Monday, September 23, 2013

The Fed's Bill Dudley: This Is How Panicked We Are About the $2 Trillion In Excess Reserves Overhanging the Economy

The dirty little secret about Ben Bernanke's various QE programs is that much of the QE money, that the Fed has printed, has not ended up in the economy but back at the Fed as excess reserves. Banks earn only the very low rate of 0.25% at the Fed, but they are still parking money there. They do this because the money placed there is risk-free, it is not a charge against capital reserve requirements and it allows banks flexibility on the short-end of the yield curve, if they expect rates to climb in the near future. But once rates start to climb, it is going to be very tempting for banks to pull the money from the Fed and loan it out. That's when the full price inflationary impact of  quantitative easing will be felt, unless the Fed can quickly drain the funds from the system.

In an attempt to prepare for the eventual draining operation of funds from the system, the Fed has created a new "tool," it is called the fixed-rate, full allotment overnight reverse repo facility.

What it really suggests is how panicked the Fed is about the $2 trillion in funds that might come flying out of excess reserves and into the economy.

At a speech today before the Fordham Wall Street Council, Fordham University Graduate School of Business, New York City, Bill Dudley, President of the New York Fed had this to say about the new facility:
[...]such a facility should reassure investors that the Federal Reserve has sufficient tools to manage monetary policy effectively even with a very large balance sheet.
But, they really don't know how it will work. They are just testing it. Here's Dudley again:
 In coming months we will test the facility with two goals in mind.  First, we want to be assured that there are no glitches operationally with somewhat higher transaction volumes than in previous tests, that we can accept cash from a larger array of counterparties, post collateral in the tri-party repo system and reverse the transactions each day smoothly.  Second, while the limited size of the operations during this exercise will prevent the operations from having a significant impact on market rates, we will observe how the facility impacts individual investor demand relative to other market rates.  Additionally, we can see how sensitive that demand is to changes in market conditions such as quarter-end that increase the demand for safe assets.  These observations will give us some insight into how the facility could affect the entire constellation of money market rates.  Only by testing and learning will we be able to assess how best to use the facility.

So Dudley was really blowing smoke, when in another part of the speech, he said:
 There are several reasons motivating our interest in developing such a facility.  First, such a facility should enable the Federal Reserve to improve its control over the level of money market rates[...]Second, this new facility is also likely to reduce the volatility of short-term interest rates.
They really don't know how the facility will really work in game time, panic conditions. But even further, the fact of the matter is that "control" is relative for this facility, even if it can be executed efficiently from a technical perspective. It all depends upon where market rates are in the first place. If market rates are climbing and are, say, at the 5% level, which is causing banks to pull excess reserves and use them in the economy, the Fed will be able to raise the facility rate above 5% to drain reserves, but they won't be able to "control" the rate and push it down to, say, 4.75% and drain reserves from the system. The Fed's control of rates via this facility are limited and could take on a tiger by the tail-type Fed response during a climbing interest environment.

Bottom Line: Excess reserves are a ticking time bomb, the Fed knows it and this new tool does nothing but create another draining tool, of which there are others, but it won't work unless the facility rate is boosted above market rates and therein lies the ticking excess reserve time bomb. The reserves can be drained but only at above market rates. Will the Fed really be willing to push rates higher or will they allow some of the excess reserves to seep into the system? Either alternative does not look pretty.


  1. Two questions:
    1) Why does the Fed not increase the required reserve ratio and cause the "excess" reserves to become "required" reserves, thus locking them up? Are the idiots at the Fed so clueless that they forgot they have this regulatory power, or are they too frightened of what such a move would do to the banks?
    2) When rates go up, of course banks will want to lend. That's the supply action of the supply-and-demand. What about the demand side? When rates go up (prices go up), how much demand for loans will there be?

    1. Not sure about #1. Perhaps its i the special intersts of the major bankers for that not to happen.

      #2. There will probably be a tendency for no one to borrow because of the high rates. The cost of borrowing will be very high. Although no one is borrowing now because confidence is low, regulations are suffocating the market, and businesses are having a tough time handling the coming of the ACA, among other problems as well like inflation.

    2. If rates are rising, it is becuase demand for borrowing is rising or because supply of funds is shrinking (or both), not because no one wants to borrow. It indicates that there is more demand than ready supply, so the market must force the least willing borrowers to forgo borrowing by raising the price of funds above the level at which they would borrow.

      Excess reserves indicate that supply is not constrained (which is what concerns the author of this article and several other people who complain about QE), which means that if investing opportuinties turn up, any ready borrower will likely find funds available at a price of his liking. This could lead to inflation, which is generally the fear with the entire exercise.

      It is hard to see why the writer of this article is so alarmed, however. If rates are rising because of inflation, this new vehicle enables the Fed to raise rates and absorb excess reserves, clamping down on monetary velocity (to offset the expansion of base money from the reserves they have created).

      If rates are rising instead because natural demand for money is rising (a non-inflationary expansion), then the Fed can let banks and financial intermediaries work their will, and slowly drain excess reserves through asset sales and through not rolling over assets as they mature.

      Worst case, as Anonymous notes, they can always increase the level of required reserves (though this would hurt the banks returns on capital), but they could also then slowly ease off that brake as well.

      Quite frankly, while I generally believe markets are the best means of setting rates, I am starting to question some of the political economy of Fed critics. I think the Fed has done a very good job of maintaining the payment system and preventing economic collapse, which is what a reserve bank should do. The sky has not fallen (although monetary policy has not really had much influence on employment, so perhaps it is best to end the experiment) and the economy continues to expand, if not at a rate that would absorb lots of the unemployed rapidly.

      While this last bit is disappointing, I think the Fed deserves some credit.

  2. This might seem counter-intuitive but banks (as a group) cannot "lend out" or spend their reserves. Reserves go up when the Fed balance sheet increases and down when it shrinks. Period.

    When a customer takes out a loan from a bank the bank simply adds the loan balance to the customers checking account. When the customer writes a check on that account - for example to buy a car - the money/reserves wind up at another bank. Total reserves unchanged.

    Reserves can be changed by transferring actual cash (notes and coins) out of the banking system. But this is not common or considered a problem.

    Want to be even more confused - banks (as a whole) don't need reserves or deposits to make loans. The loans become an asset and the newly created deposits a liability.

  3. Strategic Investor, in the short term the FR with its monopoly control of US money does a "pretty good job in maintaining the payment system" and therein lies the problem. If the "payment system" were collapsing the FR would be for all practical purposes a nullity, so in a sense the observation is merely a truism.

    The Austrians have made a strong case that, longer term, inflationary manipulation of the money supply and interest rates for political purposes causes systematic misallocation of resources via bubbles thereby destroying capital. The FR's record since 1913 is abysmal. It has financed senseless wars, prolonged depressions, disincentivized real capital creation, and concentrated what capital remains in the hands of the politically connected, among other things. Society as a whole would be better off without the resulting poverty and hopelessness. Central banking as an enabler of empire and the political class is a real problem.

    Let the US dollar (or any currency) freely compete with any other medium within the US without assessing taxes on monetary exchanges, and see which currencies evolve. The power of the central government would be diminished, in favor of greater prosperity to the people.