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Guest Post: When At First You Don’t Succeed, Bring In the Reserves

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Served by Jesse of Le Café Américain

Someone asked why Bernanke seemed so positive about the US recovery, and what he would do if his prediction turned out to be incorrect.

The first answer is rather straightforward. He is ‘jawboning’ or trying to increase confidence in the system to motivate businesses to spend and consumers to buy. The Fed can only set the playing field, but the players have to be confident enough to take the field. We think he is underestimating the neglect that the American consumer has taken over the last twenty years in terms of their overall poor condition (real income), and the disrepair of their equipment (household balance sheets), not to mention the rocks and snares and pitfalls remaining on the field from the gangs of New York and the economic royalists.

But let’s assume Bernanke’s first major gambit does falter. What is he likely to do next?

Beranke’s Fed does have a printing press, and he has been using it as we all know. Here is a chart showing the expansion of the credit side of the Fed’s Balance Sheet. This is from the top line labeled “Reserve Bank Credit” from the weekly H.41 report which is becoming more popularly followed these days. If one adds the Feds gold holdings, currency in circulation, and Special Drawing Rights, we get the Total Factors Supplying Reserve Funds.

http://www.federalreserve.gov/releases/h41/Current/

So what would Ben do for “Plan B?” Would he merely add more programs, expand the Fed’s Credit Items even more aggressively?

There was an important function added to the Fed’s bag of tricks during this crisis that has not received sufficient attention perhaps: their ability to pay interest on reserve funds on deposit with the Fed from the Member Banks.

As can be seen from this next chart, this amount is now substantial running close to a trillion dollars. A portion of this would be characterized as ‘excess reserves.’ The Fed should be able to motivate banks to use these reserve by adjusting the riskless interest rates they pay.

This was a much desired tool by the monetarist Fed because it enabled them to expand their Balance Sheet and add a significant amount of credit to the banks system immediately, but to keep ‘a bit of a leash’ on the downstream effects of this liquidity even after it was deployed.

As the Fed’s interest rate remains sufficiently high, the reserves, especially the excess reserves, remain in the banking system, and are not deployed actively as loans and inflationary additions to the financial system.

The Fed issues an H3 report, Aggregate Reserves of Depository Institutions and the Monetary Base. In their latest report, they characterize $708.5 Billion of these reserves as ‘Excess Reserves.’

So, what we might expect to see is the Fed, as the banking system stabilizes after perhaps some new programs and credit facilities, begin to slowly unleash these excess reserves by reducing the interest to the Member Banks, which would lower the bar and motivate them to engage in more commercial loan activity.

We think one problem is that the banks have more options than merely keeping their excess capital at the Fed or loaning it out to private companies.

Certainly Goldman Sachs has shown that it can defy all the odds and make millions each day by aggressively playing the equity, bond and credit markets. It is also more likely that banks would be inclined to invest their excess capital through acquisitions of other banks, which might represent a moral hazard in creating fewer, and more “too large to fail” institutions.

Therefore we might see the first serious moves towards financial reform before the Fed begins to really unleash the liquidity which they have created in the banking system.

There is of course also their monetization of Treasury Debt, to support the stimulus programs being run from the fiscal side of the US financial apparatus. That would be included in the expansion of their Balance Sheet, and we would expect that to continue on at the very least indirectly, if not overtly on the Fed’s balance sheet.

An Aside on the Gold Stock of the Fed

By the way, one method the Fed might use to immediately expand its Balance Sheet would be to recognize that their gold stock is significantly undervalued.

In the H.41 Report, the Fed shows a credit of $11 billion dollars in Gold Stock held primarily in New York, Chicago, Atlanta, and San Francisco, with lesser amounts at each of the Regional Banks. This gold is part of the collateral against the Federal Reserve Notes in circulation, and has been valued at an official rate of $42.22 per troy ounce for many years.

1. Gold held “under earmark” at Federal Reserve Banks for foreign and international accounts is not included in the gold stock of the United States; see table 3.13, line 3. Gold stock is valued at $42.22 per fine troy ounce

By calculation the Fed has 261,511,132 fine troy ounces on its books. If the Fed revalued their gold stock at a more reasonable market price of let’s say $1000 per ounce, then this would immediately add $261 billion to the Fed’s Balance Sheet IF the gold is really held by the Fed without encumbrances.

