Houston, we need ignition! I'm speaking to the Houston branch of the Dallas Federal Reserve, and the NY Fed and Mr. Ben Bernanke, Chair of the USA Federal Reserve.
Maybe you've heard that the amount of money "on reserve" at Federal Reserve Banks is at record levels. The increase in reserves is beyond dramatic - Just look at this chart from the Fed that illustrates the meteoric growth rate - http://research.stlouisfed.org/fred2/series/EXCRESNS
The system is awash with over a trillion dollars in reserve funds, compared to about $60 billion before the financial crisis. This is money that banks could, and should be loaning out!! But they haven't for various reasons (low loan demand, lending fear, etc.) But one of the reasons they aren't lending is that they are being paid NOT to lend it!
That's right, at a time when we need that money circulating and helping this economy grow and putting people back to work, the Federal Reserve is actually paying the banks interest to discourage them from lending it. How could that be?
Here's 1) How, 2) Why, and 3) What's about to change in my opinion.
1) How:
I bet very few people know that for the first time in history starting back in Oct. 2008 The Federal Reserve was given the authority to pay banks interest on their reserves. In other words the Fed was given the ability to do something it never did before - actually pays interest to banks on their reserves to discourage them from lending. I pasted the wording from the Federal Reserve circular issued October 6, 2008 explaining this. (BORING ... just skip past)
Board Announces Payment of Interest on Reserve Balances, Changes to TAF and Regulation W
October 6, 2008
Circular No. 11998
Interest on Reserves The Financial Services Regulatory Relief Act of 2006 originally authorized the Federal Reserve to begin paying interest on balances held by or on behalf of depository institutions beginning October 1, 2011. The recently enacted Emergency Economic Stabilization Act of 2008 accelerated the effective date to October 1, 2008.
Employing the accelerated authority, the Board has approved a rule to amend its Regulation D (Reserve Requirements of Depository Institutions) to direct the Federal Reserve Banks to pay interest on required reserve balances (that is, balances held to satisfy depository institutions’ reserve requirements) and on excess balances (balances held in excess of required reserve balances and clearing balances).
The interest rate paid on required reserve balances will be the average targeted federal funds rate established by the Federal Open Market Committee over each reserve maintenance period less 10 basis points. Paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector.
2) Why:
It makes sense for the Federal Reserve to have the authority to pay interest on reserves. And, it's not a bad thing. Simply put it gives the Fed another tool to fight inflation. The Fed was concerned that with TARP (bailout #1) and TALF (bailout #2), and lower interest rates, inflation would heat up when the recovery took off. By paying banks interest on their reserves the Fed can draw money out of the economy. This provided the Fed with a way to discourage banks from lending their reserves by giving them an incentive, ala interest for just parking their money at the Fed at no risk and with little to no effort. (Making loans takes lots of effort and expense.) If the Fed feels inflation is heating up they can more rapidly draw down the money supply by combining this new tool with existing tools (e.g. Fed funds rates, reducing the Fed Balance sheet, etc). So it's actually a good thing that the Fed has this new option for inflation fighting. But now is not the time to be paying the banks interest on their reserves and that's what they've been doing since Oct. 2008!
3) What's about to change in my opinion:
Here's the most important point. It's an observation I made and shared in "Letters to the Editor" back in 2009. (None of which got published.) For quite a while, and until recently, the primary fear has been "inflation." Even though the economy is sluggish at best, and unemployment is stubbornly high, the leading opinion was that with the Federal Government spending money like drunk sailors (an unintended insult to sailors) and the Federal Reserve printing money
at record pace, the logic would suggest a high risk of inflation. And so the Fed has been paying banks a small, but meaningful interest on their reserves. But the attitude about inflation has shifted, and now the Fed's greater concern is deflation and high unemployment. We need higher growth rates of about 5-7% to bring down unemployment. So the Fed has really got to step on the gas to more than double the rate of growth from the current 2% rate. I liken it to trying to get a space ship into orbit -- you need much more fuel to reach escape velocity.
Houston, we have ignition ...
Here it comes!! QE2 AND if I'm right, a halt to the Fed paying interest on Reserves. I don't expect the Reserve Interest rate change to get much press. It didn't get much press when they passed the law to pay it in the first place either. I think the media believes it's too complicated to explain to "John Q. public." But I think you get it! And here's what you get ...
Can you say 15 year mortgage at 3.25%? Or 0-1% on auto loans (with the help of the manufacturers)? If you haven't refinanced or purchased the home you want - it's about to be the time! It's also going to be the time to buy a new car, renovate, do a new energy efficient furnace and A/C. It's going to be time to expand your business, and the banks will be calling us with attractive lines of credit.
Hopefully the US Economy "space ship" has enough fuel to escape from the funky gravitational grasp of the financial crisis that's been pulling us down for nearly three years. If not, and we crash back to earth it ain't going to be pretty!
Nov. 2010