Sunday, November 16, 2008

Paying Banks to Hold Excess Reserves - Huge Mistake, Huge!

At the conclusion of the previous post I said that I would next explain how the Fed was getting ready to convert their control of monetary policy from what I claim is currently an "iron bar" to that limp "string" that many economists claim the Fed is always pushing on.

Fed Accelerates Plan to Pay Interest on Excess Reserves

In this press release, the Federal Reserve announced its intention to begin paying interest, for the first time ever, on excess reserves held by banks. One of the expressed reasons for doing so is cited at the end of the 7th paragraph: "Paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector."

Unfortunately, it is that very opportunity cost that created the "iron bar" of monetary policy discussed in the previous post. As of October 1, 2008, that "iron bar" has been converted into a "limp string" and I fear the Federal Reserve has now lost control of monetary policy without even realizing they've done so.

Read the Monograph!

In nearly every post I refer to A Monograph on Monetary Policy, an unpublished paper that I wrote several years ago to explain how monetary policy has worked in this country for decades. If you've read it and actually understand it then you will also understand that it was the "opportunity cost of holding required reserves" that the Fed has just set out to "essentially eliminate" which gave the Fed tremendous power over the economy in the short run, and over inflation levels in the long run.

Now the Fed has relinquished a large part of that power. I say "a large part" because they still have a 75 basis point (0.75%) penalty rate that they impose, but that will likely not be enough to prevent banks from just holding onto excess reserves at the end of the two-week reserve calculation period. In the past, banks treated such reserves essentially as toxic waste and circulated them aggressively in an effort to drive their "opportunity cost" down to the minimum possible.

Again, as explained in the monograph, this "toxic waste" treatment resulted ultimately in the "iron bar." That is, even a modest provision of excess reserves would result in money growth. Conversely, a modest withdrawal of reserves, resulting in negative excess reserves would cause banks to have to scramble to find reserves, a process that resulted in an almost immediate contraction of the banking system as measured by demand deposit balances (with all the caveats discussed in the monograph applicable here.)

Japan, Again?

This country has been on a Japanese trajectory for over 20 years now. Japan had their stock market mania, then their real estate bust and then their lost decade, a decade when the Japanese monetary authorities could not get their money supply to expand. The reason for that failure was that they made the mistake of allowing the equivalent of their fed funds rate to go to nearly zero. This removed the "opportunity cost" that our own Fed is so concerned about, resulting in converting their iron bar of policy to the limp string so often discussed. The result was that for years they were indeed attempting to run the monetary policy of Japan by "pushing on a string."

This is why Bernanke was justified in being so concerned about deflation in the early part of this decade, a time when our Fed Funds rate was headed dangerously close to zero (though I doubt, given the recent decision, that he was concerned for the right reason.)

Now, we have doubled the reasons to be concerned. We are once again pushing the interest rate on federal funds to near zero, thereby risking the emulation of Japan's policy that created their "lost decade," and we have gone them one better by paying interest on excess reserve balances, thereby creating a situation where even at higher interest rates the Fed will have no power (or a much reduced power) to reverse a decline in the money supply.

What to Conclude?

Assuming the Fed has relinquished its power to easily and forcefully affect policy, in the sense that they could easily adjust reserves and thereby force money supply to increase or decrease accordingly (and quickly), force the economy to adjust accordingly (within a relatively short span of just six months) and force the inflation rate to adjust as well (over a much longer span of several years,) then we have entered, as they say, interesting times.

My advice, to myself as well as others, is to pay close attention to the level of demand deposits. They have ballooned since mid-September at an unprecedented rate. (Note that this process began several weeks before the Fed implemented the new policy of paying interest on excess reserve balances incidentally, indicating that the massive provision of excess reserves at that time had an immediate effect on the money supply.) Now, if the world works as laid out in the monograph, in almost exactly six months from mid-September, i.e., in about mid-March, the economic statistics will start looking up. Retail sales will have already rebounded, durable goods orders will also have begun turning up and the March (or possibly April) unemployment report will provide the final confirmation that the worst has passed. During that time, the stock market will have rebounded as well, greased by easy money and leading the economy, as usual, by several months. (A side forecast: When this happens, falling gasoline prices will get most of the credit.)

The Caveat

All of this is more or less baked in the pie already unless the Fed's new policy of paying interest on excess reserve balances results in their relinquishing control of monetary policy, as would be evidenced by a steady decline of the level of demand deposits over the next several months in spite of massive reserve provision by the Fed. The entire point of this post is that this might indeed happen. If it does, it would be nice if someone besides me actually understood why it was happening.

This concludes what I have to contribute to the theoretical discussion surrounding monetary policy and reserve management. I might add one further post that lays out what I believe a sensible reserve regulation regimen should look like, but if I never do that, simply going back to the 1950's policy would be an excellent beginning. This is not to say that we should run policy as we did in the 50's, 60's and 70's, because even then the Fed did not fully understand their potential power. But the 1950's reserve regulations gave them exactly the powers they need today, powers they have now all but relinquished.

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