Economics Questions

Re: Question for Esuric regarding interest paid on excess reserves.

chloe732 — Tue, 21 Sep 2010 03:30:38 GMT

Esuric,

Thanks, you've confirmed what I suspected.

So here is the situation (as I see it): The Fed will continue quantitative easing (since its "interest rate policy tanked"), thus propping up the treasury market and bond market (MBS's).

Since extinguishing this high powered money will crash the bond markets, the Fed will instead tinker with the interest rate it pays on excess reserves for the foreseeable future. If banks do start lending, and monetary aggregates expand more than the Fed desires, the Fed will increase the rate it pays on excess reserves rather than selling treasuries (or MBS's), thus putting a break on lending (but the bank's will keep their interest spreads nice and fat).

In other words, we are looking at a one way direction for monetary policy; expansion.

From 1980 to 2008, it was one direction (expansion) but with periods of tightening (fed funds went from 20% to 0%). Now, it will be 0% fed funds, and QE into the future to keep bond yields low, something Greenspan never attempted directly. Control of the money supply will now be directed through the rate paid on excess reserves.

From the Austrian perspective, I am describing a dooms day scenario, correct? A malinvested capital structure will (again) follow. Busts are therefore inevitable in spite of the Fed's tinkering and low interest rates.

Esuric, is my scenario accurate? If so, the economy is going to have hell to pay, 2008 was just the beginning. We ain't seen nothin' yet.

Re: Question for Esuric regarding interest paid on excess reserves.

Esuric — Mon, 20 Sep 2010 08:43:50 GMT

Doesn't the Fed's interest on reserves provide a disincentive to lend as the bank can get .25% at no risk on money created from nothing?

Yes, exactly, and that's the point. The central bank has expanded the supply of high powered money (monetary base, or M0) to such an extent that the monetary aggregates would expand to uncontrollable levels once the banks began lending. This would, of course, lead to extremely severe general price inflation.

The FED immediately slashed the FFR to 0% in order restore confidence and stabilize expectations. In other words, it is their way of saying that they will prevent a deflationary spiral (correction) at all costs, which they perceive to be the greatest economic threat (it also propped up the stock market). Unfortunately, they cannot drain the system of excess reserves without collapsing the demand for government securities. The demand for T-Bills is, right now, a function of open market purchases by the FED. Thus if the FED engaged in open market sales, the demand for U.S. debt would collapse, interest rates would spike, and we would experience a severe depression.

Simply put, this new tool of monetary policy allows them to directly prevent an expansion in the monetary aggregates. In other words, Obama denounces the banks for not lending while Bernanke pays them not lend.

Question for Esuric regarding interest paid on excess reserves.

chloe732 — Mon, 20 Sep 2010 06:21:09 GMT

I understand the Fed is paying .25% to banks as interest on excess reserve balances. Why is the Fed doing this?

Here is my understanding of the situation: The banking system loan portfolios have been decimated, net worth has been impaired (TARP and TAG postponed the liquidation). Thus, the banks can't lend.

The Fed created an extraordinary amount of excess reserves in the system by buying short term and long term treasuries, MBS's, etc. These reserves would normally be loaned out, but now sit on the books of the banks as assets.

The banks can choose to invest these reserves in U.S. Treasuries, which props up the bond market, loan them overnight to other banks at 0% to .25%, or leave them on account at the Fed at .25%.

Doesn't the Fed's interest on reserves provide a disincentive to lend as the bank can get .25% at no risk on money created from nothing?

If the Fed wants to re-ignite fractional reserve lending, why are they paying interest on reserves? Merely to provide banks with income to rebuild their net worth? Or is there more going on here?