At the September Federal Open Market Committee meeting, the Fed felt that, with “ample reserves” in our banking system, they could orchestrate a cut in the federal funds rate (the interest rate on overnight reserves exchanged between banks) by simply announcing the new lower target for the funds rate to be in the range of 1.75% and 2.00%. The spike in the interest rate on overnight secured funding in the repo market ahead of the decision to cut the target of the federal funds rate, however, belied the notion of ample reserves or excess reserves in our financial system. Two days prior to the FOMC meeting overnight funds traded in the repo market at interest rates as high as 10%.
This spike in overnight interest rates on secured funding surprised the Fed. The Fed felt that with excess reserves in our banking system, banks would be willing to lend their excess reserves in the repo market to gain a higher return than they were getting from the Federal Reserve, if interest rates in the repo market rose above the federal funds rate. This arbitrage action was anticipated to result in an overnight repo rate very close to the target range for the federal funds rate at the time.
Why didn’t this arbitrage take place as expected? The simplest answer is that there really was not an effective large surplus of excess reserves in our financial system. This might seem strange to argue when the Fed’s H.3 statistical release reports that there are over $1.3 trillion in excess reserves in our banking system, which is reserves held over and above what the Federal Reserve requires banks to hold.
This measure of “excess reserves”, however, is not meaningful in today’s banking system. The measure was meaningful, particularly, when banks earned nothing on their reserves. Today, in contrast, banks are earning a 1.8% interest on these reserves, which is about 30 basis points higher than they can earn on a 10-year Treasury note today. Ever since the end of 2007, the Federal Reserve has paid interest on excess reserves, but only to depository institutions.
However, depository institutions are not the only financial institutions that demand reserves with today’s need for immediacy of funds. Our large government sponsored enterprises like Fannie Mae and Freddie Mac, just to name the largest, along with non-depository financial institutions like money market mutual funds, and other financial institutions are significant suppliers and demanders for reserves in the overnight repo market.
The spike in the interest rate on secured overnight repos provides a clear market signal that there was an insufficient supply of reserves in our financial system, not an excess supply. In fact, the Federal Reserve’s increasing the amount of reserves with temporary injections in the overnight repo market is consistent with this market-based characterization.
It appears that our financial system has grown the demand for immediacy in the form of reserves to the point that there no longer is an excess supply of bank reserves, even with the expanded Fed balance sheet. In this environment, any increases in the demand for short-term credit, putting upward pressure on short-term interest rates, necessitates a Fed expansion in bank reserves if they want to prevent short-term interest rates from rising. To the extent that financial institutions, however, are willing to simply hold these newly created reserves, and not lend them out or make security investments with them, this will not expand the money supply or result in inflation any more than the previous episodes of quantitative easing by the Fed did.
By Scott Hein, President, Hein Consulting