The Fed in Reverse
Excess bank reserves are called "high powered money." While they sit in an account at the Fed, they don't directly influence economic activity. But when banks lend, the newly minted money gets into the private sector and affects economic activity. And if there is no excess capacity in the labor or capital markets, inflation ensues.
Just think of how much money the banks can create if their current excess reserves are 33 times more than they need. Given the magnitudes here, the use of the reserve requirement policy tool to control future bank lending doesn't appear to be feasible.
So what about the use of its most powerful traditional tool, OMO? Unfortunately, the recent overuse via QE2 and QE3 has made this tool ineffective. Imagine the Fed trying to control bank lending by reducing excess reserves. It would have to sell trillions of dollars of securities into the open markets before excess reserves would become an issue for the banking system. Where would interest rates be at that point?
Furthermore, long-term fiscal issues have become a real concern. With somewhere between $85 trillion and $120 trillion of unfunded liabilities rapidly approaching, huge fiscal deficits are a certainty barring entitlement, Social Security, Medicare and Medicaid reform.To keep the cost of the debt manageable within the U.S. government budget, the Fed must continue to keep interest rates low. With pressures building internationally for a different world reserve currency, foreign purchases of Treasury debt may diminish in the future. That leaves the Fed as the major lender to the Treasury via OMO purchases. Trying to reduce its holdings of securities at this time would likely result in another financial panic. Unable to use the "sell" side of OMO to influence the banking system, and unable to effectively use reserve requirements because of the magnitude of the imbalance, the Fed is now stuck with only one tool, the discount or borrowing window. Only now, because the financial system is drowning in the sea of liquidity produced by the Fed, the borrowing window and discount rate must now work in reverse. In the traditional use of the borrowing window, the Fed used the discount rate (short-term borrowing rate to encourage (by lowering rates) or discourage (by raising rates) banks from borrowing to lend to the private sector. But now because of the volume of excess reserves created by QE2 and QE3, the Fed will have to use the rate it pays, currently 0.25%/year, to the banks with excess reserves to encourage or discourage bank lending. Yes! Not the rate the banks pay to the Fed to borrow, but the rate the Fed pays to the banks to encourage them to keep their reserves instead of lending them. The original concept of the Fed as the lender of last resort has been turned on its head. Instead of the private-sector banks paying to get needed liquidity, the public sector, i.e., taxpayers, will be paying the banks not to use the excess the Fed has created. It's backward -- it's Bizarro! This article was written by an independent contributor, separate from TheStreet's regular news coverage.
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