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The Fed Plan to Revive High-Powered Money; Don't only drop the interest rate paid on banks' excess reserves, charge them
Topic Started: 13 Dec 2013, 09:22 AM (652 Views)
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The Fed Plan to Revive High-Powered Money

Don't only drop the interest rate paid on banks' excess reserves, charge them.

Alan S. Blinder
Dec. 10, 2013 6:34 p.m. ET

Unless you are part of the tiny portion of humanity that dotes on every utterance of the Federal Open Market Committee, you probably missed an important statement regarding the arcane world of "excess reserves" buried deep in the minutes of its Oct. 29-30 policy meeting. It reads: "[M]ost participants thought that a reduction by the Board of Governors in the interest rate paid on excess reserves could be worth considering at some stage."

As perhaps the longest-running promoter of reducing the interest paid on excess reserves, even turning the rate negative, I can assure you that those buried words were momentous. The Fed is famously given to understatement. So when it says that "most" members of its policy committee think a change "could be worth considering," that's almost like saying they love the idea. That's news because they haven't loved it before.

So what exactly are excess reserves, and why should you care? Like most central banks, the Fed requires banks to hold reserves—mainly deposits in their "checking accounts" at the Fed—against transactions deposits. Any reserves held over and above these requirements are called excess reserves.

Not long ago—say, until Lehman Brothers failed in September 2008—banks held virtually no excess reserves because idle cash earned them nothing. But today they hold a whopping $2.5 trillion in excess reserves, on which the Fed pays them an interest rate of 25 basis points—for an annual total of about $6.25 billion. That 25 basis points, what the Fed calls the IOER (interest on excess reserves), is the issue.

Unlike the Fed's main policy tool, the federal-funds rate, the IOER is not market-determined. It's completely controlled by the Fed. So instead of paying banks to hold all those excess reserves, it could charge banks a small fee, i.e., a negative interest rate, for the privilege.

At this point, you're probably thinking: "Wait. If the Fed charged banks rather than paid them, wouldn't bankers shun excess reserves?" Yes, and that's precisely the point. Excess reserves sitting idle in banks' accounts at the Fed do nothing to boost the economy. We want banks to use the money.

If the Fed turned the IOER negative, banks would hold fewer excess reserves, maybe a lot fewer. They'd find other uses for the money. One such use would be buying short-term securities. Another would probably be lending more, which is what we want.

A second reason for cutting the IOER answers some of the criticisms the Fed has taken for its asset-buying programs called quantitative-easing: Doing so would stimulate the economy without increasing the size of the Fed's balance sheet. In fact, the Fed could probably shrink its balance sheet.

To understand why, think back to the good old days, when excess reserves were zero. When the Fed injected reserves into the banking system, banks would use those funds to increase lending, thereby creating multiple expansions of the money supply and credit. Bank reserves were called "high-powered money" because each new dollar of reserves led to several additional dollars of money and credit.

The financial crisis short-circuited this process. As greed gave way to fear, bankers decided to store trillions of dollars safely at the Fed rather than lend them out. High-powered money became powerless money.

The Fed compounded the problem in October 2008 by starting to pay interest on reserves. And these days, the 25-basis-point IOER looks pretty good compared with most short-term money rates. If banks were charged rather than paid 25 basis points, they would find holding excess reserves a lot less attractive. As some of this excess central-bank money became "high-powered" again, the Fed would want less of it. So its balance sheet could shrink.

What are the arguments against turning the IOER negative? Over the years, Fed officials have made three, none of them cogent.

One is that cutting the IOER would have only modest stimulative effects. Well, probably. But are there more powerful tools sitting around unused? Besides, there is at least a chance that we'd get more new lending than the Fed thinks.

Second, there is a limit to how far negative the IOER can go. After all, banks can earn zero by keeping paper money in their vaults. So if the Fed charged a very high fee for holding excess reserves, bankers might find it worthwhile to pay the costs of bigger vaults and more security guards in order to keep huge stockpiles of cash. Sure. But a mere 25 basis point fee is not enough incentive for them to do so.

Third, a negative IOER could drive short-term interest rates even closer to zero, as banks moved balances from their reserve accounts into money market instruments. And that, we are told, would wreak havoc in the money markets. Really? Perhaps that was a legitimate concern three years ago, but we have now lived with money-market rates hugging zero for years, and capitalism has survived.

Besides, the Fed paid no interest on reserves for the first 94 years of its existence, the European Central Bank has been paying its banks nothing since July 2012, and the Danes have been charging a fee since then. In no case did anything terrible happen.

That said, suppose the policy failed. Suppose the Fed cut the IOER from 25 basis points to minus 25 basis points, and banks didn't react at all; they just held on to all their excess reserves. In that unlikely event, cutting the IOER would neither provide stimulus nor enable the Fed to shrink its balance sheet. However, the Fed would start collecting about $6.25 billion per year in fees from banks instead of paying them $6.25 billion in interest—a swing of roughly $12.5 billion in the taxpayers' favor. Some downside.

Read more: http://online.wsj.com/news/articles/SB10001424052702303997604579238403178592262
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peter fraser
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The Eurozone is also considering negative interest rates on bank reserves. I read an article on it last night. I'll see if I can find it as it explains the process and what it would expect to achieve.

Any expressed market opinion is my own and is not to be taken as financial advice
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Elastic
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The problem as I see it and the author fails to address is that the excess reserves will become like a hot potato. He seems to think that once lent out, the reserves will no longer be excess reserves. If the Fed gets rid of QE and the banks use the reserves to buy government bonds it will work out Ok but installing this policy while running QE is asking for trouble by encouraging banks to engage in risky lending.
The difference between the EU countries using negative rates on reserves is that I don't think they have a massive quantity of excees reserves in the system like the US.
Only a rat can win a rat race.

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Count du Monet
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As I've explained before, excess reserves are at the most fundamental level simply excess cash. And excess cash has to be shoveled back into circulation or you get deflation like no tomorrow.

It's always loaned back into the market some way or another. The excess reserves of the commercial banks immediately show up on the central bank balance sheet.

That's why it is called "a central bank".



The big question is not whether the cash is being loaned back into the market............the question is the terms.

The term of the loans and the rates being payed.

The banks will hold money via short term loans to the market..........in popular parlance these are also called reserves because they are available for bigger projects when in so many days they are returned to the bank. You can ask for a 30 year loan and the bank can fund it in so many days via the return of short term loans.

The effects following the GFC is the switch from longer term lending to shorter term lending, mainly because longer term lending has offered few useful projects. This isn't the situation in Australia the RBA isn't holding much in excess reserves. But it has been a big number at the FED, ECB, BOE etc since the GFC.

Forcing the banks to get rid of excess reserves could result in the commercial banks raising their fees on transaction accounts. And then money is no longer an asset and more of a liability. That will mean the death of fiat money and a return to gold under the bed.
The next trick of our glorious banks will be to charge us a fee for using net bank!!!
You are no longer customer, you are property!!!

Don't be SAUCY with me Bernaisse
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