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The truth about excess reserves

By Sheyna Steiner · Bankrate.com
Tuesday, August 28, 2012
Posted: 3 pm ET

The economy has hit a rough patch and analysts have speculated that the Federal Reserve may act again. Past high-profile actions have included everything from dropping short-term interest rates to zero, announcing the timing for a future rate increase and large-scale asset purchase programs, aka quantitative easing.

It has the appearance of a kitchen-sink approach but the central bank isn't out of options for tweaking monetary policy. One option is to decrease the interest paid on required or excess reserve balances held at Federal Reserve banks. The Fed isn't exactly sure how this would play out; the monetary policy committee said as much in the minutes from the last meeting.

But they do have examples to learn from: At the European Central Bank, where the rate paid on banks' deposits has been dropped to zero; and at the central bank in Denmark, where they actually charge money for certain deposits.

Economists at the Federal Reserve Bank of New York explored the topic of the rate paid on excess reserves in a blog post titled "Interest on excess reserves and cash 'parked' at the Fed," and they concluded that cutting the rate paid on required or excess reserves would not free up more money for consumers and the amount of money in reserve balances will remain the same.

In the blog post, Gaetano Antinolfi and Todd Keister wrote:

In particular, some people wonder if lowering this rate would lead banks to hold smaller deposits at the Fed and instead lend out some of these "idle" balances. In this post, we use the structure of the Fed’s balance sheet to illustrate why lowering the interest rate paid on reserve balances to zero would have no meaningful effect on the quantity of balances that banks hold on deposit at the Fed.

Banks are required to set aside a certain amount of cash based on the amount of money on deposit. These are required reserves and they can be parked at Federal Reserve banks to receive interest payments of 25 basis points. A basis point is one-hundredth of a percent, so it's a quarter of a percent.

But they may have more cash than is required, and those are excess reserves which can also be deposited with the Fed and earn 25 basis points of interest.

Excess reserves have increased dramatically since the financial crisis, leading to speculation that banks would rather sit on extra money than make loans.

That's not really true.

Banks aren't hoarding cash

As it turns out, Federal Reserve researchers tell us, the amount of cash a bank has over the required amount doesn't say anything about the bank's lending activities. In the current interest rate environment, it is indicative of the money supply and the Fed's balance sheet.

There is an abundance of reserves in the banking system because the central bank has taken steps to mitigate the impact of the financial crisis. Those steps involve the Fed's liquidity facilities and other credit programs launched by the Fed since December 2007. Basically, the central bank needed to introduce a lot of cash into the financial system, and they did so through asset purchase programs and direct lending to some institutions. The reserve balances grew with the programs.

Reserve balances will only go down through more central bank actions, reports a Financial Times article, "The base money confusion."

Izabella Kaminska writes:

Reserves, also known as base money, can only be extinguished by the central bank as part of strategic balance sheet reduction policy. This in itself can only be achieved through outright asset sales, reverse repos, negative rates or to a lesser extent by auctioning term deposits.

Individual banks may or may not lend as they see fit, but their actions won't reduce the amount of excess cash sloshing around the financial system. Cutting the interest paid on reserves or excess reserves "could feed through to changes in other interest rates in the economy and thereby potentially affect the incentives for banks to lend and for firms and households to borrow," according to the New York Federal Reserve Bank economists.

They do note that any impact would be small, though.

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