What Happened to the Fed’s Trillions? They’re Back on Deposit…at the Fed!

REUTERS/Jason ReedIn addition to announcing the beginning of tapering, the Fed on Wednesday strengthened their commitment to keeping the federal funds rate low. File photo courtesy of Jason Reed/Reuters.

While the Fed decided Wednesday to begin gradually unwinding their purchase of mortgage-backed securities and Treasuries, they reaffirmed their commitment to keeping the federal funds rate near zero not simply as long as the unemployment rate remains above 6.5 percent (as they’ve communicated in the past) but likely “well past the time that the unemployment rate declines” below 6.5 percent. In our extended conversation with former Fed economist Catherine Mann, whom we featured in our preview of the Fed’s decision, Mann explains how much of the Fed’s stimulus ends up back at the Fed.

Catherine Mann: Ultimately, the objective of tapering is for the Federal Reserve to not be purchasing U.S. Treasuries in the market, other than what they would normally have for their operations. Normally they have about 500 billion. Now they have trillions.

Paul Solman: But these trillions that they’ve added to the balance sheet are all sitting back at the Federal Reserve because the banks have taken the money and redeposited it to the Federal Reserve for a quarter of a percent interest rate.

Catherine Mann: Yes, exactly. So that has been one of the — shall we say, the leakages — between what the objective of the U.S. Treasury purchase program was and what has been the outcome. We have to remember that there were two objectives of the quantitative easing or two channels through which quantitative easing was supposed to work. One channel is the wealth channel and that is the one that we’ve observed being very effective. Stock market wealth goes up and so people who own stocks feel wealthier and they go out and spend.

The second channel through which quantitative easing is supposed to work is to provide additional liquidity to banks, and those banks are supposed to offer credit to businesses. Now that particular channel has not been very effective, precisely because the banks have not done much in the way of lending. Yes, there’s been some more lending for mortgages, commercial and residential, but there’s been very little additional lending for so-called “industrial loans” to small businesses, and to businesses in general, who do depend on banks in order to expand their inventory.

Paul Solman: Isn’t that because the Federal Reserve has been paying banks to redeposit the money at the Fed?

Catherine Mann: Well, so there is this issue of the interest on borrowed reserve or interest on excess reserves, where banks have to hold some reserves at the Federal Reserve; that’s a requirement of our banking system. It’s to provide the stability that you’re sure that there’s at least some reserve there against your deposit. Now the 25 basis points, the quarter of a percentage point that banks get when they hold excess reserves at the Federal Reserve — it’s on reserves above and beyond what they need to hold.

Some people say that these excess reserves are merely because banks are concerned about the riskiness of their portfolio. The other point of view, of course, is that in today’s very low interest rate climate, 25 basis points is actually a pretty good return — better than you can get anywhere else.

Paul Solman: I ran into a president of a bank in Rhode Island who told me, why not? That’s why we’re doing this, because we’re getting 25 basis points, a quarter of a percent, for nothing, no risk at all.

Catherine Mann: Yep, no risk at all. Right, and if we think about the credit channel, you’re talking about making a loan to an enterprise, a business, and it’s a very risky proposition to do that right now. Why? Because that loan is going to be for some period of time, let’s say it’s three years. Now we’re pretty sure at this point that, in the next three years, interest rates in general are going to be going up. The Federal Reserve has committed to tapering; we think it’s going be some time in 2014, that does mean interest rates are going to start to rise.

Paul Solman: And historically interest rates have been higher than they are now?

Catherine Mann: Right, so we are in a very low interest rate climate. So if you are a bank and you make a loan today at a low interest rate to a borrower, you know that that loan is not going to be worth it in a couple of years, when the interest rates in general are higher. Even if you give that business a floating interest rate loan…

Paul Solman: A variable rate.

Catherine Mann: … a variable rate loan, so as interest rates go up kind of generally, they will go up for that borrower too; well that borrower is now in a riskier situation then they were when you lent [to] them at very low interest rates.

Paul Solman: They might not be able to pay you back?

Catherine Mann: They might not be able to pay you back. So banks are looking at this and they’re saying, “Well I certainly don’t want to make any longer term loans.” I’ll just keep it at the Federal Reserve.

Paul Solman: Do you think the interest on excess reserves policy — offering a quarter of a percent to banks to redeposit their money back at the Fed — was a sensible one?

Catherine Mann: So this is a controversial issue now. I think we need to go back a little bit in time and recall that the Fed is used to not paying interest on excess reserves and was given the authority to do that just right as the financial crisis was breaking. And so that was when they implemented the interest on excess reserves. They wanted to have this tool because it’s yet another tool where they can adjust the attractiveness to the financial institutions of having more reserves or less reserves, so it adds to their tool chest for managing the money supply and managing credit in the economy.

Paul Solman: And managing the solvency of banks.

Catherine Mann: And managing the solvency of banks. So you can understand why they wanted to have the tool. Now the question is whether or not this tool as it was implemented throughout this financial crisis, and aftermath, has exacerbated the problems with the credit channel. A bank can decide, “Do I want to give a three-year loan to a risky borrower, or do I want to get 25 basis points at the Federal Reserve? I’m really risk averse right now. I don’t really want to lend to anybody so I’d rather take my 25 basis points.” So I believe that at the margin, this has affected the credit channel, the effectiveness of the credit channel.

Now, it is also the case that [for] very short-term money market funds, it has been been important for their continued solvency and their continued operations to have access, and eliminating the 25 basis points on excess reserves might have had deleterious effects on money market behavior. So that has been the argument for why the 25 basis points has been an important component of ensuring the full functioning of all components of the financial system, not just banks, but money markets as well.

Paul Solman: But the main purpose of having interest on excess reserves was to bolster the banks, no?

Catherine Mann: Yes.

Paul Solman: To make sure the banks would have enough in reserve should there be another possible collapse, or run on the banks, whatever?

Catherine Mann: Right, well it’s as I say, a strategy that ensures that the banks get a little bit extra for holding extra reserves at the Fed. And to the extent that extra reserves ensure that the banking system remains sound, there’s a positive argument for that.

Paul Solman previewed the economic factors influencing the Federal Open Market Committee’s decision: