The Phaserl


Gold a safe harbor on an ocean of excess reserves

by Michael J. Kosares, USA Gold:

We had initially asked to pay interest [in 2006] on reserves for technical reasons. But in 2008, we needed the authority to solve an increasingly serious problem: the risk that our emergency lending, which had the side effect of increasing bank reserves, would lead short-term interest rates to fall below our federal funds target and thereby cause us to lose control of monetary policy. When banks have lots of reserves, they have less need to borrow from each other, which pushes down the interest rate on that borrowing — the federal funds rate.” Ben Bernanke, The Courage to Act

It has been an enduring mystery to many why the enormous amount of money created by the Federal Reserve in the wake of the 2008 crisis never translated to a general price inflation.

After all, as Milton Friedman lectured us, “inflation is always and everywhere a monetary phenomena.” So why didn’t the enormous amount of money created by the Fed during its quantitative easing program – some $3.5 trillion added to the bank reserve credit – launch double-digit price inflation, or worse?

The answer, as it turns out, lies in a little discussed and understood line item on the Fed’s balance sheet labelled “Reserve balances with Federal Reserve Banks,” or “excess reserves” as it is called in the banking trade. The line item was the result of the Emergency Economic Stabilization Act passed by Congress in 2008, also known as the Wall Street bailout. In it, the Fed was given the authority to pay interest on excess reserve deposits made by commercial banks. Those excess reserves, in turn, were created by the Fed through its quantitative easing program when it purchased massive amounts of mortgage backed securities (MBS) and Treasury paper from the banks.

Up until recently, the excess reserve mechanism operated quietly in the background with little in the way of public notice on the part of either Wall Street analysts or the mainstream financial media. Excess reserves began to get more exposure in the wake of the recent Fed announcement on raising rates. Various mainstream media sources, including the Wall Street Journal’s John Carney in a Heard on the Street column, cited it as “the main tool” the Fed would use to force interest rates higher.

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