Posted by: Dirk | November 29, 2010

What can we learn from looking at excess reserves?

When it comes to excess reserves in the US banking system I am a little confused. Let me try to express where I stand. I think I understand that the Fed increased liquidity with the US banks by buying illiquid assets with money, transforming itself into an investment bank (kind of). Therefore, counter-party risk between banks is sinking since everybody is liquid. Excess reserves, so I thought, where then free to invest. Except when the Fed’s programs run out and liquidity is needed when the illiquid assets have to be bought back. However, Ben Bernanke has expected banks to put those liquid funds to use by supplying loans, it seems. Here’s Ben Bernanke at the LSE in January 2009:

Exit Strategy
Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve is effectively printing money, an action that will ultimately be inflationary. The Fed’s lending activities have indeed resulted in a large increase in the excess reserves held by banks. Bank reserves, together with currency, make up the narrowest definition of money, the monetary base; as you would expect, this measure of money has risen significantly as the Fed’s balance sheet has expanded. However, banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed. Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base. At this point, with global economic activity weak and commodity prices at low levels, we see little risk of inflation in the near term; indeed, we expect inflation to continue to moderate.

I put two parts in italics. I am a little puzzled because I know that the Fed pays interest on excess reserves. At least they say so:

The Federal Reserve Board on Monday announced that it will begin to pay interest on depository institutions’ required and excess reserve balances. The payment of interest on excess reserve balances will give the Federal Reserve greater scope to use its lending programs to address conditions in credit markets while also maintaining the federal funds rate close to the target established by the Federal Open Market Committee.

Well, by paying an interest on overnight excess reserves you establish a floor. Today, I have found a paper by the NY FED’s Tood Keister and James McAndrews which brings me back to square one:

The quantity of reserves in the U.S. banking system has risen dramatically since September 2008. Some commentators have expressed concern that this pattern indicates that the Federal Reserve’s liquidity facilities have been ineffective in promoting the flow of credit to firms and households. Others have argued that the high level of reserves will be inflationary. We explain, through a series of examples, why banks are currently holding so many reserves. The examples show how the quantity of bank reserves is determined by the size of the Federal Reserve’s policy initiatives and in no way reflects the initiatives’ effects on bank lending. We also argue that a large increase in bank reserves need not be inflationary, because the payment of interest on reserves allows the Federal Reserve to adjust short-term interest rates independently of the level of reserves.

OK, so that is more or less what a Canadian economist recently told me at a conference in Berlin (you see I am still confused). Now I read James Surowiecki of the New Yorker writing:

In reality, the economy is still dominated by caution. American banks have a trillion dollars in reserves that they could be lending out.

Here is the picture from FRED2, bank reserves and excess reserves in one graph:

Now, could anybody explain to me whether either non-borrowed deposits or excess reserves are theoretically available for making new loans? I would be truly grateful. Whatever the answer will be though, for me this is an indicator to watch. If it goes back to zero, the crisis should be over (if everything else stays constant, which would mean the crisis is still not over – hey, a Catch 23! The crisis can never end).

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