The Fed Is Saying One Thing But Doing Something Very Different → Washingtons Blog
The Fed Is Saying One Thing But Doing Something Very Different - Washingtons Blog

Saturday, November 20, 2010

The Fed Is Saying One Thing But Doing Something Very Different

Ben Bernanke has said that the Fed is trying to promote inflation, increase lending, reduce unemployment, and stimulate the economy.

However, the Fed has arguably - to some extent - been working against all of these goals.

For example, as I reported in March, the Fed has been paying the big banks high enough interest on the funds which they deposit at the Fed to discourage banks from making loans. Indeed, the Fed has explicitly stated that - in order to prevent inflation - it wants to ensure that the banks don't loan out money into the economy, but instead deposit it at the Fed:

Why is M1 crashing? [the M1 money multiplier basically measures how much the money supply increases for each $1 increase in the monetary base, and it gives an indication of the "velocity" of money, i.e. how quickly money is circulating through the system]

Because the banks continue to build up their excess reserves, instead of lending out money:

(Click for full image)

These excess reserves, of course, are deposited at the Fed:

(Click for full image)

Why are banks building up their excess reserves?

As the Fed notes:

The Federal Reserve Banks pay interest on required reserve balances--balances held at Reserve Banks to satisfy reserve requirements--and on excess balances--balances held in excess of required reserve balances and contractual clearing balances.

The New York Fed itself said in a July 2009 staff report that the excess reserves are almost entirely due to Fed policy:

Since September 2008, the quantity of reserves in the U.S. banking system has grown dramatically, as shown in Figure 1.1 Prior to the onset of the financial crisis, required reserves were about $40 billion and excess reserves were roughly $1.5 billion. Excess reserves spiked to around $9 billion in August 2007, but then quickly returned to pre-crisis levels and remained there until the middle of September 2008. Following the collapse of Lehman Brothers, however, total reserves began to grow rapidly, climbing above $900 billion by January 2009. As the figure shows, almost all of the increase was in excess reserves. While required reserves rose from $44 billion to $60 billion over this period, this change was dwarfed by the large and unprecedented rise in excess reserves.

[Figure 1 is here]
Why are banks holding so many excess reserves? What do the data in Figure 1 tell us about current economic conditions and about bank lending behavior? Some observers claim that the large increase in excess reserves implies that many of the policies introduced by the Federal Reserve in response to the financial crisis have been ineffective. Rather than promoting the flow of credit to firms and households, it is argued, the data shown in Figure 1 indicate that the money lent to banks and other intermediaries by the Federal Reserve since September 2008 is simply sitting idle in banks’ reserve accounts. Edlin and Jaffee (2009), for example, identify the high level of excess reserves as either the “problem” behind the continuing credit crunch or “if not the problem, one heckuva symptom” (p.2). Commentators have asked why banks are choosing to hold so many reserves instead of lending them out, and some claim that inducing banks to lend their excess reserves is crucial for resolving the credit crisis.

This view has lead to proposals aimed at discouraging banks from holding excess reserves, such as placing a tax on excess reserves (Sumner, 2009) or setting a cap on the amount of excess reserves each bank is allowed to hold (Dasgupta, 2009). Mankiw (2009) discusses historical concerns about people hoarding money during times of financial stress and mentions proposals that were made to tax money holdings in order to encourage lending. He relates these historical episodes to the current situation by noting that “[w]ith banks now holding substantial excess reserves, [this historical] concern about cash hoarding suddenly seems very modern.”

[In fact, however,] the total level of reserves in the banking system is determined almost entirely by the actions of the central bank and is not affected by private banks’ lending decisions.

The liquidity facilities introduced by the Federal Reserve in response to the crisis have created a large quantity of reserves. While changes in bank lending behavior may lead to small changes in the level of required reserves, the vast majority of the newly-created reserves will end up being held as excess reserves almost no matter how banks react. In other words, the quantity of excess reserves depicted in Figure 1 reflects the size of the Federal Reserve’s policy initiatives, but says little or nothing about their effects on bank lending or on the economy more broadly.

This conclusion may seem strange, at first glance, to readers familiar with textbook presentations of the money multiplier.
Why Is The Fed Locking Up Excess Reserves?

Why is the Fed locking up excess reserves?

