy. Normalizing monetary policy requires removal of excess reserves by selling assets from the Fed’s balance sheet. If the Fed starts selling its holdings, the interest rates it suppressed through QE will naturally start to rise. Interest payments on our $20 trillion in debt, a large portion of which accumulated during the Fed’s free money period, will increase along with budget deficits.
Without a return to normalization, raising the funds rate requires massive Fed manipulation. Any increase in the federal funds rate requires a corresponding increase in IOR which decreases remittances to the Treasury. This increases the budget deficit. Since almost half of the banks receiving IOR are U.S. subsidiaries of foreign banks, the Fed runs into a political problem. Funds rate hikes increase the federal deficit and tax obligations on the decimated middle class, while foreign and TBTF banks receive increased interest payments, better termed free money. The Fed, already under increased public and Congressional scrutiny, will only elevate its political problems. It is no surprise that the Fed keeps hinting at rate hikes that never materialize.
The shadow banking system doesn’t receive IOR so to effectively rase the funds rate, the Fed has to manipulate the shadow banking system rates higher also. The Fed is doing this through reverse repos (RRP). While the RRP were successful with the Fed’s first quarter point increase, it is unknown if the Fed can continue to successfully manipulate the shadow banking lending rate higher with each subsequent increase in the funds rate. The higher the funds rate, the more distortion and manipulation required by the Fed.
This is the corner the Fed has painted itself into since the Fed acted on Bernanke’s promise that “we wont do it again”. It can’t normalize Fed policy without unwinding the monetary distortion it created. The Fed’s current predicament stems from Bernanke’s, and academia in general, misunderstanding of the true cause of the Great Depression. The onset of the Great Depression was not a monetary event. The gold standard maintained base money exactly as the economy required without inflation or deflation. The Great Depression was a fiscal event caused by the Smoot-Hawley tariff wall that inhibited global trade and acted as an international tax hike. Hoover’s follow-on tax increase, a decade of economy sapping socialist policy, and FDR’s 1934 devaluation exacerbated an economic contraction, that was correctable by reversing Smoot-Hawley, into the Great Depression.
Very good read. I have not seen such interesting perspective else where.