The Federal Reserve on Excess Reserves

Following my recent comments on excess reserves, Bob Murphy linked to a paper, Why Are Banks Holding So Many Excess Reserve? (Pdf), by Federal Reserve economists, Todd Keister and James McAndrews.

The paper appears to lay out fairly clearly the Federal Reserve's view on the current increase in excess reserves, and as a byproduct the increase in the Fed's balance sheet. There's not much to disagree with from a theoretical perspective in the paper. The paper pretty much says that as long as the Fed pays interest on excess reserves, banks won't loan out against the current reserves. But, as Murphy notes, Keister and McAndrews tend to gloss over the necessity that the Fed will have to raise rates quickly if the banks start loaning out against these reserves.

As I wrote in my earlier post:

What if banks begin to believe that times are returning to normal and start making loans against these excess reserves?

The Fed will have to act quickly to prevent this from happening, otherwise the next chart that is going to look like a vertical line up will be money supply growth.

When excess reserves were not so large, banks could only make additional loans (if they didn't have any excess reserves, themselves) by buying reserves via Fed funds and, thus, there was a natural market mechanism pushing the Fed Funds rate higher. With a near trillion in excess reserves in the system that market mechanism is removed and it will require a willful, declared act by the Fed that they are raising the rate they are paying on excess reserves--and all the accompanying political pressures involved with such a move. The Fed's other options remain, draining reserves or changing the reserve requirement.

None of these options are without problems.

Suffice to say, when the market starts to put pressure on rates, and banks begin to loan against the excess reserves, the Fed's moves are going to be extremely limited--and all of them pointing to higher rates much quicker than if the near trillion dollars in excess reserves were not overhanging the market.

Thus, as I pointed out in my first comment, keep an eye on excess reserves. If they start to shrink and required reserves climb, then that means banks are opting to make loans versus opting to earn the interest rate paid by the Fed. At that point,, the Fed has only these options:

1. Allow the loans to be made, which is very inflationary, since it will mean huge increases the money supply.

2. Raise the interest rate they pay on excess reserves, thus pushing all rates higher.

3. Drain reserves, which will also put upward pressure on interest rates, and prevent the Fed from adding to its Treasury securities position.

4. Raise the reserve requirement, which if not executed properly, may, as commenter JS stated in a reply to my earlier post, could result in problems for banks that are not holding excess reserves.

All and all, it's not a pretty picture. How it plays out, unfortunately, we are all likely to find out very soon. In other words, for a signal that the fireworks are about to start keep an eye out for a decline in excess reserves. The fireworks are likely to mean higher rates very quickly.