The people running the Fed are smart, and are attempting to think through the second order effects of their decisions (this is a statement of faith, I guess). Maybe they think it through, to some extent, and then decide based on the first order effects anyway. Who knows.
This article in David Stockman’s blog by Lee Adler is interesting because until I read it, I had kind of assumed the same thing he is saying the Fed assumes. That is, if they pay interest on reserves, the banks will just hold their excess reserves at the Fed and not lend it out. But Adler is right. Banks can easily have it both ways. Thanks to the miracle of fractional reserve banking, they can literally have their cake and eat it too; they can earn the interest on the excess reserves while also loaning out the money 8 or 10 times (up to the reserve limit).
From Adler, with additional embedded quotes from The New York Times’s Binyamin Applebaum:
Yet the Fed has found itself forced to experiment. The immense stimulus campaign that it started in response to the 2008 financial crisis changed its relationship with the financial markets. It has pumped so many dollars into the system that it cannot easily drain enough money to discourage lending, its traditional approach. Instead, the Fed plans to throw more money at the problem, paying lenders not to make loans.
That is correct. The new Fed policy amounts to increasing their government subsidy. It is simple bribery. They will attempt to bribe the banks not to make loans. But they can’t enforce that. The banks will still hold all the cash they did before. The increased subsidy will lower their cost basis. I fail to understand how bribing them by paying them more money and telling them not to lend would work.
The Fed requires banks to set aside reserves in proportion to the deposits the banks accept from customers. The reserves can be kept in cash or held in an account at the Fed. Banks that need reserves at the end of a given day can borrow from banks that have a surplus. Before the crisis, the Fed controlled the interest rate on those loans by modulating the supply of reserves: It lowered interest rates by buying Treasury securities from banks and crediting their accounts, increasing the supply of reserves; it raised rates by selling Treasuries to banks and debiting their accounts.
This is incomplete, but essentially accurate. Most reserve management in recent years was done through the use of Repurchase Agreements, or repos. These were essentially Fed overnight loans to the banks. It was the key to the Fed Funds market–the bank overnight lending market–and the Fed Funds rate. The Fed set a target Fed Funds rate, and then would issue or withdraw repos daily to keep rates within the target range. In order to do that, it kept the level of excess reserves to an absolute minimum. That gave the Fed a measure of control over the Fed Funds rate.
As the crisis hit in 2008, the Fed pressed this machine to its limits. It bought enough securities and pumped enough reserves into the banking system to drive interest rates on short-term loans to nearly zero. The federal government now pays about a dime to borrow $1,000 for one month. Companies with good credit pay about a dollar to borrow $1,000 from money market funds and other investors.
But the Fed didn’t stop there. It kept buying Treasuries and mortgage bonds to eliminate safe havens, forcing money into riskier investments that might generate economic activity. As a byproduct, the Fed kept expanding the supply of reserves.
One result is a banking system almost comically awash in money. In June 2008, banks had about $10.1 billion in their Fed accounts. The total is now $2.6 trillion. Picture all of the money in June 2008 as a single brick; the Fed has added 256 bricks of the same size. On top of that first brick, there is now a stack five stories tall.
Bank of America, for example, had $388 million in its Fed account at the end of June 2008. Seven years later, at the end of June 2015, it had $107 billion. The bank could double in size and double again and still have more reserves than it needs.
To switch metaphors, the old monetary-policy machine sits at the bottom of a lake of excess reserves. The Fed would need to sell most of the securities it has accumulated before short-term rates would start to rise. Selling quickly could roil markets; selling slowly could allow the economy to overheat. So the Fed decided to find another way.
This is the crux of the issue. It is the corner into which the Fed has painted itself. It has made the market dependent on ZIRP and QE, and now the Fed fears what may happen if it withdraws them. The answer is that nobody knows, because this hasn’t been done before under similar circumstances.
What we do know is that the Fed and Wall Street fear the unknown. So they are averse to trying to do what is right and absolutely essential for restoring sanity in incentives for rational investment decisions , rather than the rank speculation and financial market distortion we have had for the past 7 years.
Instead of draining all that excess money, the Fed decided to freeze it.
Paying Banks Not to Lend
For the last seven years, the Fed has encouraged financial risk-taking in the service of its campaign to increase employment and economic growth. By starting to raise interest rates, the Fed intends to gradually discourage risk-taking.
The straightforward part of the plan is persuading banks not to make loans.
In a serendipitous stroke, Congress passed a law shortly before the financial crisis that let the Fed pay interest on the reserves that banks kept at the Fed. Written as a sop to the banking industry, it has become the new linchpin of monetary policy.In fact, if the Fed wants to raise rates, it would need to charge the banks interest on those reserves, not pay interest. In charging the banks interest, it would increase their cost of funds, forcing them to raise rates. This is exactly the opposite of what the Fed is proposing.