As Fed Vice Chairman Donald Kohn said in a speech on April 18, 2009:

We are paying interest on excess reserves, which we can use to help provide a floor for the federal funds rate, as it does for other central banks, even if declines in lending or open market operations are not sufficient to bring reserves down to the desired level.
Kohn said in a speech on January 3, 2010:
Because we can now pay interest on excess reserves, we can raise short-term interest rates even with an extraordinarily large volume of reserves in the banking system. Increasing the rate we offer to banks on deposits at the Federal Reserve will put upward pressure on all short-term interest rates.
As the Minneapolis Fed's research consultant, V. V. Chari, wrote this month:
Currently, U.S. banks hold more than $1.1 trillion of reserves with the Federal Reserve System. To restrict excessive flow of reserves back into the economy, the Fed could increase the interest rate it pays on these reserves. Doing so would not only discourage banks from draining their reserve holdings, but would also exert upward pressure on broader market interest rates, since only rates higher than the overnight reserve rate would attract bank funds. In addition, paying interest on reserves is supported by economic theory as a means of reducing monetary inefficiencies, a concept referred to as “the Friedman rule.”
And the conclusion to the above-linked New York Fed article states:
We also discussed the importance of paying interest on reserves when the level of excess reserves is unusually high, as the Federal Reserve began to do in October 2008. Paying interest on reserves allows a central bank to maintain its influence over market interest rates independent of the quantity of reserves created by its liquidity facilities. The central bank can then let the size of these facilities be determined by conditions in the financial sector, while setting its target for the short-term interest rate based on macroeconomic conditions. This ability to separate monetary policy from the quantity of bank reserves is particularly important during the recovery from a financial crisis. If inflationary pressures begin to appear while the liquidity facilities are still in use, the central bank can use its interest-on-reserves policy to raise interest rates without necessarily removing all of the reserves created by the facilities.
As the NY Fed explains in more detail:
The central bank paid interest on reserves to prevent the increase in reserves from driving market interest rates below the level it deemed appropriate given macroeconomic conditions. In such a situation, the absence of a money-multiplier effect should be neither surprising nor troubling.

Is the large quantity of reserves inflationary?

Some observers have expressed concern that the large quantity of reserves will lead to an increase in the inflation rate unless the Federal Reserve acts to remove them quickly once the economy begins to recover. Meltzer (2009), for example, worries that “the enormous increase in bank reserves — caused by the Fed’s purchases of bonds and mortgages — will surely bring on severe inflation if allowed to remain.” Feldstein (2009) expresses similar concern that “when the economy begins to recover, these reserves can be converted into new loans and faster money growth” that will eventually prove inflationary. Under a traditional operational framework, where the central bank influences interest rates and the level of economic activity by changing the quantity of reserves, this concern would be well justified. Now that the Federal Reserve is paying interest on reserves, however, matters are different.

When the economy begins to recover, firms will have more profitable opportunities to invest, increasing their demands for bank loans. Consequently, banks will be presented with more lending opportunities that are profitable at the current level of interest rates. As banks lend more, new deposits will be created and the general level of economic activity will increase. Left unchecked, this growth in lending and economic activity may generate inflationary pressures. Under a traditional operating framework, where no interest is paid on reserves, the central bank must remove nearly all of the excess reserves from the banking system in order to arrest this process. Only by removing these excess reserves can the central bank limit banks’ willingness to lend to firms and households and cause short-term interest rates to rise.

Paying interest on reserves breaks this link between the quantity of reserves and banks’ willingness to lend. By raising the interest rate paid on reserves, the central bank can increase market interest rates and slow the growth of bank lending and economic activity without changing the quantity of reserves. In other words, paying interest on reserves allows the central bank to follow a path for short-term interest rates that is independent of the level of reserves. By choosing this path appropriately, the central bank can guard against inflationary pressures even if financial conditions lead it to maintain a high level of excess reserves.

This logic applies equally well when financial conditions are normal. A central bank may choose to maintain a high level of reserve balances in normal times because doing so offers some important advantages, particularly regarding the operation of the payments system. For example, when banks hold more reserves they tend to rely less on daylight credit from the central bank for payments purposes. They also tend to send payments earlier in the day, on average, which reduces the likelihood of a significant operational disruption or of gridlock in the payments system. To capture these benefits, a central bank may choose to create a high level of reserves as a part of its normal operations, again using the interest rate it pays on reserves to influence market interest rates.
Because financial conditions are not "normal", it appears that preventing inflation seems to be the Fed's overriding purpose in creating conditions ensuring high levels of excess reserves.

