ByElisa Parisi-Capone

Despite direct asset purchases of US$868 billion through the Fed’s $1.75 trillion asset purchase program, and despite the about $500 billion in total outstanding liquidity facilities as of the end of July (according to the Fed’s monthly report “Credit and Liquidity Programs and the Balance Sheet – August 2009”), most of the new liquidity appears not to have extended beyond banks. End consumers and non-financial corporations still face declining credit growth.

Source: Federal Reserve data, H.8 Release, own calculation

At the same time, commercial banks’ excess reserves holdings with the central bank have increased sharply. The Fed’s H.3 release shows total reserves by depository institutions for the month of July 2009 to have reached $795.6 billion—of which $62.6 billion is required reserves and $733 billion is excess reserve holdings.

Source: Federal Reserve, H.3 Release

Indeed, the money multiplier, which tracks private sector credit creation in response to changes to the central bank’s monetary base, slowed sharply and failed to return to its pre-Lehman level in spite of the liquidity and asset purchase programs.

Source: Federal Reserve Board data, H.3 and H.6 Release, own calculation

M0 = Monetary Base = sum of currency in circulation  plus commercial banks’ reserves with the central bank.

M2 = currency in circulation plus overnight deposits/checking accounts (=M1) plus time-related deposits, incl. savings deposits, and non-institutional money-market funds.

All series seasonally adjusted.

Are the Central Bank’s Lending Programs Not Working?

In “Why Are Banks Holding So Many Excess Reserves?,” the NY Fed’s Todd Keister and James McAndrews show that by replacing either an interbank or a private sector loan with a central bank loan, the lending facilities do in fact allow the smooth rollover of maturing liabilities, regardless of the fact that, in accounting terms, all of the central bank’s loans and asset purchases are matched by an equal increase in reserve holdings. Bank lending to the private sector can at most change the composition of total reserves between excess and required reserves, but the authors note that in the face of large liquidity programs, the share of required reserves will remain small. It is thus inaccurate to view large excess reserve holdings a priori as ineffective if the aim of the policies is the stabilization of the banking system and not an explicit increase in bank lending to the private sector. Incentives for the latter depend on the opportunity costs of reserve holdings as discussed below. In the case of direct asset purchases, the central bank creates permanent reserve balances which remain in place until the purchased assets mature or are sold.

Keister and McAndrews provide the following example:

“Bank A and Bank B have each $10 in capital and $100 in deposits (liabilities) and hold $10 as required reserves and $10 in securities (assets). Total reserves with the central bank are $20. Now Bank B borrows $40 from Bank A and then the interbank market freezes. If additional deposits cannot be raised or a loan from another bank obtained Bank B will have to reduce lending by $40” and potentially face a bank run.

“Now suppose that the central bank lends $40 to Bank B. In making this loan, the central bank credits $40 to Bank B’s reserve account. Bank B can then use these funds to repay Bank A without decreasing its lending.  For Bank B, the loan from the central bank has replaced the interbank loan. Bank A holds the funds that it previously lent to Bank B as reserves. Notice the change in reserve holdings: total reserves have increased to $60, and excess reserves are now equal to $40.

“The policy is highly effective in this regard: it prevents Bank B from having to reduce its lending by $40. This simple example illustrates how such a policy creates, as a byproduct, a large quantity of excess reserves. Looking at aggregate data on bank reserves, one might be tempted to conclude that the central bank’s policy did nothing to promote bank lending, since all of the $40 lent by the central bank ended up being held as excess reserves. The point of the example is that such a conclusion would be completely unwarranted.”

Importantly, the same dynamics hold if the central bank lent directly to companies that hold deposit accounts in a bank, only in that case the share of required reserves would end up being  higher: “This is a general principle: Central bank loans to banks, loans to other firms, and direct asset purchases by the central bank all increase the level of reserves in the banking system by exactly the same amount.” However, “while lending by banks (to corporations and consumers) does not change the total level of reserves in the banking system, it does affect the composition of that total between required reserves and excess reserves.”

Opportunity Cost of Excess Reserve Holdings and Interest on Reserves

Whether banks have an incentive to lend reserves out or not depends on the respective levels of the target interest rate and the interest on reserves (i.e. the floor rate). “When the two are equal, the multiplier effect does not even start because banks never face an opportunity cost of holding reserves,” Keister and McAndrews write. Currently, the fed funds target rate is at 0-0.25% and interest on reserves is at 0.25%. “In such a situation,” they write, “the absence of a money-multiplier effect should be neither surprising nor troubling.” In this case, the liquidity programs are primarily directed to ease the strains in the interbank market, and not to increase bank lending to firms and households.

What happens if the target interest rate and interest on reserves are not equal? The ECB, as explained in Keister, Martin, and McAndrews (2008), operates a symmetric channel (or corridor) system that currently pays 0.25% on bank deposits whereas the main refinancing operations rate is 1% (and the marginal lending facility rate is 1.75%).  The target rate is thus higher than the interest on deposits (i.e. there are higher opportunity costs of reserve holdings), which sets in motion the multiplier process. Keister and McAndrews write: “When reserves earn interest, the multiplier process stops sooner. Instead of continuing to the point where the market interest rate is zero, the process will now stop when the market interest rate reaches the rate paid by the central bank on reserves.”

Source: ECB data and here, own calculation

M0 = Monetary Base = sum of currency in circulation  plus commercial banks’ reserves with the central bank.

M2 = currency in circulation plus overnight deposits (=M1) plus time-related deposits, incl. savings deposits, and non-institutional money-market funds.

M3 = Broad Money = M2 plus institutional money, incl. repos, money market fund shares/units, debt securities issued with maturity up to 2 years.

All series seasonally adjusted.

Source: ECB data, own calculation

Are Large Reserve Holdings Inflationary?

Since the creation of large reserve balances may conflict with the central bank’s target interest rate, the interest on reserves tool gives the central bank the ability to put an effective floor on how low the market interest rate can fall, regardless of the amount of reserve balances required to stabilize the banking system. Central bankers are confident that the interest on reserves tool allows them to fine-tune monetary policy (update: instead of private sector credit) and thus keep inflationary pressures at bay.

Deutsche Bank’s Sebastian Becker offers a broader picture in “Is the next global liquidity glut on its way?” and concludes that “it may only be a matter of time until investors become increasingly unwilling to hold liquidity at the current low level of return.”

 Graph Source: Deutsche Bank

For the time being, however, the dash for cash continues unabated (see chart below). As ECB president Jean-Claude Trichet notes in the September 3, 2009, Introductory Statement:

“The recent changes in interest rates paid on the different instruments included in M3 have continued to underlie the strong shifts in the allocation of funds from, in particular, short-term time deposits to overnight deposits. The deceleration in annual M3 growth has thus continued to combine with a substantial further strengthening of annual M1 growth, which in July rose to 12.1%. In addition, the relatively steep yield curve and the re-emergence of risk appetite, reflected particularly in the increase in stock prices over the past few months, may have dampened M3 growth to some extent.”

Fed and ECB data

M1 = currency in circulation plus non-interest bearing overnight deposits

One strand of literature viewing the self-perpetuating preference for cash in a low interest rate environment as more than just a temporary aberration is the Liquidity Trap literature. The jury is still out.

RT Finance and Banking, RT Macroeconomy, RT Monetary Policy and Inflation, RT North America, RT United States