-- Posted Tuesday, 1 October 2013 | | Disqus

The following is excerpted from a commentary originally posted at www.speculative-investor.com on 29^th September 2013.

For the entire history of the Federal Reserve prior to October of 2008, the Fed was not legally able to pay interest on bank reserves. However, the Emergency Economic Stabilization Act of 2008 gave the Fed the power to pay interest on reserves and the Fed has since made use of this power. We are going to explain why this change was made and why it greatly reduces the probability of future US deflation.

Before we outline the reason for the Fed's decision to grant itself -- by adding an item to an act that was being rushed through parliament at the time -- the power to pay interest on reserves, it is worth reiterating some facts about bank reserves. These facts rule out the reasons that have been put forward by some 'experts' to explain the Fed's new power.

Fact #1 is that when the Fed monetises X$ of assets it adds X$ to demand deposits within the economy and X$ to bank reserves held at the Fed (that is, held in Federal Reserve deposits). The demand deposits are liabilities of commercial banks and the reserves are assets of commercial banks. In effect, the reserves 'cover' the demand deposits.

Fact #2 is that although the reserves held at the Fed are assets of commercial banks, the commercial banks are strictly limited in what they can do with their reserves. The banks cannot, for example, loan their reserves into the economy or spend their reserves, but one bank can lend reserves to another bank and reserves will be transferred between banks as cheques are cleared (when a cheque written by a customer of Bank A is presented at Bank B, there will be a transfer of money and a transfer of reserves from Bank A to Bank B).

Fact #3 is that apart from a small annual drainage of reserves from the banking system due to the public's steadily increasing demand for physical notes and coins, all reserves held at the Fed will remain at the Fed until they are removed by the Fed. It is fair to say that the Fed has absolute control over the volume of reserves within the banking system.

Fact #4 is that total bank reserves can be separated into "required reserves" and "excess reserves". The amount of reserves defined as "required" is the amount needed to satisfy the minimum legal reserve requirement, but all reserves have the sole function of providing cover for money in commercial bank deposits.

Fact #5 is that reserves do not (and cannot) leave the Fed as a result of an expansion of commercial bank credit. When banks make loans and grow their deposits it is possible that some reserves will shift from the "excess" category to the "required" category, but an increase in bank lending cannot cause the banking system's total reserves to change.

A hypothetical example can hopefully make Facts 4 and 5 more clear. Assume that a) the total amount of money deposited in bank accounts is $10T, b) $2T of the aforementioned $10T is subject to reserve requirements, c) the legal reserve coverage is 10% (meaning that the banking system in our example is legally obligated to hold at least $200B of reserves), and d) the banking system holds $1T of reserves. The banks therefore have "required reserves" of $200B and "excess reserves" of $800B. Now assume that the banks lend $5T of new money into existence, $2T of which ends up in accounts that are subject to reserve requirements, while the Fed makes no additions to or deletions from bank reserves and the public's demand for physical currency remains the same. The result is that total bank reserves will still be $1T, but the quantity of reserves defined as "required" will now be $400B and the quantity of reserves defined as "excess" will now be $600B.

Fact #6 is that the Fed currently pays the same rate of interest (0.25%) on all reserves held at the Fed, regardless of whether the reserves are defined as "required" or "excess". This means that if part of a bank's reserves shift from the "excess" to the "required" category due to an expansion of its deposit base, there will be no change in the amount of interest earned by the bank on its reserves. In broader terms, the total amount of interest paid by the Fed on bank reserves will not be affected by the amount of new loans made and new money created by the commercial banking industry.

One implication of the above set of facts is that the payment of interest on bank reserves provides no disincentive whatsoever to bank lending. This means that the Fed did not start paying interest on bank reserves in order to restrict the amount of new money loaned into existence by the commercial banks.

Rather than providing a means by which the Fed could discourage bank lending, perhaps the Fed's decision to start paying interest on reserves was part of the central bank's wide-ranging bailout of private banks. That is, perhaps it was just another way to boost the assets of the private banks. This is the explanation we favoured until recently, but the numbers don't make sense. At an interest rate of 0.25%, even with $2.5T of reserves the annual interest payment would only be $6B. In the context of the overall banking system and the multi-trillion-dollar wealth transfer from the rest of the economy to the banks that was engineered by the Fed over the past five years, this is 'chicken feed'. It would not be worth the trouble. To put the aforementioned $6B interest payment for the entire US banking industry into perspective, over the past two years a single US bank called JP Morgan paid $7B in fines, suffered an $8B loss on its "London Whale" trading fiasco, paid $10B in legal expenses and is reportedly in the process of settling mortgage-related claims for $11B, all without noticeably denting the bonuses of its top executives.

What, then, was the real reason that the Fed changed the rules to enable the payment of interest on bank reserves?

The answer is linked to the massive increase in bank reserves that occurred as part of the Fed's draconian efforts, beginning in September of 2008, to inflate the prices of certain assets.

To understand why the change was made, first consider the ramifications if the change had not been made. With such a huge volume of "excess" reserves in the banking system, very few banks would ever find themselves in the position of needing to borrow reserves from other banks, and most banks would always be happy to lend their reserves to other banks at a miniscule rate of return. Consequently, the Fed Funds Rate (FFR), the overnight rate at which banks lend reserves to each other and the main interest rate directly targeted by the Fed, would be stuck near zero. This would not be an issue as long as the Fed wanted the FFR to be near zero, as is the case right now, but what would happen in the future when the Fed decided that a higher FFR was appropriate?

Further to the above, if the Fed were still limited by its pre-2008 rules of operation it would have no way of increasing the FFR in the future without massively reducing both the quantity of money and the quantity of bank reserves. To put it another way, as long as the banking system was inundated with "excess" reserves, the effective FFR would be stuck near zero regardless of where the Fed set its FFR target. Increasing the FFR would therefore necessitate a huge monetary contraction, but this would collapse the equity and debt markets.

Just to be clear, the problem of not being able to hike the FFR without implementing a crisis-precipitating monetary contraction stems from having a gigantic quantity of "excess" reserves in the banking system. If reserve levels were roughly the same today as they were at any time during the 50 years prior to 2008, then the Fed would only need to make a small adjustment to the supplies of money and reserves in order to hike the FFR.

Enter the new power to pay interest on bank reserves. With this simple addition to its powers it is now possible for the Fed to increase the FFR to whatever level it wants without contracting the quantities of money and bank reserves. It simply has to make sure that the interest rate on bank reserves is the same as its FFR target. For example, if the Fed sets its FFR target at 1% and the interest rate on bank reserves at 1%, then no bank will lend reserves to another bank at less than 1% regardless of how many "excess" reserves it has.

In summary, the ability to pay interest on bank reserves eliminates the future need for the Fed to contract its balance sheet in order to hike its targeted short-term interest rate. It is therefore another substantial nail in the coffin of the deflation case.

-- Posted Tuesday, 1 October 2013 | Digg This Article | Source: GoldSeek.com

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