Does the current situation of excess reserve imply failure of QE?

Question

Excess reserve @ Fed

In the past it was assumed that excess reserves should be kept around 0 and banks should be lending to each other as much as they are borrowing. The central banks would correct the negative or positive balance at the end of the day by lending or borrowing at premium rates, but that was only a short term solution.

Now we have 5 years of excess reserves at the Fed and a lot of articles about how banks don't care about cash deposits.

Is this the failure of QE? The money being lent and given frivolously circles right back into the Fed in the form of excess reserve it seems.

Is this making it categorically impossible to raise real interest rates? Maybe interest rates could go up if a devaluation process was launched and inflation started climbing, but I'm more interested in understanding what makes the real interest rate move.

Am I misunderstanding something or everything?

Answer 1

You ask a few questions. I'll try to generally answer them:

Is this the failure of QE? The money being lent and given frivolously circles right back into the Fed in the form of excess reserve it seems.

No, the existence of excess reserves is not a reflection on bank lending. A significant fraction of excess reserves originate in money market mutual fund holdings. This is very clearly explained in Singh (2015):

The interest rates in most of these markets are in the range of zero and 25 basis points (bps). The Federal Funds (FF) rate or policy rate has been around 10–15 bps since the crisis, and is largely a negotiated rate stemming from the excess cash balances of nonbanks such as GSEs (i.e., Fannie Mae, Freddie Mac etc.), and banks. Only banks have access to the 25 bps interest on excess reserves (IOER) and thus arbitrage by depositing nonbanks cash at the Fed.

The reason for nonbanks' extra cash showing up as the excess reserves of banks is that it flows through money markets to the Fed because it allows banks and nonbanks to split the 25bps IOER. Singh again:

The Fed’s balance sheet increased from roughly \$1 trillion (end-2007) to over \$4 trillion by end-2014, owing mainly to some \$3.4 trillion of asset purchases that sit on its asset side. The approximate corresponding entry are excess reserves of \$2.9 trillion on the liabilities side— these are deposits of nonbanks (who sold assets to the Fed) at banks, who then place them as deposits at the Fed. Since October 2008, the Fed offers banks 25 basis points per annum for their deposits (including excess deposits over the required reserves), but pays zero interest on deposits from nonbanks, especially GSEs.

As I note in the discussion in the comments, zero dollars of QE were "lent" or "given"— QE consisted entirely of purchases of government and agency securities on the open market, at market prices. What QE does is change the mix of "safe assets" versus cash. There's nothing "frivolous" about it.

Is this making it categorically impossible to raise real interest rates?

Due to the payment of interest on excess reserves (IOER) and the creation of the Reverse Repurchase Program (RRP), the existence of excess reserves does not prevent the Fed from raising real interest rates. As noted above, IOER effectively provides a reason for banks to continue to borrow funds from money markets by subsidizing them at a fixed rate, while RRP provides a floor under risk-free rates (by providing a place to park excess collateral at a positive rate, independently of the supply of collateral at dealers banks) that is under the control of the Fed.

Real interest rates are low because the FOMC has decided not to raise them yet for policy reasons.

Answer 2

As part of QE, the Fed has purchased approximately \$2.5 trillion in bonds, increasing total (required + excess) reserves by the same amount. Irrespective of whether banks engage in additional lending or not, the total reserves remain basically fixed, although the amount of required vs excess reserves can very. Right now required reserves are about \$100bn, and excess reserves are about \$2.5 trillion.

Really, the Fed isn't lending \$2.5T to the banks. It is the opposite! By depositing \$2.5T in reserves at the Fed, the banks are lending to the Fed. But the Fed IS lending the \$2.5T to the federal gov't, since the Fed's bond holdings are Treasuries and agencies. But since the federal government owns the Fed, it becomes circular.

Now suppose that zero interest is paid on reserves. Even at zero rates, there are still limits to banks' demand for reserves in order to make loans (since loans aren't risk free). Maybe around 0% Fed funds rate, banks would only need around say \$120bn of required reserves. So the rest (around \$2.5T) is just excess reserves. And raising the interest paid on reserves from 0% to 0.25% only changes things marginally, we go from say \$120bn to \$100bn demanded required reserves.

So what is the point of QE? It seems that the main point is to take long-dated bond risk (duration risk) off the banks' hands and transfer it to the Fed. The same thing would have been accomplished it the federal government had shifted their debt composition by \$2.5T from 10-yr notes to T-bills. I think it is an open question has to if and how much this reduces long-term interest rates and whether it has much stimulative impact on the economy.

I'd be keen to hear other point of view on this.

Answer 3

Since there really is no "real" money, being that all money is issued out of debt this raises the obvious question about risk. The Fed risks nothing since it actually has "nothing" but keyboard entries on a computer, all the rest is just a jugglers game. If I can create all the money I want out of nothing for what ever purpose I desire then the only risk is "over filling" the bucket, i.e., inflation, but whoa, why does the Fed insist on the two percent inflation?

Because that is how the system has to work. Credit money created leaves a residue and that residue is inflation and here is the reason why the Fed is paranoid about deflation.

However, the monkey in the woodpile is that the forced growth in the money supply is without end. The Keynsian formula always provides that "stimulus" to force people to spend and if they don't, well, step on the accelerator pedal some more. In the end analysis, in mathematics, the Keynes formula fails because it is a powered function meaning that eventually the rate of increase of money supply has to go to infinity, however, before it gets there the little wheels always fall of the money cart. The reason is that you can't "taper". Tapering works in the short term, zirp, but this in turn brings about the failure of the credit money system simply because then money has no return value as a commodity anymore. It has to fail and there is no way to prevent the failure.