The Trap Janet Yellen Will Be In

There are $2.3 trillion sitting as excess reserves at the Fed that could enter the economy at any time. That is the legacy Ben Bernanke is leaving Janet Yellen ("He left the lady with trillions in excess reserves to deal with."). At WSJ, Phil Gramm and Thomas R. Saving detail just how big a problem this will be for Yellen. They write:

If we listen to the Fed governors, the potentially explosive increase in the money supply inherent in the current $2.3 trillion of excess bank reserves won’t be allowed to occur. At the first sign of a real economic recovery, the Fed will sell Treasurys and mortgage-backed securities (MBSs) to soak up excess bank reserves, or achieve the same result through repurchase agreements and paying banks to hold excess reserves.

It sounds simple, but in a full-blown recovery the Fed will have to execute its exit strategy quickly enough to keep the inflation genie in the bottle without driving interest rates up to levels that would derail the recovery. And every month that the Fed’s monetary expansion continues, its exit strategy becomes more difficult and dangerous[...]

Even if the Fed could sell its MBSs, absorb its losses and withstand the public outcry as mortgage rates soared, its work would not yet be finished. The Fed would still need to move about $600 billion of U.S. Treasurys off its books to reduce excess reserves in the banking system. The effect of these sales would be substantial, since the Fed now finances 62% of the deficit and holds 18% of all marketable Treasury securities. And as a legacy of its “Operation Twist,” the Fed now owns 36% of all Treasury securities with maturities between five and 10 years and 40% with maturities longer than 10 years. Selling this long-term debt would compound market disruption[...]

As the Treasury borrows to meet its interest expense and the Fed sells assets to soak up excess bank reserves, private borrowing will be crowded out and the recovery will start to crater. The pressure on the Fed to stop selling will be immense, but if it does, banks will respond to rising interest rates by making more loans with their excess reserves. The money supply will spike, putting upward pressure on prices[...]

Fed Chairman Ben Bernanke tells us there is another way to stop the banks from lending out their excess reserves—by increasing the 0.25% interest the Fed now pays on bank deposits it holds. As the Fed pays higher interest on deposits, Fed earnings, the source of the $88.9 billion the Fed remitted to the Treasury last year, will begin to dry up. Treasury borrowing will increase as interest payments from the Fed decline. And interest paid to banks will add to the monetary base and can itself fuel a multiple increase in the money supply.

If the Fed uses its bond holdings as collateral to borrow (a reverse repo) it can lock up excess reserves for a given period of time, but the impact would be the same as paying banks not to lend. Paying banks not to lend or selling repos as rising interest rates choke off the recovery will create a political firestorm. Such a policy would be unworkable over any extended period of time.

Finally, the Fed could simply raise reserve requirements and force the banks to hold the expanded monetary base. However, it’s hard to imagine that reserve requirements could be increased anything like the more than 25 times current levels that might be required to absorb the existing level of excess reserves, without crushing any recovery.

The last time the Fed tried to absorb the excess reserves of the banking system by dramatically raising reserve requirements was in 1936. Then, a less than doubling of reserve requirements helped send the economy back into the depression[...]


Never in our history has so much money been spent to produce so little good, and the full bill for this failed policy has yet to arrive. No such explosion of debt has ever escaped a day of reckoning and no such monetary surge has ever had a happy ending.