The Fed's Policy May Be Responsible for Interbank Lending Seize-Up

A great discussion of the Fed's balance sheet at Econbrowser 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.

With a rapidly increasing monetary base pictured below, we have near term deflation as this new money is not circulating yet.

Are these intended or unintended deflationary consequences of a 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.

Stock position: Long SPY, Short TLT.

Comments

[Smarty_Pants:]

"The Fed's Policy"

The answer to every financial problem is to create more money.

2008 Oct 27 12:01 PM

[dlaw:]

This is a ridiculous thesis fit only for those who - because of self-interest or prejudice - cannot possibly bring themselves to blame the obvious culprits here: the PRIVATE financial system.

If left to their own devices, these criminally-badly-manag... banks and insurance companies would destroy the financial system. In fact, they nearly have.

Try and blame the government all you like: Deflations Eat Lies.

2008 Oct 27 01:58 PM

[Michael B. ...:]

The title isn't mine. The original is 'partially responsible.' The responsibility clearly lies in the originator of the bad loans. My point is that Fed intervention in this prescribed way may be exacerbating the problem, and will most likely have long term effects that may be considered detrimental to some end.

2008 Oct 27 10:30 PM

[Moon Kil Woong:]

This is about the Fed's interest on deposit's policy. And yes, it may contribute. Anytime their is a increased reward for taking $ out of the public market and putting it into bonds or reserves etc. it takes money out of the economy by slowing the money multiplier.

Clearly the deficit is a drag on us as is the billions being held in foreign countries. Adding the fact the Fed needs more money and will pay interest only adds to pressure to dump money into low yield safer government pots rather than going to riskier higher yield corporate bonds, mortgages, etc.

The way the fed is going there is no reason for private banks at all. They pay interest, guarantee banks, money markets, mortgages, bank to bank lending, brokerage deposits, CDs, and just about everything else. They also need more deposits. In fact, guaranteeing brokerage deposits, CDs, etc. only makes putting money into the banks less appealing and will probably contribute to even more bank failures and problems.

Helicopter Bernake who's famous speech was, if there is a problem the fed can just fly over and start dumping money out of a helicopter must go. That is why Bush Jr. liked him. That is why it was insane to pick him to be the head of the Fed. But after all, it is a private bank who's interest has nothing to do with the general public. We get no say in how they screw the economy.

2008 Oct 27 11:40 PM

[flow5:]

The FFR is 1.5% & (1.5% - .35 basis points = 1.15% or the interest rate on excess reserves). This compares to .96% for 3 month T-Bills on 10/23/08. Thus it is more profitable to hold balances at the Reserve banks, than buy creditorship obligations.

The required interest rate payment is 1.4%. This is of course more restrictive and is a disincentive to loan or invest.

Increases in bank credit & the money stock can be offset by indirectly raising reserve ratios (pegs). Depending upon the FFR formula used for the payment of interest on "excess reserves", the FED's new tool can be used as a credit control device.

(I.e., payment of interest on excess, & required reserves (inter-bank demand deposits (IBDDs) held in the Reserve Banks, owned by the member banks, or excess reserves & legal reserves), is method by which the "trading desk" can raise commercial bank reserve requirements . I.e., the higher the volume of discretionary or liquidity reserves held by the banks; where risk-free payments are applied, (excess reserves & required reserve balances), the lower the banking system's “ expansion coefficient” , or weighed arithmetic average of reserve ratios applicable to deposit liabilities.

Presumably, the volume of inter-bank lending, and borrowing, will be reduced. I.e., the Reserve Banks will attract a disproportionately larger volume of (interest-bearing) unused, excess-balances, and this will displace trading in the FFR market (where the market risk is unknown).

These balances and potentially balances (excess vault cash, excess clearing balances, and pass-through balances), may be increased, or redistributed, and add to the excess, interest-bearing reserves.

Since 1942 bankers have remained fully "lent up", i.e., they held no excessive amount of excess legal lending capacity to finance business (or consumers). Excess reserves were used to acquire a piece of the national debt or other creditorship obligations that are eligible for bank investment. Now the FED is either "Pushing on a string", or simply offsetting their liqudity infusions.

2008 Oct 28 09:53 AM