One has to wonder why the Fed has never taken the revaluation on its Balance Sheet for gold since the value of $42.22 is so clearly an historic artifact. They perform much more market based calculations for the Special Drawing Rights and their Foreign Exchange holdings. One certainly does not need to sell the gold in order to monetize it, since that has already been accomplished, albeit at a much lower rate.

One can only wonder.

Federal Reserve H3.1.2 US Reserve Assets

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42 comments

  1. Anonymous

    Valuing gold to current market prices would show paper currency as a failure.

    We'll probably enter a two tier currency system where Fort Knox gold is used to back our foreign debts due and the little people get stuck with continuing paper dollars.

    As long as they can draw on it, no one in the world will question how much stated gold is in US vaults….it would be to disconcerting to show proof.

    In other news…http://fullmetalpatriot.blogspot.com/2009/08/congress-is-planning-to-raid-every.html

  2. tawal

    The gold isn't there; it's been secretly sold off or absconded. That's a big reason why the Fed won't allow itself to be audited. The common myth is that the Fed is solvent; they have alot of gold valued at cost, not market. But do they; I think not. The emperor has no clothes. Trust is the only thing that keeps a social contract. Trust was irrevocably broken when impeachment due to war crimes was off the table. No rule of law, no trust, no society. The MAN is Dead. We are soon to enter a fully underground society, amass bullets and demerol.

  3. skippy

    Um, how far can the FED *Price is Right* Matterhorn game go on before the little cut-out climber falls, soon probably.

    Skippy…dam you Jesse, the *satellite of love* was my default designation of last resort. The cruelest fate they have yet encountered, I'm coming boys stay strong.

  4. Anonymous

    I agree with the rule-of-law and trust which will be the demise of the dollar but no one will ever ask for an audit of Fort Knox. Whether they loan against the gold or paper trade it, it's there. Enough to satisfy our foreign obligations. If the gold was lacking, government would confiscate the miners.

  5. Bruce Krasting

    I am confused on the excess reserves issue. The Fed agreed to pay interest on reserves. Then it created the reserves and put them in the banking system. The banks deposited them back to the Fed as these excess reserves, right?

    So the next step is the Fed used the excess reserves to buy 'stuff'. They bought Tbonds, F/F MBS. Agency Debt and all the other crap that now adds up to $2 trillion.

    So they spent the Reserves buying paper. This is the QE process.

    If the Reserves go away because the banks find something better to do with the money (make loans) where does the money come from that backs up those assets that have piled up?

    If Excess Reserves were to fall by 10% it would mean $200 billion of funding requirement for the Fed, No?

    Where would that money come from? The Fed could sell $200 billion of its assets and reduce its balance sheet. But that would cause a crisis overnight so that is a non starter. So I am lost as to the Exit Strategy on this.

    On Gold, Yes sure it is worth a lot more than we have it on the books and revaluing it to some higher number would make things look better but it does not solve any problems.

    Say we revalue it to $950. It does not matter. We could sell the gold and raise the $250b it is worth but that would be a disaster for the dollar. This is an "optic" problem. So I do not think gold sales are in the future. Keep in mind that if we sold the whole thing it would reduce Fed debt by 10%. That is nothing.

    This is analogous to California revaluing the Golden Gate Bridge. Sure it is worth much more than what it cost but it does nothing for California unless they sell the bridge. If they did sell it, it would help balance the books, but the likelihood of that is about the same as the sale of all that gold. About "0".

    The US has a cash flow problem. Selling assets is always an option in that situation. But if we start selling things like gold and bridges we will expose the problem and that will surely backfire on us. It is is a desperate measure. We do not have the liquid assets that we can sell to 'fix' the cash flow hole. These numbers are just too large.

  6. Anonymous Monetarist

    Jesse,

    You are spot on about the IOER … please see piece below imaging a conversation , using the parties; exact words, from a recent Grant newsletter:

    Grant's Interest Rate Observer
    Volume 27, number 16
    August 7, 2009

    GRANT: The philosophical question to complement the technical one is whether human beings are fit to manage a system of uncollateralized paper currency?

    YELLEN: I will be the first to say that it is always difficult to get monetary policy just right. but the Fed's analytical prowess is top-notch and our forecasting record is second to none.

    DUDLEY: The Federal Reserve needs to set an IOER rate(that's the interest rate on excess reserves) consistent with the amount of required reserves, money supply and credit outstanding consistent with its dual mandate of full employment and price stability. If demand for credit exceeds what is appropriate, the Federal Reserve raises the IOER to reduce demand. If the demand for credit is insufficient to push the economy to full employment, then the Federal Reserve reduces the IOER rate, recognizing that the IOER rate cannot fall below zero.

