Friday, September 28, 2012

If the Fed wants more growth then why is it still paying interest on bank reserves?

One thing has puzzled me about current Fed monetary policy so perhaps you, kind reader, might have the answer. Fed policy has been expansionary. Ben Bernanke has solid support on his Open Market Committee for loose monetary policy. Just read the speeches of the Fed governors. Atlanta Fed president Dennis Lockhart has said "For me," Lockhart told the Atlanta Institute of Internal Auditors, "the policy question was what tools in combination have the greatest chance of producing real results in terms of faster growth and employment gains while preserving price stability." ( Well Lockhart and his Fed buddies have me confused because the one obvious change that they could have made but haven't is the rate the Fed pays on bank reserves. For years, the Fed paid zero interest on bank excess reserves - the amount that banks hold over the amount that they are required to hold on transactions deposits (10%). Currently, the Fed is paying 0.25 percent on excess reserve holdings. To put that in perspective, the 3-month, 6-month, one year and two year Treasury all yield less than 0.25 percent. That means that banks could simply hold excess reserves than buy Treasurys and earn higher rates! No wonder the Fed instituted QE1 and QE2 which purchased Treasurys. Wouldn't it have been simpler just to lower the rate paid on excess reserves? That way the banks would be induced to purchase the Treasurys and the Fed would not have bloated its balance sheet. Now that the Fed (re: Lockhart) states that its objective is to promoted faster economic growth, then wouldn't eliminating the rate on reserves push banks into lending more? Sure this is a tough environment but the world on the street is that the banks' lending standards have become unreasonable even in these difficult times. Perhaps the reason is that they do not have to make as many loans due to the Fed paying them interest on reserves.

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