This comes as a shock. The Federal Reserve is about to abandon its attempt to issue their own debt. As I have pointed out before, the Fed was attempting to get Congressional approval to issue debt as a way to sop up the monetary base, once the money multiplier returns to a more normal level, otherwise money growth will skyrocket.
Reports Bloomberg:
The Federal Reserve has backed off from seeking a new tool to forestall inflation, refraining from asking Congress for the power to issue its own debt, according to a person familiar with the matter.There is only one reason the Fed would refrain from asking Congress for this power, the Fed's reputation on the Hill is sinking, and sinking fast.
No wonder the Fed has hired a lobbyist to deal with Congress.
So what other option is the Fed considering as an alternative to debt issuance? (Note: The Fed could also work with the Treasury and have the Treasury issue more debt and have the proceeds deposited with the Fed, which would shrink the monetary base, but this runs into debt ceiling problems and thus dealing with Congress again)
According to Bloomberg:
If the Fed's move to pull the debt request was a shock, the Fed's Option 2 is shock squared. This is a never before tried "tool" for controlling money growth.
The central bank intends to rely instead on paying interest on banks’ reserve deposits to prevent a flood of cash into the economy.
Although paying interest on reserves would supply incentive for banks to not convert the funds to physical cash, it would not, unless regulations are changed in some other way, create incentive for banks to stop lending money out on their reserves.
Perhaps what the Fed will do is pay more interest on reserves that are not actually backing any loans outstanding, and less interest on reserves that are. The next question becomes, "What rate will the Fed have to pay and how will the Fed prevent a mass exodus away from making loans to simply depositing with the Fed at the higher rate and earn money risk free?".
It is clear we are headed into uncharted outer space, where the potential for a disastrous misstep has increased significantly. The Fed can create workarounds for all the questions I have raised, but with each new tinkering the potential for a move with serious unintended consequences grows dramatically.
Very interesting point.
ReplyDeleteAlthough paying interest on reserves would supply incentive for banks to not convert the funds to physical cash, it would not, unless regulations are changed in some other way, create incentive for banks to stop lending money out on their reserves.
ReplyDeleteI'm not sure about this. It's true that for the system as a whole, reserves don't go down when a bank decides to make additional loans.
However, from the individual bank's point of view, if it starts out with $100 million in excess reserves, and then makes a loan for $100 million, won't most of those reserves end up getting wired to other banks? I.e. when the first bank's customer writes checks on that $100 million, which end up deposited (presumably) at other banks, doesn't the interbank clearing end up moving most of the $100 million elsewhere?
--@BobMurphy
ReplyDeleteMy point is that the Fed could neuter those reserves by paying a high enough interest rate. Say for example that a bank does have $100 million in excess reserves. If the Fed decides to pay 10% on those reserves, why would the bank loan the money out at a lower rate? It will let the money sit with the Fed, and no loans will be made.
That said, it is always dangerous to monkey with such a complex and important system. Who knows what the Fed has failed to take into consideration? Remember, they already had to rush to fix a problem with correspondent banks because of their tinkering.