This article originally appeared on Real Money at 12 p.m. ET on Feb. 10.
In the last five weeks the Fed has allowed reserve balances at Federal Reserve banks (banks in the Fed's system) to rise to $2.2 trillion from $1.85 trillion, a $375 billion increase. Some might look at this and call it a "stealth" easing. That would not be correct.
The rise in reserve balances obviously reflected upward pressure on the Fed funds rate. The Fed had to allow the level of reserves to rise to sustain its policy rate, which is at 75 basis points at the moment.
Why would there be tightness in the funds rate? The likely reason is that the Treasury has already issued $513 billion more Treasury securities than last year. The sale of Treasuries is a reserve drain and if left unchecked the Funds rate would skyrocket as reserves got drawn down. The Fed counteracts this by conducting open market operations to replenish reserves in the system. That keeps the rate from rising.
On the flip side, if the government never sold securities but just kept spending, reserves would pile up in the banking system and rates would plummet to zero very quickly. In fact, one could argue that the natural rate of interest for a currency issuer is zero. It's not "artificial" like many claim; it's the rate for any currency monopolist.
I have explained in the past why the sale of Treasuries is no longer needed. It dates back to the days of the gold standard when the government would need to drain reserves, otherwise holders of the government's currency could ask for gold in exchange. If that happened then the government's money-creating power would be taken away. The sale of securities was the way it effected this reserve drain.
We are no longer on the gold standard so the sale of Treasuries is an anachronism. Even more so since 2008. That's when the Fed was authorized by Congress to pay interest on reserves directly. This action puts a floor under the rate since no bank will lend reserves under what they can earn from the Fed. That would be like taxing itself.
Operationally, the Fed adds reserves by buying securities from the public. So, in effect, it is sopping up some of the Treasuries that the government sold and replacing it with reserves. Recently, and because of the rate hikes, the Fed itself has been adding reserves via reverse repurchase agreements. That's when the Fed sells some of its securities holdings (mainly Treasuries) to dealers with the promise of buying them back at a higher price in some fixed time, usually a week or two. That action of buying back at a higher price effectively constitutes the "paying" of interest. Those funds add to reserves and to bank deposits. I spoke about bank deposits in the past and noted that they are resuming positive year-over-year growth again after nearly a three-year deceleration.
Unfortunately, all this has done very little to encourage credit demand, a theme I have been covering. Loan growth is decelerating and has been since late August with the slowdown becoming more pronounced recently.
I keep saying this is a barometer of demand, generally, so it's perhaps saying something about the economy. Yesterday I pointed to the steep falloff in gasoline demand as well. It's the sort of decline that we only see in recessions.
Stock investors clearly see things differently at the moment. The jury is still out.