Today I’m highlighting an insightful article from the NY Times on the state of our economy- as banks continue to stockpile cash and not lend, we fall deeper into a deflationary trap, while simultaneously running massive inflationary risks. Huh? How’s that possible?
Well, with high levels of liquidity in the financial system, most people see inflation on the horizon…. rightly so. But with nearly zero velocity of money, we have a moribund economy and stagnant growth. Deflation is at work, as people deleverage, hold on, and tighten belts further still.
Banks are at the heart of this mess, and the Fed’s policies are squarely to blame, as this article makes clear.
The Fed Should Stop Paying Banks Not to Lend
By BRUCE BARTLETT
Bruce Bartlett held senior policy roles in the Reagan and George H.W. Bush administrations and served on the staffs of Representatives Jack Kemp and Ron Paul. He is the author of “The Benefit and the Burden: Tax Reform — Why We Need It and What It Will Take.”
The Federal Open Market Committee, the policy-making arm of the Federal Reserve, meets Tuesday and Wednesday to discuss what, if anything, it will do to stimulate economic growth. There is widespread speculation that it will adopt further “quantitative easing” and inject more money into the economy.
It has done this twice before: between November 2008 and May 2010, and between November 2010 and June 2011. The expected new effort has been labeled QE3.
Many economists, however, are doubtful that more of what hasn’t worked already will do any good. Some suggest that it is time for the Fed to think “outside the box” and do something different.
In a Wall Street Journal commentary on July 22, Alan S. Blinder, the Princeton economist and former vice chairman of the Federal Reserve Board, suggested that lowering the interest rate the Fed pays banks on their reserves would force them to lend more and thus stimulate growth.
To explain why this is potentially important, it is first necessary to explain something about the relationship between the Fed and the banking system.
Typically, when the Fed wishes to stimulate growth it increases the money supply. It buys Treasury securities from banks and credits their accounts at the Fed. All banks maintain accounts at the Fed, just as people have accounts at commercial banks. When the Fed credits their accounts, they have more money to lend.
Banks must maintain a certain level of required reserves in the form of vault cash or balances at the Fed as a percentage of their deposits, in order to provide adequate liquidity. Reserves over and above those required are called excess reserves.
Historically, banks held as little in the way of excess reserves as possible, because this was money that could be lent immediately, upon which no income was earned. One way income on excess reserves could be earned was by lending them to other banks overnight, through what is called the federal funds market.
The interest rate charged on such overnight loans is called the fed funds rate and it is essentially controlled by the Federal Reserve, which routinely adds or subtracts reserves so as to meet its target rate. Since Dec. 16, 2008, the target fed funds rate has been between zero and 0.25 percent.
Under normal conditions, such a low fed funds rate would be more than adequate to create a considerable amount of new lending. Since the rate is the basic cost of money to banks, they would make a profit even if they made loans at a 1 percent interest rate.
But rather than make loans, banks instead are simply sitting on the money, so to speak. According to the Federal Reserve, they have $1.5 trillion in excess reserves. This is extraordinary. It is as if individuals took $1.5 trillion of their savings out of stocks, bonds and every other income-producing financial asset and put it all into non-interest-bearing checking accounts back in 2009, and just left it there.
Economists have puzzled about this phenomenon for years. They note that historically the Fed never paid interest on reserves, but in October 2008 it began doing so. Moreover, the Fed pays interest on excess reserves as well as required reserves. Originally, the rate was 0.75 percent to 1 percent, but since Dec. 17, 2008, it has been fixed at 0.25 percent.
This may not sound like much, but keep in mind that interest rates on United States Treasury securities with maturities of less than two years are currently less than 0.25 percent. The effective fed funds rate is also lower than 0.25 percent. In recent weeks, it has been as low as 0.13 percent. Compared with these rates, a riskless return of 0.25 percent looks pretty good.
There is no consensus view on why market interest rates are so low. A lack of demand for loans by businesses is thought to be the key reason. With the gross domestic product growing at only a 1.5 percent rate in the second quarter, businesses have no difficulty meeting the demand for goods and services without having to invest or expand capacity.
Moreover, nonfinancial corporate businesses have more than $1.5 trillion in financial assets available to them, according to the Fed’s flow of funds report. This is money they could invest tomorrow if they saw any need to do so.
Another possibility is that the economy is experiencing de facto deflation; that is, a falling price level. While this is not evident in the consumer price index, economic theory nevertheless suggests that this may be the case.
That is because theory says that the real (inflation-adjusted) interest rate is relatively stable. A recent Federal Reserve Bank of St. Louis study says the “natural rate of interest” historically has been about 2 percent. So if banks are satisfied with a market interest rate of 0.25 percent or less, this suggests that the economy may be experiencing a deflation rate of about 2 percent. (The rate of deflation is added to the market interest rate to yield the real rate.)
If this is true, it explains why the economy appears to be suffering from tight money despite low nominal interest rates and a vast amount of excess reserves in the banking system. Deflation has a paralyzing effect on business activity because downward pressure on prices causes profits to be squeezed.
Indeed, the International Monetary Fund has lately warned of the danger of deflation, and The New York Times reports that China is now suffering from it. There is also evidence of deflation in the United States in daily price data collected by the Massachusetts Institute of Technology.
Under these conditions, which economists call a liquidity trap, monetary policy is impotent because the Fed cannot reduce nominal interest rates below zero.
However, the Fed can penalize banks for holding excess reserves by charging them interest rather than paying them interest. This has been done in other countries. From July 2009 to July 2010, the central bank of Sweden charged banks 0.25 percent on their reserves, and on July 5 the central bank of Denmark announced that it would begin charging an interest rate of 0.2 percent on reserves.
In effect, this reduces the real interest rate received by banks and thus, ironically, would ease monetary policy and encourage bank lending.
No one thinks the Fed is ready to follow Denmark and Sweden. However, economists speculate that the Fed may be ready to reduce the 0.25 percent rate paid on reserves and see what happens. It would be a move in the right direction.