August 18, 2016
Banks must maintain a certain percentage of their deposits in an account at the Fed known as that bank’s “reserve” account. Because they do not want to overdraw their account, prudent bankers always seek to hold just a little bit extra. This little bit extra is known as “excess” reserves. Prior to the recent recession that “little bit extra” added up over all the banks in the banking system, was a little bit less than $2.0 billion. During the recession when liquidity in the banking system dried up, the Fed essentially put the pedal to the metal and started stuffing reserves into the banking system right and left. Its overriding objective was to get the economy moving again and, indeed, it succeeded. The economy turned around in June 2009 which was sooner than many economists had anticipated. But now the Fed has a problem. Excess reserves in the banking system today are $2.2 trillion (with a T, not a B). Those reserves represent funds that could be lent out by banks to fuel a spending spree the likes of which we have never before experienced. They are, in some sense, “ammo” available to the banking system for lending.
Between the collapse of Lehman Brothers in September 2008 and the end of that year, excess reserves rose quickly from $1 billion to $900 billion.
At the end of 2010 the Fed decided that it was unhappy with the unemployment rate at almost 10% and it engaged in a second round of easing which as become known as QE2 (or Quantitative Easing 2). They decided to purchase another $600 billion of Treasury securities at a pace of $45 billion per month, which quickly boosted excess reserves to $1.5 trillion. The effort was designed to push long-term interest rates lower, provide additional stimulus to the economy, and (hopefully) push the unemployment rate sharply lower.
The third step in Fed easing occurred in September 2011. They decided to sell $600 billion of Treasury bills and short-dated Treasury notes, and buy an equivalent amount of long-dated Treasuries. By doing this “swap” the Fed did not further inflate its balance sheet. The object was to push long rates lower and, hopefully, provide further stimulus to the housing market.
The fourth step in the Fed easing process came in September 2012 when the Fed indicated that it was not happy with the 8.1% level of the unemployment rate and wanted it to decline more quickly. So to jump start the economy, the housing market in particular, it told us that in addition to its purchases of $45 billion per month of U.S. Treasury securities, it also intended to buy $40 billion of mortgage-backed securities every month until such time as the unemployment rate declined to a more acceptable level. That was in addition to the $45 billion of Treasury securities that it was purchasing every month. As a result, excess reserves have now climbed from $1.5 trillion to $2.7 trillion.
Thus, at its peak in late 2013 the Fed was purchasing $85 of long-dated securities every month — $45 billion of Treasury notes and bonds and $40 of mortgage backed securities. The Fed began to slow its pace of purchases by $10 billion at every FOMC meeting during 2014. It phased out its purchases of securities in October 2014
If the Fed allows all those reserves to be used, inflation would skyrocket. Clearly, the Fed can not and will not allow that to happen. As it stands right now this is only a potential problem. The reserves for the most part are simply sitting in the equivalent of a checking account at the Federal Reserve. They are not boosting the money supply, they are not being lent out extensively to consumers or businesses. They are not in any way inflationary. Why? Because until recently both consumers and firms were more interested in paying down debt than in adding to it. During that period of time their income has been going up, their outstanding debt has been going down, hence their “debt burden” has become far more manageable. Indeed, it is now well below what most economists would characterize as a “comfortable” level of debt.
But now all of us as consumers and as business people are a bit more willing to borrow again and banks are a bit more willing to lend. As a result, total loans are now growing at an 8.0% pace. This will ensure that the pace of economic activity remains solid for the foreseeable future.
It has a game plan on how it intends to eliminate the huge volume of excess reserves. It can raise the rate of interest it pays to banks on their reserves account. In that event, the excess reserves would still be there, but would effectively be neutralized. Why lend money to you or me at 6% when banks can keep the money in their reserves account at the Fed, risk free at, say, 5%. Indeed, in December 2015 the Fed raised the rate it pays on excess reserves from 0.25% to 0.5%. It will continue to raise this rate slowly. The Fed says it does not intend to sell any of its vasts holdings of securities, but it will allow some of its security holdings to run off as they mature. If that is what it chooses to do it will take a long time, probably through the end of the decade, for the Fed to shrink excess reserves back to a more normal level.
But the real question is, will all of this work? The Fed thinks it can pull it off. But it is important to remember that they have never been in this situation before. In the old days they might have to drain $2 billion of reserves. Today they have to drain $2.2 trillion. That is 1,100 times bigger than anything they have had to deal with in the past. They may be successful, but the order of magnitude here creates the risk of unintended consequences.