    GRANT: Our hunch is that it[the Fed] will overstay its radical easing and mishandle its brand-new "interest on excess reserves" policy device

    However, Jeese, the way I see it is that total excess reserves only represent about 4% of the 18 trillion in bank debt. Loans provided against crappy paper to meet the short term funding needs of crappy paper might represent the majority of these excess funds…

    The Fed loaned against assets no once else would in order to replace the system composed of conduits, SIVs, investment banks/broker dealers, money market funds, hedge funds etc.

    Good summary RGE Mar 2008:

    All these institutions look similar to banks because they are highly leveraged and borrow short and in liquid ways and invest or lend long and in illiquid ways. This shadow financial system is, like banks, subject not only to credit and market risk but also to rollover or liquidity risk, i.e. the risk deriving from having a large stock of short term liabilities (relative to liquid assets) that may not roll over if creditors decide to withdraw their credits to these institutions

    Dudley again : The triparty repo market is a market in which investors such as money market mutual funds lend funds, mostly on an overnight basis, to securities dealers, with the loans collateralized by high-quality securities. During the crisis, this market became less stable. As the financial condition of some of the major securities dealers worsened, the clearing banks became more reluctant to return the cash that the triparty repo investors had invested the prior evening. The clearing banks were worried that if a dealer were to fail, they could be stuck with a large obligation. The nervousness of the clearing banks, in turn, spilled back to the investors. If there is some chance that I might not get my cash back and instead be stuck with the collateral, do I really want to make the loan in the first place?

    So in summary Jesse, the Fed is stuck with the crappy paper and the banks have to maintain funding of insolvent (not illiquid) assets.

    The squeeze of running out of collateral with funding requirements increasing should see excess reserves increase without inflation short-term.

    And why boys and girls will the system need a collateral injection? Cause, wow, its' still matter of solvency not liquidity.

    In addition to the stated bank debt, there is still a quite a few trillion off balance sheet … most of which is in pretty sad shape.

  7. Siggy

    The bank sends assets to the Fed. The Fed issues Dollar credits for the assets. The bank leaves the dollar credit at the Fed as Excess Reserves. The Fed pays nominal interest on the Excess Reserves. What does the bank do with the recevied interest?

    This rigamarole strikes me as being the monetization of what might otherwise be private debt. That monetization is occurring at the rate of the interest being paid on the Excess Reserves.

    Will someone please explain to me why this program does something about curing our asset bubbles and and unservicable debt problem?

  8. Lee Adler

    The reserves were created first when the Fed created the alphabet soup programs, at which time they were paying 1% above Fed Funds, so the banks held the funds which they borrowed under these programs at the Fed because they got a better rate than they could safely get in the market. The net inflationary effect was therefore nil.

    Now that alphabet soup programs are radically shrinking, the Fed keeps the reserve base stoked by buying MBS, GSEs, and Treasuries from the banks. The banks, rather than deploying the fresh cash, have mysteriously been leaving it on deposit at the Fed. Only the Primary Dealers have acted in some small way to deploy the fund speculatively, for the most part by aggressively manipulating stock prices higher, which is their typical knee jerk response when they have plenty of cash.

    Why have the banks at large sat on their hands? The interest rate on the excess reserves at the Fed was lowered to the Fed Funds rate concurrent with the Fed moving the rate to effectively zero. There's no incentive for the banks to hold these funds at the Fed, yet they still do!

    Reason?

    There's no loan demand, nowhere for them to invest the funds where they can earn a safe return. So when the Fed buys MBS securities from them, they hold the cash at the Fed, essentially earning nothing. The impact of the mountain of new Fed credit is therefore nil. Unless and until the banks deploy these funds, they are not inflationary. In essence, the runs off that printing press are still sitting in a locked safe in the basement at 33 Liberty Street, NY, NY.

    They system is broke. Both lenders and borrowers continue to have one objective- get debt off the balance sheet. At the same time, when their capital is further impaired by writing down bad debt, they are forced to hold more cash at the Fed. Under the circumstances, the Fed's massive expansion of the balance sheet is not inflationary. It is pushing on a string, and the string is just crumpling.

    Continued below

    Maybe what we should worry about is the point at which the Fed's balance sheet begins shrinking again. Can that be done without some manifestation of inflation, perhaps hyperinflation?

