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Home Publications Blogs Beat the Press Did the Fed's Decision to Pay Interest on Reserves Slow Growth?

Did the Fed's Decision to Pay Interest on Reserves Slow Growth?

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Saturday, 28 August 2010 07:23

In his speech at the annual meeting of central bankers in Jackson Hole, Wyoming, Federal Reserve Board Chairman Ben Bernanke listed his options to counter a faltering economy. One of the three items on the list was reducing the 0.25 percent interest rate that the Federal Reserve Board now pays on reserves.

It is striking that Bernanke would include this item on his list because he just instituted the policy of paying interest on reserves last year. At the time there was no discussion of the possibility that paying interest on reserves would have any significant negative impact on growth. If paying interest does not slow growth, then reducing the interest rate paid on reserves cannot raise growth.

Reporters covering Mr. Bernanke's speech should have made this point, since it suggests that he does not have any real plans to deal with a weak economy. It would have also been worth pointing out that the economy is growing much slower than the 3.0 to 3.5 percent range that the Fed had forecast earlier in the year. The second quarter data showed the economy growing just 1.6 percent, with final demand growing at a 1.0 percent rate. If Bernanke is prepared to take action in response to a weak economy, this would appear to be the time, as the unemployment rate is likely to rise through the rest of the year.

It is worth noting that at this gathering 5 years ago the participants debated whether Alan Greenspan was the greatest central banker of all time.

Comments (11)Add Comment
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written by Fed Up, August 28, 2010 9:12
Reserves are not the problem. The "banks" are either capital constrained, can't find creditworthy borrowers, creditworthy borrowers do NOT want to borrow, or some combination.
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written by flow5, August 29, 2010 1:47
The volume of interbank demand deposits held at the District Reserve Banks, owned by the member banks reached the all-time high (as a percentage of note and deposit liabilities) @ 91.1% in 1941. This past percentage is much higher than the current volume of $1.035T in excess reserves now existing (@ c. $1,045T/$9,214T or total reserves @ $1,099.2T/$9,214T).

In effect, the FED has doubled the maturity distribution (based on Treasury securities), now covered under the level of the remuneration rate’s umbrella (in just the last couple of months).

The BOG's remuneration rate @ .25% on excess reserves (interbank demand deposits - IBDDs), held at the District Reserve Banks, owned by the member banks, now exceeds the Daily Treasury Yield Curve (from previously 6 months), all the way out to 1 full year.

In effect, the FED has tightened monetary policy as IORs (interest on reserves), are the functional equivalent of required reserves. I.e., an increase in the volume of outstanding un-used IBDDs (other things being equal), acts just like an increase in the volume of required reserves would; both types of reserve balances decrease the legal lending capacity of the member commercial banks (by siphoning the liquidity out of , or limiting the expansion of, the commercial banking system).

Note: the Board of Governors of the Federal Reserve System (BOG) defines legal reserve requirements as: "the amount of funds that a depository institution must hold in reserve against specified deposit liabilities". Bank reserves are held as vault cash & as District Reserve Bank deposits.

By increasing the variety, and thus the volume, of competitive instruments and yields (vis a' vis IORs), the FED makes it less and less likely that the member banks will want to make new loans or purchase new investments (i.e., it is less and less likely that the money supply will grow).

Note: every time a commercial bank makes a loan to, or buys securities from, the non-bank public, it initially creates an equal volume of new money.

But that’s just the beginning. Whereas the member banks once were unencumbered and unimpaired in their lending operations, now they are constrained by excessive levels of bank capital adequacy ratios, and:

(1) declining numbers of qualifying credit appraisals (a) of the bank’s established customers, (b) let alone the demonstrated, & verified appraisals of newly qualified customers) &

(2) the continuing deterioration in investment grade (credit quality), eligible securities (bond rating tiers are continuously - revised downward – some to eventually junk): –-- both have disappeared.

This scenario is contractionary. It belies a downward contraction, and a cumulative and reinforcing, deflationary spiral, i.e., credit destruction. It belies a full scale induced depression. It fits the definition of “pushing on a string”.
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written by flow5, August 29, 2010 1:52
It’s a scientific fact that economic forecasts are mathematically infallible. Nominal GDP will cascade in the 4th qtr (down in every month - Oct, Nov, & Dec), without extra (upwards of the linear path), fiscal & monetary intervention/stimulus. It is a sure bet that Congress will fail to act. We will never reach "escape velocity".


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written by flow5, August 29, 2010 1:55
this is a lousy metric (a surrogate-- because the FED discontinued the G.6 release). but it's better than anything the FED uses. it is inconsistent & non-conforming, but, we still definitely, & unquestionately, know the future:

2010jan,,,,,,,0.54,,,,,,,0.22top
2010feb,,,,,,,0.5,,,,,,,0.09
2010mar,,,,,,,0.56,,,,,,,0.07
2010apr,,,,,,,0.55,,,,,,,0.13top
2010may,,,,,,,0.48,,,,,,,0.05bottom
2010jun,,,,,,,0.47,,,,,,,0.04
2010jul,,,,,,,0.5,,,,,,,0.07
2010aug,,,,,,,0.48,,,,,,,0.07Top
2010sep,,,,,,,0.5,,,,,,,0.03
2010oct,,,,,,,0.37,,,,,,,0.02
2010nov,,,,,,,0.29,,,,,,,-0.02
2010dec,,,,,,,0.22,,,,,,,0.02
2011jan,,,,,,,0.03,,,,,,,0.01bottom
2011feb,,,,,,,0.11,,,,,,,-0.03
2011mar,,,,,,,0.19,,,,,,,-0.02
2011apr,,,,,,,0.11,,,,,,,0.01

As the #'s indicate, the proxy for inflation falls (-47) in four months. This is skewed to the downside (exaggerates), but the change is huge. The economy will crash, stocks will crash, bonds will top out, and another selling & buying opportunity of a life time will present itself.
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Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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