How can you possibly have too many reserves? You would think that the more reserves the healthier the institution and so there would be no such thing as “excess reserves”.
We’ve mentioned this in previous articles such as FED Looks for New Ways to Crank Up Money Supply and How “Excess Reserves” and the Money Multiplier Could Trigger Inflation but excess reserves are in the news once again as Philadelphia Federal Reserve Bank President Charles Plosser says that that “excess reserves” could push inflation dramatically higher. Well, we have been telling you that for quite some time so it shouldn’t be news to long time readers. But if you are new to InflationData…
What are Excess Reserves?
Excess reserves are reserves held above the minimum required by law. Generally they are held as accounting entries with the Federal Reserve. In good times of high loan demand banks prefer to loan out these reserves because they can earn more on them in the open market than they can by leaving them on deposit with the FED. As a matter of fact, up until recently banks were not paid interest on the “required reserves” held by the FED let alone “excess reserves”.
It wasn’t until the Financial Services Regulatory Relief Act of 2006 that the Federal Reserve was authorized to pay interest on reserves. Up until that point banks had to leave their required reserves interest free with the FED. And the Relief Act of 2006 only required the FED to begin paying interest effective October 1, 2011. But then along came the crash of 2008 and so the date was advanced to October 1, 2008 by the Emergency Economic Stabilization Act of 2008 in an effort to help the banks shore up their reserves. From October 2008 through the end of 2008 the FED paid as much as 1.4% and then tapered down to 0.25% on required reserves and between 1.00% and 0.25% on excess reserves. From 2009 onward the rates stayed at 0.25% on both excess reserves and required reserves.
Why Would Banks Settle for Only 0.25%?
According to former Fed governor Alan Binder, Today banks hold a whopping $2.5 trillion in excess reserves, on which the Fed pays them an interest rate of 25 basis points—for an annual total of about $6.25 billion.
But that begs the question why would banks leave $2.5 trillion dollars with the FED earning only ¼%? There are only three reasons I can think of:
1) They were so shaken by the crash and the possible bankruptcies of their banks that they have decided on an extra margin of safety despite the cost of holding it.
2) They don’t like the risk reward ratio of lending the money out. In other words they can’t find qualified borrowers to loan the money to.
3) The FED is twisting their arm somehow to keep that money on reserve at the FED.
So What’s the Problem?
According to Plosser, the problem arises when the banks decide to take that money out of the FED and start loaning it out. Once all that money starts sloshing around in the system it could cause a massive explosion in the money supply and thus massive inflation.
Remember, up until October 2008 banks had no incentive to hold excess reserves with the FED, as a matter of fact they had a disincentive, i.e. they weren’t earning any interest on that money. But today not only are their excess reserves earning money but so are their required reserves. This has given the FED an additional tool to control the money supply. Previously the only way to adjust the amount of reserves was to mandate a higher or lower percentage of required reserves. But now they can encourage (or discourage) holding of excess reserves by changing the interest rate they pay. At the moment they are only paying ¼% and banks are still willing to leave $2.5 trillion on deposit.
One would assume that if the economy were better and the demand for loans higher that number would decrease. And that is Plosser’s fear, that as the economy picks up this excess money basically sitting on the sidelines will flood the economy and cause a massive jump in inflation. The FED no longer tracks M3 but Shadow Stats estimates that the M3 money supply is around $16 Trillion so an influx of $2.5 Trillion would result in a 15.6% increase in the money supply compared to the roughly 5% that it is currently increasing by.
But if we compare excess reserves to M1 we get a much different picture. M1 is the most restrictive measure of the money supply. It only measures the most liquid forms of money; it is limited to currency actually in the hands of the public. This includes travelers checks, demand deposits (checking accounts), and other deposits against which checks can be written. According to the St. Louis FED, currently the M1 money supply is $2.777 Trillion so if excess reserves suddenly were all converted into M1, the “M1 money supply” would roughly double.
Is a massive shift on that scale possible? Maybe. Is it probable? Not likely. People would have to have a massive boost in their confidence in the economy to be willing to borrow all that money even at the current historically low interest rates. And then the question arises, even if somehow everyone’s checking account magically doubled what would people do with it? Some would spend it but some would use it to reduce debts and others would invest it in the stock market. So a significant percentage of it would rapidly shift from M1 to M2 or M3 and we would go from the possibility of 100% inflation in the money supply back toward a 15.6% increase. And remember the current 5% increase in the M3 is resulting in a roughly 2% increase in prices. Price increases are roughly equal to money supply increases minus GDP increases. So we can theorize that a 15.6% increase in the money supply would probably result in 12-13% price inflation. But to stem this exodus of flows from excess reserves all the FED would have to do was raise the interest rate it is willing to pay or if that failed raise the level of required reserves.
You might also like:
- FED Looks for New Ways to Crank Up Money Supply
- Inflation Expectations and the FED
- Goodbye M3 – What is the Government hiding?
- M3 Money Supply Numbers are Back- Sort Of
- Inflation Cause and Effect