    Continued below

  9. Lee Adler

    Maybe a financial accountant could expand on or correct this, but if the bank deposits held at the Fed, a Fed liability, begin to decline perhaps due to pressure from withdrawals by bank depositors, then something on the asset side of the balance sheet would have to decline as well. Would not the Fed have to sell an equal portion of its securities holdings to meet the withdrawals, thereby shrinking Fed credit and blunting any expansionary or inflationary effects. Any decrease in the deposit liability would need to be met by an equal decrease in an asset, or increase in a different liability, but what?

    This bulge on the Fed's balance sheet looks like dead weight right now, does it not? The inflationary effect should have come at the outset, but since the system couldn't support it, does this not become a deflationary bomb waiting to explode?

    And is this not why the Fed wants to promote the illusion of inflation, so as not to encourage economic units to further pay down debt? I think that this thing is still an inverse pyramid, with the potential for a massive deflationary collapse still looming.

    I say "potential" because I don't know what will happen, but I want to remain open to any possible outcome, so as not to get locked in to a mindset that could prove disastrous. Although I spend hours studying and reporting on the Fed's actions and its balance sheet each week, I am not a financial accountant, and I may well be missing something.

    We are in uncharted waters here, and so is the Fed, and I have documented over the past couple of years where the Fed has been surprised by the unintended and unanticipated consequences of its actions. By giving it a little thought, we have been able to see some of these things coming.

    Once again, it seems to me that Bernanke has wildly been trying anything and everything to forestall collapse and bring on a moderate inflation, and that there's still no assurance that he will be ultimately successful.

    I do not believe that the current stock market run is any evidence of his ultimate success. We know exactly what is causing this move. I reported on that cause at the time it began, and continue to report on it. One thing seems certain. It cannot be sustained indefinitely. It will either be withdrawn, probably within the next 6 months, or external forces will bring about massive destabilization, most likely within the next couple of years.

    Maybe what we should worry about is the point at which the Fed's balance sheet begins shrinking again. Can that be done without some manifestation of inflation, perhaps hyperinflation?

    Maybe a financial accountant could expand on or correct this, but if the bank deposits held at the Fed, a Fed liability, begin to decline perhaps due to pressure from withdrawals by bank depositors, then something on the asset side of the balance sheet would have to decline as well. Would not the Fed have to sell an equal portion of its securities holdings to meet the withdrawls, thereby shrinking Fed credit and blunting any expansionary or inflationary effects. Any decrease in the deposit liability would need to be met by an equal decrease in an asset, or increase in a different liability, but what?

    Continued below

  10. Lee Adler

    This bulge on the Fed's balance sheet looks like dead weight right now, does it not? The inflationary effect should have come at the outset, but since the system couldn't support it, does this not become a deflationary bomb waiting to explode?

    And is this not why the Fed wants to promote the illusion of inflation, so as not to encourage economic units to further pay down debt? I think that this thing is still an inverse pyramid, with the potential for a massive deflationary collapse still looming.

    I say "potential" because I don't know what will happen, but I want to remain open to any possible outcome, so as not to get locked in to a mindset that could prove disastrous. Although I spend hours studying and reporting on the Fed's actions and its balance sheet each week, I am not a financial accountant, and I may well be missing something.

    We are in uncharted waters here, and so is the Fed, and I have documented over the past couple of years where the Fed has been surprised by the unintended and unanticipated consequences of its actions. By giving it a little thought, we have been able to see some of these things coming.

    Once again, it seems to me that Bernanke has wildly been trying anything and everything to forestall collapse and bring on a moderate inflation, and that there's still no assurance that he will be ultimately successful.

    I do not believe that the current stock market run is any evidence of his ultimate success. We know exactly what is causing this move. I reported on that cause at the time it began, and continue to report on it. One thing seems certain. It cannot be sustained indefinitely. It will either be withdrawn, probably within the next 6 months, or external forces will bring about massive destabilization, most likely within the next couple of years.

  11. don

    In a far reaching interview with Red Pepper, David Harvey argues that the current financial crisis and bank bail-outs could lead to a massive consolidation of the banking system and a return to capitalist ‘business as usual’ – unless there is sustained revolt and pressure for a dramatic redistribution and socialisation of wealth.

    http://www.redpepper.org.uk/Their-crisis-our-challenge

    David Harvey is a Distinguished Professor at the City University of New York (CUNY) and the author of various books, articles, and lectures.