As Barron's notes:
The multiplier's decline "corresponds so exactly to the expansion of the Fed's balance sheet," says Constance Hunter, economist at hedge-fund firm Galtere. "It hits at the core of the problem in a credit crisis. Until [the multiplier] expands, we can't get sustainable growth of credit, jobs, consumption, housing. When the multiplier starts to go back up toward 1.8, then we know the psychological logjam has begun to break."

It's not just the Fed. The NY Fed report notes:
Most central banks now pay interest on reserves.
Robert D. Auerbach - an economist with the U.S. House of Representatives Financial Services Committee for eleven years, assisting with oversight of the Federal Reserve, and subsequently Professor of Public Affairs at the Lyndon B. Johnson School of Public Affairs at the University of Texas at Austin - argues that the Fed should slowly reduce the interest paid on reserves so as to stimulate the economy.

Last week, Auerbach wrote:
The stimulative effects of QE2 may be small and the costs may be large. One of these costs will be the payment of billions of dollars by taxpayers to the banks which currently hold over 50 percent of the monetary base, over $1 trillion in reserves. The interest payments are an incentive for banks to hold reserves rather than make business loans. If market interest rates rise, the Federal Reserve may be required to increase these interest payments to prevent the huge amount of bank reserves from flooding the economy. They should follow a different policy that benefits taxpayers and increases the incentive of banks to make business loans as I have previously suggested.
In September, Auerbach explained:

Immediately after the recession took a dramatic dive in September 2008, the Bernanke Fed implemented a policy that continues to further damage the incentive for banks to lend to businesses. On October 6, 2008 the Fed's Board of Governors, chaired by Ben Bernanke, announced it would begin paying interest on the reserve balances of the nation's banks, major lenders to medium and small size businesses.

You don't need a Ph.D. economist to know that if you pay banks ¼ percent risk free interest to hold reserves that they can obtain at near zero interest, that would be an incentive to hold the reserves. The Fed pumped out huge amounts of money, with the base of the money supply more than doubling from August 2008 to August 2010, reaching $1.99 trillion. Guess who has over half of this money parked in cold storage? The banks have $1.085 trillion on reserves drawing interest, The Fed records show they were paid $2.18 billion interest on these reserves in 2009.

A number of people spoke about the disincentive for bank lending embedded in this policy including Chairman Bernanke.

Jim McTague, Washington Editor of Barrons, wrote in his February 2, 2009 column, "Where's the Stimulus:" "Increasing the supply of credit might help pump up spending, too. University of Texas Professor Robert Auerbach an economist who studied under the late Milton Friedman, thinks he has the makings of a malpractice suit against Federal Reserve Chairman Ben Bernanke, as the Fed is holding a record number of reserves: $901 billion in January as opposed to $44 billion in September, when the Fed began paying interest on money commercial banks parked at the central bank. The banks prefer the sure rate of return they get by sitting in cash, not making loans. Fed, stop paying, he says."

Shortly after this article appeared Fed Chairman Bernanke explained: "Because banks should be unwilling to lend reserves at a rate lower than they can receive from the Fed, the interest rate the Fed pays on bank reserves should help to set a floor on the overnight interest rate." (National Press Club, February 18, 2009) That was an admission that the Fed's payment of interest on reserves did impair bank lending. Bernanke's rationale for interest payments on reserves included preventing banks from lending at lower interest rates. That is illogical at a time when the Fed's target interest rate for federal funds, the small market for interbank loans, was zero to a quarter of one percent. The banks would be unlikely to lend at negative rates of interest -- paying people to take their money -- even without the Fed paying the banks to hold reserves.

The next month William T. Gavin, an excellent economist at the St. Louis Federal Reserve, wrote in its March\April 2009 publication: "first, for the individual bank, the risk-free rate of ¼ percent must be the bank's perception of its best investment opportunity."

The Bernanke Fed's policy was a repetition of what the Fed did in 1936 and 1937 which helped drive the country into a second depression. Why does Chairman Bernanke, who has studied the Great Depression of the 1930's and has surely read the classic 1963 account of improper actions by the Fed on bank reserves described by Milton Friedman and Anna Schwartz, repeat the mistaken policy?

As the economy pulled out of the deep recession in 1936 the Fed Board thought the U.S. banks had too much excess reserves, so they began to raise the reserves banks were required to hold. In three steps from August 1936 to May 1937 they doubled the reserve requirements for the large banks (13 percent to 26 percent of checkable deposits) and the country banks (7 percent to 14 percent of checkable deposits).

Friedman and Schwartz ask: "why seek to immobilize reserves at that time?" The economy went back into a deep depression. The Bernanke Fed's 2008 to 2010 policy also immobilizes the banking system's reserves reducing the banks' incentive to make loans.

