Wednesday, July 21, 2010

Further Confusion about Excess Reserves

WSJ is out with a comment that if the Fed eliminated interest on excess reserves, it would not impact the economy. To back-up this absurd notion they quote Joseph Abate at Barclay's Bank.

WSJ on Abate:
He noted much of the money that constitutes this giant pile of reserves is “precautionary liquidity.” If banks didn’t get interest from the Fed they would shift those funds into short-term, low-risk markets such as the repo, Treasury bill and agency discount note markets, where the funds are readily accessible in case of need. Put another way, Abate doesn’t see this money getting tied up in bank loans or the other activities that would help increase credit, in turn boosting overall economic momentum.

Abate buttressed his argument that banks really just want to stay liquid by noting who is holding reserves at the Fed. He said the 25 largest U.S. banks account for just over half of aggregate reserve levels, with three by themselves making up 21% of the reserves.
Ah, note to WSJ and Abate, if banks move funds out of excess reserves and put it anywhere else, it means the money is in the economy (as opposed when it sits as excess reserves). This would, at a minimum (assuming Abate's belief that there would be no money multiplier impact--though this is questionable), mean that an additional trillion dollars would be in the system. That would result in at least a 12.5% increase in the money supply (M2)---more than likely much more, if further lending is done against the reserves.

Bottom line: An elimination of interest on excess reserves, far from being a non-event, should be considered a nuclear option, with only bad consequences. Bernanke at some point may play around with the rate on excess reserves, but he is not going to eliminate the rate all together, or even come close to doing so.

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