Sunday, August 5, 2012

One Point Five Trillion Dollars

That's the amount of excess reserves banks are sitting on right now. For those of you who don't know, excess reserves are basically just the money banks keep  on hand above and beyond their legally-required reserves of money. Now, in normal cases, excess reserve levels are pretty low, since banks can usually just loan the money out to people, other banks, or whatever. If you think about it, why would they keep extra money around? It wouldn't earn them anything in interest, ordinarily. Except that right now, sitting on excess reserves is profitable for a bank.

The reason for this is that, in 2008, the Federal Reserve started paying banks interest on their excess reserves. The Emergency Economic Stabilization Act of 2008 gave the Fed the power to do this, although the reasoning behind it is spurious, at best. The point, I guess, is that the Fed started paying interest on excess reserves (IOER) to signal to banks that it may later pay higher rates on them if the Fed needs to pull money out of the economy in the case of an inflation problem. The way this would work is that, by paying higher interest rates on excess reserves, banks would have an incentive not to loan out more money, thus cooling off the overheating economy. But this leads to the question: why don't they just do what they always do to head off inflation--raise interest rates? Well, I don't really know. Moreover, this policy makes even less sense when you consider the fact that the Fed is supposed to be taking expansionary activity right now, not trying to head off inflation risks that are nowhere to be seen:

In any case, do you all remember how I said that banks usually can lend their excess reserves to one another at a certain interest rate? Well that interest rate is called the federal funds rate, and that's what the Fed cuts when the headlines say that they cut interest rates. Since late 2008, the fed funds rate has been somewhere between 0 and .25%. So basically, banks lending to one another would have a rate of return somewhere between those two numbers. Recently, that number has been about .13%. 

But here's the problem: the Fed is also paying banks interest on their excess reserves right now. They're only paying about .25% in interest, but that's a pretty solid rate of return when compared to what they'd get lending it out to other banks (remember, 0 to .25% interest rates on those loans). This creates the incentive for banks to hoard their money. And they have a lot of money on hand right now. 1.5 trillion dollars of it.

Now just think about that for a minute. The point of the Fed cutting interest rates is so that loans are more attractive for businesses and consumers. But if the Fed simultaneously rewards banks for hoarding excess cash by offering a riskless rate of return, any newly printed money is much less likely to end up into the system. Perhaps this graph will paint a more vivid picture for you than I can:

The blue line is how much money the Fed has "printed" and the red line is the amount that's actually flowing through the economy, rather than sitting in banks. The red line is the actual amount of money that banks have lent out into the economy. You'll notice that the trend hasn't so much as budged since the Fed started ramping up its money-printing extravaganza. That's quite a lot of excess money that banks could be lending out, don't you think?

I realize that this may not seem like a powerful tool for central bankers to use, but what do they have to lose, realistically? From what I've read, the arguments against lowering the interest paid on excess reserves are all fairly weak, just like the initial reasoning for the policy. Meanwhile, the potential upsides to such an action by the Fed are pretty substantial. The Fed has never paid interest on excess reserves before, and as you can see, the previous two recessions don't look as if they had similar issues with bank hoarding. Obviously this recession is much, much more severe, but I feel as if we might have seen hoarding on a much smaller scale in milder recessions if the Fed had paid interest on excess reserves in the past.

Something else to consider, too:

Just a thought, is all. Anyways, I think we should take a page out of Sweden's book right about now and turn that interest rate negative--charging banks a fee for sitting on excess cash. Or at the very least we could stop paying them to hoard cash. 

Paying them to do so seems like a waste of money, if you ask me. $4 billion a year, to be exact.