  12. Siggy

    I'd like an audit of the Fed's Balance Sheet. Just what is the massice increase in assets composed of? having moved from a bank to the Fed, the Bank's Balance Sheet suggests that the Bank is no longer insolvent. If you look at Retained Earnings there's been precious little improvement. The Yield Curve will have stay very steep for a long time for these banks to 'earn their way' to solvency.

    Nationalize the banks, restructure and return them to NEW Private Ownership as quickly as possible!

  13. fresno dan

    "Guest Post: When At First You Don't Succeed, Bring In the Reserves – Sunday, August 23, 2009 – Jesse"
    Good article.
    But what gets me about the Fed is that as more and more money is made more and more cheaply available to banks, it seems the people who MIGHT actually be willing and able to borrow are being charged higher rates on credit cards and home equity lines of credit – not to mention how they may not even be eligible for a loan.

    Can the Fed really not understand that? Or am I missing something? I mean, why would anyone borrow now, in a more uncertain time, at higher rates?

  14. Fullcarry

    There seems to be a misunderstanding of excess reserves. There are only two ways a dollar can exist, as part of the banking system or as currency.

    The banking system as a whole cannot extinguish reserves in any material way. The excess reserves are a function of the FED's balance sheet. Only the FED can extinguish aggregate reserves.

    The misunderstanding about reserves seems to be widespread. The NY FED recently issued a paper explaining how reserves in the banking system work. Here is a link to the paper:http://is.gd/2v5Np

  15. Anonymous

    Adler: You answered your own question, there is insufficient data to draw a short term conclusion. While waiting for the consumer to begin spending again government attempts to blow another bubble, somewhere, anywhere.

    Deflation leads to liquidation and is trying to be avoided at all costs.

    So how long is "indefinite?" China cuts back on US paper but Japan and the UK picks up the slack at least this time around.

    Looks more and more likely a bank holiday ensues with a movement of the decimal point lopping off a zero to further extend insolvency. Gold to foreign obligations while consumers languish for decades at best.

    A system where savings is abhorred but credit creation is encouraged. Crazy.

  16. Anonymous

    Fullcary: That paper totally glosses over "when the economy recovers." Federal Reserve actions are stopgap measures. Without the consumers requesting more credit, we're/they are screwed.

  17. Hugh

    I agree with Bruce Krasting and Lee Adler. The Fed is pushing money through a broken system hoping that at some point something will click and everything will go back to normal. There is no indication this will happen.

    As for anonymous monetarist, that is a great, unconsciously funny, quote by Yellen:

    YELLEN: I will be the first to say that it is always difficult to get monetary policy just right. but the Fed's analytical prowess is top-notch and our forecasting record is second to none.

    These are the same guys who couldn't see an $8 trillion housing bubble when it was sitting there immediately in front of them.

  18. But What do I Know?

    Love the picture of Bernancke in MST3K mode–push the button, Ben.

    I thought the original reason for the Fed paying interest on bank reserves was that otherwise the banks wouldn't keep them there (or some such talk). If the Fed cuts the interest rate on the reserves to an undesirable amount, won't that put them back in the same place?

    Can anyone elaborate on this? Thanks.

  19. Fullcarry

    Anon 2:37 That wasn't a point that the paper was trying to address. The point is that the existence of excess reserves in no way tells us anything about bank lending.

    The existence of excess reserves is purely a function of the FED's balance sheet and the statement from the article: "As the Fed's interest rate remains sufficiently high, the reserves, especially the excess reserves, remain in the banking system, and are not deployed actively as loans and inflationary additions to the financial system." is completely misleading. The banks can't materially reduce excess reserves only the FED can.

  20. Fullcarry

    Some additional info:

    There are two ways that the FED can increase the funds rate. It can unwind its balance sheet expansion and eliminate excess reserves in the banking system. This way banks as a whole would be short required reserves and would need to compete to get them. This would increase the funds rate to just below the FED discount rate (assuming no stigma to going to the window).

    The other way would be to allow excess reserves to remain in the banking system and raise the rate the FED pays on excess reserves. Unless they got paid on their excess reserves, banks would play hot potato with their excess reserves until overnight rates got to zero. So paying on excess reserves keeps a floor to the daily funds rate.

    With the ability to pay on excess reserves, the FED is able to maintain its funds target within a channel defined by the discount window at the upper end and interest rate on excess reserves at the lower end.

