NY Fed Paper Reveals the Fed's Elusive "Exit Strategy": Paying Banks to Sop up the Liquidity

Pic credit: David Dees

It isn't bad enough that the Fed has essentially expressed a desire to keep interest rates low until aliens come to Earth and the Mayans are reborn as the "chosen" people on December 21, 2012 or whatever the hell is supposed to happen on doomsday. A reasonable person might think that's the worst the Fed can do but if you know the Fed, you know that for every boneheaded trick they've got up their sleeve lie two more just-as-if-not-more boneheaded tricks just waiting to be hatched into action.

Like this winner.

I have looked at the concept of negative interest rates before. But this is really pushing it and I don't understand how NY Fed thinks paying banks interest on deposits held at the Fed will work in concert with a plan to gradually crank up interest rates to 2%. I'm lost. Can one of those Fed brainiacs please get in touch and explain this? I'm no idiot, I get it 99% of the time, this scheme is just so off-the-wall that even after three Racer 5s I still don't get it.

Someone get me a shot of tequila or something.


A new paper by the Federal Reserve Bank of New York offers some empirical support to the view among senior Federal Reserve officials that they do have the technical means to raise interest rates when needed, despite some naysayers who caution there is too much money in the system to do so effectively.

The Fed has pumped $1 trillion into the banking system in the past year, which in theory means all of that cash floating around in the financial system puts downward pressure on bank lending rates, interfering with the Fed’s ability to raise rates as the economy improves to fend off inflation.

But there is a way around it: The Fed can pay banks interest on bank reserves of unused cash.

That puts the Fed in a position to bid up rates if and when it chooses to, even if there’s a lot of cash in the financial system. The New York Fed paper argues that the Fed could get its target fed funds rate to 2% or higher even if there were $800 billion of extra cash in the banking system.

I'm going to stop this right now. The Fed needs to admit the raging conflict of interest that comes into play when it starts manipulating banks in a last ditch effort to stave off the inflationary monster they have created.

Up until this point, the Fed has used the banks as a vehicle to advance its agenda whether or not the banks wanted to play. Because of TARP, they may have had a little more room to negotiate ("Sorry, Ken, Tim says you have to buy these Treasurys, there's no if about it..."), all the while still claiming to "regulate" the very banks they rely on to get them out of this mess. If that doesn't make sense to you, don't worry, you aren't alone. It probably doesn't make sense to the Fed either but we all know they don't necessarily operate with both feet planted firmly in financial reality.

The Fed is drinking their own Kool-aid, they'll never make it out of there alive.

And more importantly, do they have a plan to tame mortgage markets once their asset purchases finally end?

(the answer is no. In fact, the answer is hell no, they didn't even think about that part of the plan and are pretty much doomed. You're welcome)

Jr Deputy Accountant

Some say he’s half man half fish, others say he’s more of a seventy/thirty split. Either way he’s a fishy bastard.


J.D. Stein said...

The Fed didn't have a choice about paying interest on reserve balances, once it decided to try to influence long-term rates by buying longer-dated assets.

In other words, the excess reserves were the natural accounting fallout from buying longer-term bonds so they needed to neutralize them. They don't have the choice to not pay interest until they unwind the quantitative easing.

Otherwise, the Fed will be unable to maintain a Fed Funds rate greater than zero even if they raise the target.

For example, let's say the Fed Funds rate target is 3%. That of course is only the target, the actual rate is set by interbank lending in the overnight market. The Fed keeps the interbank lending market running smoothly by buying and selling securities as part of their open market operations so that the supply of interbank funds roughly equals the demand. So in a normal environment, the actual Fed Funds rate hovers close to the target.

If the Fed set the target at 3% today, but didn't offer to pay 3% on all those excess reserves, then the banks would be unwilling to hold the reserves. There would be a supply demand imbalance, and the actual Fed Fund rate would fall to zero even though the target is 3%.

If you recall in 2008 after Lehman went bankrupt, the Fed had the exact opposite problem in that the banks were hoarding their reserves and were unwilling to lend to each other in the overnight market so the the Fed Funds rate shot well above the target.

At the current reserve levels, if the Fed announced it was no longer paying interest, we would still be at a zero percent Fed Funds rate just like we are now, and of course banks continue to contract the supply of credit. They aren't lending because they are risk averse and are weighed down by bad loans. The Fed can't force banks to lend.

If the economy begins expanding further and banks begin to lend, and the Fed wants to cool things down a bit so the economy doesn't overheat, they would naturally raise the Fed Fund target.

If they don't raise the rate they pay on the reserves at the same time, the actual Fed Funds rate won't budge from zero, which of course would be inflationary because short-term rates would be overly accomodative for the environment.

Bottom line is the Fed can make excess reserve (balance sheet) decisions independent from its monetary decisions by paying interest on the reserves.

They won't stop paying interest on the the reserves because it would completely undermine their ability to conduct monetary policy by setting a Feds Fund rate target.

I've not yet read the paper you referenced, but here are two that do a decent job of explaining the methods behind the madness.



Is Steve Forbes running the Fed? The Fed can control the size of its balance sheet or interest rates, not both. That's economics 103. Perhaps Zimbawe Ben forgot that course.