Fed paying interest on deposits = causing credit lockup

Discussion in 'Economics' started by scriabinop23, Oct 27, 2008.

  1. Pretty complex stuff worth reading over a few times, but I think the gist is this: The Fed is paying interest to banks on their reserve holdings. This disincentivizes them from lending out to other banks when they can earn interest on the cash.

    So in actuality, the Fed is deliberately freezing the credit markets and not inflating (yet) in exchange for recapitalizing the banks. The minute the fed stops paying interest on reserves, the new money in the system will start sloshing around, credit markets will unlock, and inflation will take off...


    An interesting comment:

    It seems to me that this cannot go on like this.

    The Treasury is issuing new debt, and the proceeds from those purchases of debt end up as increases in reserve balances at the Fed, and the Fed is paying interest on reserves in order to keep the funds there and thereby prevent inflation. But by paying interest on reserves, the Fed is shutting down the credit system, because banks no longer lend to each other if they can earn interest on their reserves at the Fed.

    It seems to me that the Fed has a choice: it can continue to prop up banks while shutting down the credit system, by paying interest on reserves, or it can restart interbank lending by not paying interest on reserves, at the cost of igniting inflation. I think eventually inflation is inevitable, if phrased in these terms.
  2. Here's a quick blog on it, since I consider this genuinely compelling:


    A great discussion of the Fed's balance sheet at <a href="http://www.econbrowser.com/archives/2008/10/the_federal_res.html">Econbrowser</a> bears fruit of realization that banks are disincentivized to lend out when they can earn interest from the Fed directly on their reserve balances, as per the following release:

    Release Date: October 6, 2008

    For release at 8:15 a.m. EDT

    The Federal Reserve Board on Monday announced that it will begin to pay interest on depository institutions' required and excess reserve balances. The payment of interest on excess reserve balances will give the Federal Reserve greater scope to use its lending programs to address conditions in credit markets while also maintaining the federal funds rate close to the target established by the Federal Open Market Committee. </blockquote>

    With a rapidly increasing <a href="http://research.stlouisfed.org/fred2/series/BASE?cid=124">monetary base</a> pictured below, we have near term deflation as this new money is not circulating yet.


    Are these intended or unintended deflationary consequences of policy designed to recapitalize the banking system? Considering our system can not afford deflation on a long term basis (due to our ballooning debts and dependence on uptrending tax revenues), I imagine these policies will eventually be revoked. In the end, this new money supply will not be inert as it is now when policies are reset back to normal. It looks like the end game is a future which holds either high Fed Fund rates to mop up this extra supply and some extreme level of inflation.
  3. This is very interesting for sure. Kind of fills in a piece of the puzzle for me. Germany got away with printing money post-WWI for a while because people were saving and there were rations and such, the inflation hit when people started spending again.

    The model didn't quite fit with the US because we aren't savers and even in this environment, we're starting to save, but not large amounts.

    Seems like this is our "saving," but it's not by the people, it's by the banks themselves.

    Thanks for the thread!
  4. Daal


    The fed doesnt pay interest on reserves to 'prevent inflation'. They do it to reach that target rate without running out of treasuries. What they do to prevent inflation is tap the treasury for more bonds, they dont want to do that forever and keep pressuring the treasury and the bond market with more issuance.

    Paying interest on reserves doesnt cause a 'credit lockup', they pay a lower rate to encourage lending, looking at the effective fed funds rate there is no way the fed funds market is even close to locked right now. If anything its too loose, thats why they hiked the rate
  5. If I as a bank CEO were receiving interest on reserves, at amount, especially in this environment, I would be less incentivized to lend versus if I received nothing on reserves. It doesn't matter if the interest gained on lending is sufficiently higher than keeping the funds from going anywhere.

    This policy must be having a real effect and have introduced an unexpected lending dynamic to the market. No bank CEO will complain about it since it contributes to recapitalize him at zero risk, even albeit slowly.

    Take a look - now only .35 under FF:


    Uncirculating reserves are not the original idea the treasury sold to congress.
  6. I never said the goal of paying interest on reserves was anti-inflationary. But an effect of uncirculating money even with increased money supply is in the near term -not- inflationary. As long as the money stays in the bank, it is the same as practically not existing (for purposes of the argument that money supply affects inflation rates).
  7. Daal


    you know what else does that?lending at the fed funds market and guess what banks are doing that in a VERY loose fashion. if the interest on reserves had driven the fed funds rate to 5% then your argument would make sense
  8. http://www.newyorkfed.org/markets/omo/dmm/fedfundsdata.cfm

    Last few days of fed funds...

    10/24 0.95 1/4 2 0.21 1.50

    10/23 0.93 1/4 2 0.28 1.50

    10/22* 0.81 1/4 2 0.27 1.50

    10/21 0.67 1/4 2 0.33 1.50

    10/20 0.70 1/4 2 0.33 1.50

    Why would I lend at fed funds at .95 or lower when I can get paid on reserves at 1.15 ? (1.5 - .35)
  9. Which brings another point... a question: If I can borrow at the discount window at 1.75, and collect 1.15 on those reserves, then my true cost of borrowing is 60bp, right ? What a great way to ride out bad home loans and maintain reserve ratios.

    These sort of dynamics probably explain why foreclosures are not coming to the REO market at bargain basement prices in the past month or so. When you can borrow at 60bp to hold the inventory, no reason to sell now.
  10. Daal


    thats the point the fed is trying to make, they need to hike the interest rate to discourage banks from lending at the fed funds market at less than the target. but the point is that banks have so much cash they are lending like hell, not to the consumer but into the fed market. they dont seem slighly worried

    the fed staff are a bunch of academics but if the interest on reserves were causing a credit lockup you would expect these phds from the Chicago University to notice
    #10     Oct 27, 2008