  21. Anonymous

    Excuse me, the Federal Reserve function is not to artificially control interest rates. They follow the markets because they are not big enough to do anything else. Playing pretend won't effect the final outcome.

  22. Ingolf

    Second Fullcarry's recommendation of the NY Fed article.

    It's well written and clears up many misconceptions.

  23. Jesse

    I am familiar with this Fed Paper referenced, and it changes *nothing* in what I have said.

    The excess reserves are a function of the excess liquidity that the Fed has created, for the most part. That much is obvious.

    The reserves are 'neutralized' by the fact that the Fed is willing to pay interest on the excess reserves.

    This is the same way as saying that the Fed is placing a floor under interestrates without having to drain reserves.

    Its a matter of terminology. The facts remain the same, as do the motivations IF you think about why they are doing what they are doing.

    The NY Fed paper is a bit misleading because they have a bit of an axe to grind whereas I do not.

  24. Jesse

    The point of my essay had nothing to do with the level of the reserves per se.

    It had EVERYTHING to do with the deployment of the reserves.

    It is a tool used by the Fed to manage the interest rate level at a time when it is flooding the banking system with liquidity.

    IF the Fed stopped paying interest on reserves, the banks would be highly motivated to lend, and risk would be discounted.

    This is something FullCarry and so many others forget. The element of 'risk' in addition to the nominal rates on 'riskless' investments.

    It is natural. It is a shame the Fed paper did not have the presence of mind to address this.

    Also FullCarry oversteps in some of his statements.

    The fed is not the SOLE source of reserves, just in this case the overwhelming source.

    Obviously the money multiplier has a hell of a lot to do with it especially in normal circumstances.

    One day the Fed controls all the reserves and money supply, and the next day they don't control anything and all money is created by banks and even non=banks.

    I don't give a fuck what some staffer in the Fed says to take the heat off his boss. Facts are facts. And paying interest rates on the reserves does EXACTLY what I said they do, and if they stopped paying them, lending would increase because banks would start expanding their risk parameters.

  25. Susie Dow

    Facts are facts. And paying interest rates on the reserves does EXACTLY what I said they do, and if they stopped paying them, lending would increase because banks would start expanding their risk parameters.

    What I am unclear on is the WHY?

    Based on your comment, why do they NOT want banks to increase lending? For surely that is the intent if they are paying interest rates on the reserves, no?

  26. Fullcarry

    It is definitely not my intention to upset anyone. There is widespread misunderstanding regardging this subject and I was hoping to add some clarity.

    While it is true that an individual bank can reduce the amount of excess reserves it holds, it isn't true that the banking system as a whole can do that. For example, if bank A lends 100MM to XYZ corporation, that money does not leave the banking system. The money goes from bank A to whatever bank XYZ corporation uses to hold the money. Bank A's excess reserves go down, but the other banks reserves go up. Aggregate reserves in the banking system stay, by and large, unchanged.

    Now many people ask shouldn't required reserves go up in this transaction. It could have some effect, but given bank regulation changes in the early 1990s, banks can reduce their reserve requirement on demand deposits by sweeping the money into other accounts that don't have any reserve requirements. You can see this effect in the following chart: http://is.gd/2whSB. Note also from the chart that during banking credit boom of the 1990s and 2000s, required reserves hardly increased. In fact, you can see that required reserves seem to be more a function of short term interest rates and the opportunity cost of holding money in checking accounts, and have ranged at a relatively meagre amount between $40B and $60B.

    And finally, if there is an economic entity other than the FED that can affect the amount of aggregate reserves in the banking system I would like to know about it.

  27. Anders

    @Susie Dow:
    Well, the only rational explanation I can find is that they believe that the banks should have excess reserves for *something*.

    I guess it is one way to get the banks to keep capital sloshing around without forcibly increasing the capital reserves, since that would make people think the banks are in bad health. If this is a part of the "Recession Is Over – Consume!" charm-offensive, it would make some sense.

  28. Anonymous Monetarist

    Jesse,

    The conventional wisdom is that if the FED were to lower IOER than the banks would lend.

    Of course without an audit of the FED and granularity on FICC 'winnings' discerning whether the funds are 1)sitting waiting for Don Quixote to show up with all that pent-up demand or 2)short-term financing for all the crappy paper cause no one else wants the overnight risk is problematic ..although my bias is that I favor the latter argument.