This is a bad policy even if the banks approve. The correct policy now should be to slowly reduce the interest paid on bank reserves to zero and simultaneously maintain a moderate increase in the money supply by slowly raising the short term market interest rate targeted by the Fed. Keeping the short term target interest rate at zero causes many problems, not the least of which is allowing banks to borrow at a zero interest rate and sit on their reserves so they can receive billions in interest from the taxpayers via the Fed. Business loans from banks are vital to the nations' recovery.

The fact that the Fed is suppressing lending and inflation at a time when it says it is trying to encourage both shows that the Fed is saying one thing and doing something else entirely.

I have previously pointed out numerous other ways in which the Fed is working against its stated goals, such as:
And see this.

Postscript: If the Fed really wants to stimulate the economy, it should try Steve Keen's idea.


  1. This is very interesting, indeed. But I refuse to believe that people like Bernanke are not aware (after all these two, almost three years of such policies and such results) what they are doing?

    So this really stinks to a well conceived plan to prevent recession recovery, right? Why? Probably in order to push the working class against the fence once more by increasing unemployment.

    Or what else? Can you tell me why they are doing this?

  2. The US banking system is terribly bankrupt. The Bernank cannot state this fact. So everything else is collateral damage, which seems to be just deserts in a way, in a country that thinks nothing of real collateral damage it causes countries.

    Today on the Sunday talk shows, Hilary Clinton expressionlessly described who it is OK to kill in Afghnanistan, and who it is problematic to kill. The placid, zombie face of true evil.

  3. This game of economic chess is being played against several competitor-players, and against numerous trends that also amount to unpredictable real-world adversaries.

    It is not a game for the faint of heart, except as a know-it-all who has nothing much to lose.

    Nor is this necessarily a game for the deeply reflective.

    The Fed has set as a goal re-inflating the credit economy of the West, and -like a typically obsessive-compulsive computer- he has continued down this path regardless the negative consequences to the economy, quality of life or the increasingly tenuous planetary condition.

    Not unlike Norwegian polar explorer Roald Amundsen, Ben Bernanke is going to drive his dogs to exhaustion, whereupon he seems intent upon eating them.

    Those dogs Bernanke is going to eat -are the economies of every other country on earth.

    Things are really tough outside this country right now, really-really tough. Don't fool yourself about that.

    This is a different world, and one that no one, not even Ben Bernanke, fully understands.

    BUT, you can rest assured, what is going on behind the scenes is fully couched in the reassuring delusional comfort, that the US has all the marbles in the game -in a game, being played in its own backyard -where more marbles are being rolled off the presses, and everyone who holds America's marbles is rooting for Bernanke's complete success.

    If Bernanke wins his war with the windmills, the world will be completely dollarized when he gets through.

    If Bernanke loses his war with the windmills, the world will be completely dollarized when he gets through.

    The route there comes in two flavors.

    The first flavor is, every other world sovereign will fold before Bernanke runs out of marbles.

    The second flavor is, one of those sovereigns will -scream and holler that Ben Bernanke is cheating, -threaten war, -and suffer the consequences of picking a fight with the biggest economic and military bully on the planet.

    Neither flavor Ben Bernanke is pursuing makes any sense, except in some insane inclination for the worse-than perverse preservation of the Armageddon-bound status quo.

    But, at least -for the time being- this is not like Mutually Assured Destruction.

    For the time being, any country that either argues too belligerently -or- even bets aggressively against the Fed, is going to face its own destruction -all alone-.

    No one voted for any of this. The conditions that led to this circumstance have come barreling down the mountainside like an avalanche of fate.

    But I see no parallel to the supposed end of the Roman Empire. The barbarians then were much more aggressive, much more reckless and persistent in their repeated attempts to topple that Empire.

    And even those barbarians were entirely absorbed.

    The final chapter of Gibbon's -Decline and Fall- covers history well into the 15th Century A.D.

    And really, nothing so much has changed to allow anyone to say, -this is the end of the Roman Empire.

    Gibbon simply got tired of writing his several-thousand-page tome -I think.

