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The Money Base vs. Currency in curculation

October 13, 2011

A few days ago, I noted that reserves don’t cause inflation, only spending does, and spending is influenced by currency in circulation. I decided to track down the exact split between excess reserves triggered by the Fed’s interest on reserves policy and currency in circulation. Below is a graph from the St. Louis Fed:


The interest on reserves policy was started on October 6, 2008.

The entire increase to the base was excess reserves. Some people have expressed reservations that such a small rate on reserves (0.25%) could lead to such an enormous increase in reserves held (around 1.5 trillion), but such thinking ignores the central economic model of how people behave. People choose between alternatives and pick the best option available to them at any given time. Even if an option is bad, they will pick it if it is the best one available. Banks will put their money where they can get the highest return and the lowest risk. Right now, their alternatives to holding government assets are very poor. The stock market has been chaotic, other banks are risky, and housing prices have been falling quite steadily. In order to beat the interest rate on reserves by buying government issued securities, banks would need to buy 2 year Treasuries. Simply put, reserves at the Fed are the best investment option many banks have.

Is the Fed powerless to stop banks from depositing excess reserves? Of course not. I believe that simply lowering the interest on reserves to a level equal to 1 month Treasuries would remove most of the excess reserves from the system. If that did not work, the Fed could lower the interest paid to 0, and if that still didn’t work, they could start charging interest on reserves. The interest on reserves policy is the reason monetary policy has appeared so helpless since it was enacted in October of 2008. I think it is an underhanded method for the Fed to bypass Congress and subsidize Wall Street. Additionally, by making monetary policy more contractionary that it would otherwise be, the interest on reserve policy hurts the economy.

From the Fed’s FAQ:
“Without authority to pay interest on reserves, from time to time the Desk has been unable to prevent the federal funds rate from falling to very low levels.”

The Fed Funds rate has not been above the IOR since they enacted the policy, which implies that the policy makes the Fed Funds lower, not higher.

“With the payment of interest on excess balances, market participants will have little incentive for arranging federal funds transactions at rates below the rate paid on excess.”

The whole point of increasing base money is to induce banks to make loans. The Fed admited that their intent was to stop that from happening, and they were successful.

“Paying interest on excess reserves will better enable the Desk to achieve the target for the federal funds rate…”

Yes, it makes it easier to hit the interest rate target, but the point of the interest rate target is to affect the broader economy, which IOR prevents. Pure cargo cult economics.

“5. Does paying interest on excess balances constitute a change in monetary policy?

No. The stance of monetary policy continues to be set by the target for the overnight federal funds rate established by the FOMC. Paying interest on excess balances just makes it easier for the Desk to implement the target federal funds rate chosen by the FOMC.”

How, in the wildest fever dreams of a madman, does a policy change which takes 1.5 TRILLION dollars out of the economy NOT constitute a change in the stance of monetary policy?!?! I’m just stunned.

4 Comments leave one →
  1. October 13, 2011 3:59 pm

    So to a relative layman like me, why did they start offering interest in the first place?

    • October 13, 2011 5:15 pm

      I updated the article a bit. Here is their official reasoning, which I don’t believe. I think they see monetary policy as a nominal interest rate, not a rate of inflation. Thus, anything that helps them hit that interest rate is good, regardless of its effects on the broader economy.

Trackbacks

  1. The Money Base vs. Currency in circulation « azmytheconomics « Economics Info
  2. The Red Toed Elephant: Interest on Reserves « azmytheconomics

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