    The Jackson Holies chanting in unison that they see signs of stabilization but still 'just to be prudent' still have the zero-bound machine set to perpetuity should cause one to consider that perhaps it isn't the boogeyman of 1937 motivating such angst but rather a dear understanding of a financial system where the excess reserves are little more than DIP financing.

  29. Jesse

    The 'level' of reserves is not the point.

    It is the deployment of the excess reserves that is the issue.

    Are they parked at the FED gaining interest there, or are they being used to generate loans.

    This is why I got cranky, because the major point of MY essay is being turned over to a red herring issue, repeatedly.

    But at the risk of returning to the question of excess reserves, the Fed paper itself indicates near the bottom of page 4 individual banks can affect the level of excess reserves.

    But Fullcarry seems to have a good knowledge of bank accounting, and I certainly do not. Perhaps he or she can address each of these examples?

    JPM takes a 40% writedown on its loans and derivatives?

    Goldman Sachs declares bankruptcy and defaults on all its repos and other obligations by 90%?

    Congress passes a program and gives Fannie and Freddie one trillion dollars to immediately make new home mortgages at zero percent interest?

  30. Jesse

    I had an addtional example I wished to inquire about, but I had to close off and attend to the market open.

    The FDIC admits it is insolvent, and as a result the public in general begins withdrawing its deposits in the banks, and selling all its stocks, and places the money in gold and silver purchased from Canada, China and South Africa.

    Also, does the FED posit that it is all central banks that have complete control over its country's excess banking reserves, or is it just the Fed, and if so why? Because they are 'smarter' or because that is how the system works?

  31. Fullcarry

    The excess reserves in the banking system do get mobilized on a daily basis. You see it operating in the money markets driving nominally riskless, short maturing issues (repo, general collateral, USG bills etc) to the IOER. They flow from bank to bank driving the rate on short maturity securities lower. Of course, the process stops once all securities are jammed lower to a rate where a bank decides to go for the IOER. Note that at the end of the day some bank will have to do this no matter how many times the money rotated through the banking system.

    Yes banks can affect the amount of excess reserves, but not aggregate reserves. As banks lend, there could be an increase in demand deposits which would require higher reserve requirement and hence reduce excess reserves. But as I showed in my previous comment that effect would be negligible compared to the amount of aggregate reserves.

    Regarding defaults, note that they have no effect on aggregate reserves. They extinguish assets and liabilities in equal parts.

    Regarding writedowns, it has no effect on aggregate reserves as it is also zero sum in its effects.

    Government (ex FED) needs to borrow or tax to spend and again their actions would have no effect on aggregate reserves.

    Only the FED can affect aggregate reserves.

  32. Fullcarry

    Any public transaction is an exchange of money for a certain good by one party and the reverse by the other party. Money changes hands, but is neither created or destroyed.

    Only the FED has control over aggregate dollar reserves. Other central banks cannot affect this.

  33. Jesse

    And so, if the Fed stopped paying interest on excess reserves, and in fact started charging a small fee for holding excess reserves, what would the likely impact of that be?

    It would lower the bar for lending and make additional transactions feasible.

    And this is the point of the program, and of my essay.

  34. Jesse

    And so, for example, you would say that banks do not 'create money' through the act of lending, but it is the Fed a priori and their creation of reserves?

    I was under the assumption that it is the creation of money which occurs at the point of lending that generates money, and the Fed merely keeps the books balanced.

    But perhaps you think that is incorrect?

  35. Fullcarry

    My issue with the essay as I said earlier was the following statement:

    "As the Fed's interest rate remains sufficiently high, the reserves, especially the excess reserves, remain in the banking system, and are not deployed actively as loans and inflationary additions to the financial system."

    But if your main argument is that the FED should reduce rates further from 15bps and maybe go to negative rates, fine. Others have made that argument and it doesn't need any mention of excess reserves.

    I am an avid follower of your blog and appreciate your clear thinking (especially regarding inflation/deflation). Keep up the great work!

  36. Fullcarry

    Yes commercial banks do create money, but not reserves. As I know you know :), there are money structures (M2, MZM, etc) built upon reserves.

  37. Jesse

    The Fed has created an enormous amount of excess reserves, as you yourself have indicated.

    They have a 'leash' on those reserves through their ability to pay interest and set a 'floor' on the hurdle by which a loan transaction is judged feasible.

    There are times when the Fed 'creates' reserves, and times when the Fed add reserves to keep the system in balance, when the economy is 'vibrant.'

    The point about excess reserves was important because they are indicative of an activist Fed that is grossly expanding the monetary base.

