The Opposite Effects of Current Interventionist Policies of the Fed

This is a really quick blog post, and I will probably return back to this topic as market conditions change and new information is available.

I’ve been doing some research about why there is still a liquidity trap in the loans market. It’s still impossible for people to get loans.

In normal economic conditions, banks hold around .02% of excess reserves. They hold on to the required 10% by the Fed, but loan out anything that is left. Because of the money multiplier, this is actually the main way money is created (only holding 10% in currency, and lending out the other 90% and treating it as real “funds”). According to the latest Fed report, as of January 2011, banks are holding an unprecedented 51% of excess reserves! Remember Obama’s empty rhetoric about injecting money into the economy through bailouts so that banks could start lending out money again and the credit freeze would be solved? Those billions of dollars have ended up in the excess reserves of the banks.

I have found 2 reasons why this money isn’t being lent out.. I found them in reports published by the New York Fed in 2009, which is fairly ironic because their own actions to “stimulate” the economy have provided incentives for banks to not “stimulate” the economy!

1. The opportunity cost of lending is too high. With short-term interest rates driven down to almost 0% through open market purchases, banks can’t make any money off their investments, even if there is minimal risk involved. This means anyone trying to get a loan for any kind of entrepreneurial project is definitely out of luck. People who have steady income, excellent credit, and want a basic car/house loan can’t even get it. The central banks are paying interest on those excess reserves that banks hold, and it looks like those rates are higher than the rates the banks can get loaning out the money to entrepreneurs.

2. Remember how I mentioned open market purchases and bailouts? The reason why we haven’t seen any inflation from billions of dollars in money creation through those activities is because the banks are keeping them in excess reserves. The Fed report I mentioned earlier warns of the possible danger of massive inflation if banks lend out these 51% of excess reserves. So it looks like the Fed is in a sticky situation. Their 2 goals are inherently conflicting. They can’t keep price levels stable (control inflation) and also promote conditions for maximum GDP output. They want to thaw the credit freeze by injecting money, but don’t want inflation. It makes no sense.

Basically, the Fed has completely messed with economic incentives. Banks are now in a corner as well. It will be interesting to see what happens with these billions of dollars in excess reserves.

~ by rfreeland on February 23, 2011.

2 Responses to “The Opposite Effects of Current Interventionist Policies of the Fed”

  1. “In normal economic conditions, banks hold around .02% of excess reserves.” Does “normal” here mean during the decade or two before the recession?

    And perhaps the Fed is paying such high interest because they know of the hyperinflation that could occur if these excess reserves were loaned out?

  2. This trend of holding massive reserves (as seen in the graph above) is completely unprecedented in U.S. financial history. Here is another graph that shows reserves back to 1960.

    The interest that the central banks are paying on excess reserves is still pretty low, most likely around a quarter of a percent. I’m going to continue to research this more, but as I said in the post, it seems like there are 2 conflicting goals here.

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