Saturday, August 22, 2009

Is the Eye on the Wrong Federal Reserve Ball?

WSJ is dutifully reporting from Jackson Hole that both Ben Bernanke and Fed Vice Chairman Donald Kohn are stating that they plan to maintain rates at low levels for the foreseeable future. This may be what Bernanke and Kohn would like to see, but the real variable in the equation may be with the banking sector.

Currently, the banking sector is holding huge excess reserves. Take a look at this chart:



Note: Look in the last gray box denoting recession and you will see a straight blue line up in the box. For the rest of the 60 years, there is a blue line near zero, since bankers in the last 60 years never kept excess reserves to the degree they are today.


We are certainly living in unprecedented times. 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.

If the Fed tries to drain reserves to halt such an occurrence, this will decidedly put upward pressure on short-term rates. As the Fed will have to be buying net assets as opposed to selling them. A second option would be for the Fed to raise the reserve requirement to prevent the banks from aggressively making new loans. But if the banks are suddenly willing to make loans, the banks may start to bid for reserves, thus pushing up rates in that fashion.

Bottom line: In many ways, the rate decision can be forced by commercial bank sentiment and not Federal Reserve policy. Further, one wrong move by the Fed could mean huge inflation, or an error in the other direction could mean significant deflation. It's as though the economy is in intensive care and the attending physician has decided to use the intravenous tube as a jump rope, with the patient still attached to it. Who knows when it will be pulled out, ripped, or juiced with a huge new dose of medication?

9 comments:

  1. Robert, I think what is happening here is that even though the definition of reserves has not changed, that what is today considered reserves is anything but. These excess reserves are backstopping the absolute trash (bad loans) that is the rest of the banks reserves. If they start lending, the Fed can force the banks back to mark-to-market and get the FDIC to close them down. I think that is the gun that will keep things in check.

    The wild-card though, could be Congress. If they pressure banks to start lending and create legislation, then the Fed is screwed and your concerns become realized.

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  2. The Fed started paying interest on excess reserves (during the Bush administration). Banks have an incentive to let the money sit and generate a super safe return.

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  3. Bernanke bumped up the interest paid on excess reserves during the fall 2008 implosion.

    http://peureport.blogspot.com/2008/10/credit-seizing-up-again.html

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  4. http://www.youtube.com/watch?v=e3zo7zjYk2E

    I strongly believe we need a federal reserve audit. The recent stock market action suggests to me the federal reserve is intervening in a free and open market. I believe the biggest beneficiary of this TRILLION DOLLAR stock market move in a couple of weeks was Goldman Sachs. Goldman Sachs sells derivatives in our equity markets its apparent that Goldman Sachs Has Total Control Over our stock market using the unlimited capital available from the federal reserve. I believe Goldman Sachs doesn't have the best interest of our markets. They are misusing the federal reserve to manipulate the stock market and making huge 100 BILLION DOLLAR profits THIS IS ILLEGAL people expect our government to obey the laws just like citizen. Also this manipulation without regards for cost continues to put our government and the people more and more in debt

    JUST THE FACT GOLDMAN SACHS HAS HAD SUCH IMPOSSIBLE SUCCESS AT TRADING IS ALL THE PROOF OUR GOVERNMENT NEEDS TO KNOW TO PROVE MANIPULATION!!!!!!


    AUDIT THE FEDERAL RESERVE

    http://www.auditthefed.com/

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  5. Do we know how spread out the excess reserves are? If it's mainly the big banks holding those reserves, then raising the reserve ratio would nuke the smaller banks without the excess reserves. I don't see how Ben can raise the ratio if the reserves are extremely equally distributed.

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  6. @JS

    Very good point. I'm not sure if there is any public breakdown on the ditribution of the reserves. I'm going to see if I can find out.

    But remember, Berrnanke is a tinkerer and he will get desperate so there is nothing to stop him from saying, the reserve requirement is raised for any bank that as of xx-09 had excess reserves greater than y.

    We are truly living in new times.

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  7. It's about time. This global financial crisis has dragged on for too long.

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  8. I suppose I cheated and read the PDF " Why Are Banks Holding So Many Excess Reserve?" before I read this post....Am I crazy or is the fact that the fed pulled money out of the system (practically, not technically) by paying interest on the reserves one of the things that got us here in the first place?......Also, tell me if I'm wrong, but doesn't the interest give them a little bit more control over money in the system? and take some of the control out of the hands of the government by basically side stepping bonds?

    Even if I'm 100% off base, your blog is one of the greatest pieces of media anywhere.

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  9. Good Move Obama keep up the good work..

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