  4. the fed is saving the banksters... at a tremendous cost here and the rest of the world

  5. Does no one here get this stuff??? The Fed is paying interest on excess reserves held at a Fed bank. Period. So say you are a bank and you need to hold reserves. You will hold the money where you are getting interest to hold it AND you will lend it out!!! The Fed is feeding more money to the banks. PERIOD. The fact these banks are holding it at the Fed only makes good sense. This doesn't limit how much they are lending out. It's still used to calculate how much they can lend. They are getting an extra quarter point interest which means the money supply has been expanded by an extra quarter point on those reserves and they can then take that money multiply it by 10 AND LEND IT OUT. So therefore they now have the capability to expand the money supply by 2.5% of the money held in excess at the Fed and they get to lend that out at interest. Meaning more money has to be created to pay off that being lent. etc etc.

    The banks used to make money by holding transactional cash but guess what - in a cashless socity they can't do that. So what do they do? They take an orchestrated financial crisis and use it as an opportunity to write themselves a way to create even more money. Why? Because banks make money by making money. Get it. They take your money and lend it back to you and then make you take more money to pay them back. Guess what the next step will be once things start getting out of control - the Fed will start paying even more interest on excess reserves in the guise of controlling inflation. But that will in fact fuel inflation which will be to the bank's benefit even more so.

    Does no one here know how the banking system works??? Most of the money that is created in the system is created through the private banks themselves - not by the Fed. That's why it's a fractional reserve banking system. If the private bank holds one dollar at the Fed, it can create nine dollars on the outside. Now the Fed pays interest on that one dollar i.e. more dollars are created. Where does that interest come from??? More debt. Whose debt??? Taxpayer debt because every dollar issued by the Fed is a Treasury liability ultimately even if it isn't created by the Fed. When the banks blew up who was on the hook? The taxpayer. Why? Because ultimately the banks have no real assets. The assets they are lending are the public's (i.e. the taxpayer's deposits whether Treasury or otherwise). All the banks do, in a nutshell, is churn those assets (actually liabilities) to take a cut and generate even more liabilities (what are falsely considered assets but can't be because all money is debt and all debt is money).

    What the banks are doing with the cash they can create on the outside is another thing. Maybe they are sitting on it. Maybe they are using it to play the market and maybe they are lending it to their own hedgefund buddies. Who knows. You can guess who will be the last to find out though. And just in case you can't here's a hint: it's you.

    Don't believe what I say - do your own investigating or wait and find out the hard way. And be very careful what you are consuming from people who profess to have any clue and are in fact clueless, and from those who intend to misdirect because I guarantee those are out here in cyberspace as well. If you don't want to be bothered with any of this, just sign a blank check to the GS/JPM consortium.

  6. My conclusion is that it is really all about non-inflationary monetizing of the government debt rather than whatever the Fed says it is about.

  7. The privately owned Federal Reserve Central Banking system functions for the benefit of the multinational bank owners, not for the American public. Naturally, the Fed lies to imply that they function for the public economic good and well being.

    A Free (Free to whom?) Trade “jobless economic recovery” is laughable. Our government and economy is dominated by an Oligarchy of multinational corporations that are merely world banker assets. They are the ones who put America in the economic situation that we are in today.

    How can new industry grow in the USA with innovation of new technology when the emerging industry is whisk away to foreign countries for cheaper manufacturing and higher profits for the monopoly of multinational corporations?

    “Free Trade” instead of “Fair Trade” has been death to the American manufacturing economy. Remember, the American taxpayer developed computer and internet technology that would have sustained our American economy for one hundred years by selling our product through out the world with Fair Trade?

    Free Trade hollowed out the American manufacturing economy base in favor of Globization and world governance by the monopoly of multinational banks and corporations. The Fed has no stimulus plans to develop new technology and industry inside the United States of America; they want to maintain the manufacturing status quo and the advancement of world governance (power) and currency.

    Where are the unencumbered grants to stimulate inventors of new green energy technology that would move the world away from the use of fossil fuels? The Federal government has taxpayer developed electromagnetic advancements in technology that would spur new manufacturing but how would we keep the manufacturing in the United States under Free (sic) Trade?

    I knew when the corrupt Congress passed new Currency, Bankruptcy and Patent laws that the citizens of the United States was destined to be Fascist controlled by debt servitude and that is what we have today.

    “Free (sic) Trade not Fair Trade” will be written on our United States of America epitaph unless there is a revolution today or tomorrow to change it. We need a list of names for prosecution, there is not that many of them, they are just high placed in government and central banking; these people need to be identified and replaced, and soon.

  8. ALL Banks are criminal enterprises. They create money out of thin air by ledger entry, using the borrower's downpayment and credit/cashflow to give it value. The banks provide no good and valuable consideration. Only the borrower does. The banks generally don't even sign the document, making it non-enforceable, if anyone cares to challenge it.
    Banks and financial crisis


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