    The interest rate on reserves is important because it is how the FED continues to set interest rates at a time when there are severe imbalances in the traditional makeup of its own asset portfolio.

    At the appropriate time, the Fed can lower or even dispense with the rate it pays on reserves. It can also increase it.

    If they decrease it, what is likely to happen? The loan market will achieve more of the funds.

    If the Fed raised the rate to let's say 20 percent, it would stop the economy cold, because no loans would be made.

    It is a tool for managing the interest rate at a time of extremes in excess reserves in the banking system.

    Why are there extremes in reserves? Because of the actions of the FEd to provide a cushion to the banks because of the state of a good portion of their asset portfolios (probably marked 10 to 20 percent over market at the least).

    How are the banks using this liquidity? Some are sitting on it at the FEd. Some are paying themselves huge salaries and bonuses while gaming the markets.

    These are all the things which that essay said. You hijacked it, bringing in a point (an important one but not germane to my argument) and proceeded to throw a Fed paper at it and dismiss it as mistaken.

    I resented this. I resent it because my goal is to clarify things for people, to make the system and the situation clearer to them, to explain it in as simple terms as I can obtain.

    Many others throw jargon and obtuse examples at them, and make that all too difficult for them.

    They do this for a variety of reasons. Often they have a pet point they would like to make, and have no blog on which to make it. Others purposefully do this, and most often appear on financial television.

    That is the long and short of this, and sir, you may be a 'fan' of my site, but I will ask you not to waste my time playing dodgeball with me by splitting hairs and choosing to selectively answer questions and raise red herring issues.

    That is what I most despise about the economics profession, and you may find my response to be inhospitable.

    Now, I have done with this. I have spent too much time on it as it is, and have probed your points sufficiently to know now what you know.

    And I change nothing in what I said at the first.

  38. Dave in Denver

    @Lee Adler. Lee, I hate to be critical, but there are so many fundamentally incorrect statements in your response Jesse's essay, that I'm wondering if you've ever taken even a basic, fundamental college level economics course.

    Of course, a lot of the material Jesse's essay covers requires a more in-depth understanding of how the Fed operates, but your comment alludes to the idea that instant excess reserves should translate into instant inflation. That is simply outright wrong. If you have studied any statistical time-lag studies, you would know that, depending on the source of liquidity being injected, there's anywhere from a 3 month to at least an 18 month time lag between the policy action implemented and resulting inflation showing up in prices.

    And you don't need to be a "financial accountant" to understand how the Fed books work, although I did take some advance accounting work at U of Chicago GBS in my day. Jesse's analytic work and research is about as thorough and accurate as I've seen on this subject matter.

    To be frank, anyone who read your piece and is not familiar with the subject matter has been seriously misled if they have faith that your commentary is accurate.

  39. Jesse

    The notion that Reserves are completely independent of money supply, that they exist as an entity to themselves, without respect to money creation and the organic growth of the productive economy, is certainly an interesting concept, and perhaps the triumph of monetarism over common sense.

    But I think I have said more than enough.

    This is not 'rocket science.' What the banks lack in integrity they hide behind jargon.

  40. Anonymous Monetarist

    Jesse,

    Have no issue with your long term views, short term though my lens says deflation.

    Deflationistas such as Mish or Depew would agree with you long term but would disagree with the path given deleveraging.

    How is …

    'So to summarize, what is the Fed likely to do if economic activity falters?

    They are likely to lower interest rates paid on excess reserves closer to zero. They could even charge a 'haircut' on excess reserves which would highly motivate the banks.'

    Any different than the savings rates' for folks nowadays? You would agree the consumer is bust , you would agree the banks are bust.

    How could you imagine they will ramp IOER and start 'liquidating' and how in turn would lowering IOER motivate institutions that are too bankrupt to go broke to start financing the windmills? … unless you think we are going to jump the shark to becoming China.

    It would appear that the highest probability is an overshoot of inflation equal in some measure as to how bad the deleveraging turns out to be.

    I appreciate the 'control' IOER gives the Federales and agree with Grant they will wait too long to increase … my point is why they will wait too long …which you would seem to disagree with in dismissing deflationists.

  41. skippy

    @Jesse, Grrrr!!

    The poker game is getting smaller by the quarter, fewer players and bigger sums of monies and the bluff only works till the final call.

    Skippy…Jezz their actually waiting for the planets to come into alignment and then invoke the special incantation, pronounce the gods are sated, whee.

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