Federal Reserve Chairman Ben Bernanke is about to provide the republic with another watershed moment. Last week it was reported that total reserves held for banks on the Fed's balance sheet reached more than $2.365 trillion. Of that total, only about $59 billion are required reserves—what banks must hold at the Fed to meet regulatory guidelines. The rest, just over $2.3 trillion, are excess reserves.
Never before have banks maintained such gargantuan excess-reserve positions at the Fed. More striking is that excess reserves are now just shy of a record-setting 60% of the Fed's $3.85 trillion balance sheet. On the current course, the 60% hurdle will be cleared by year end. It's hard to see how this large and growing pile of dollars doesn't become a nightmare for the nation.
The Fed has been rapidly creating new money as it buys bonds in a strategy designed to push down long-term interest rates. This "quantitative easing" is adding $85 billion per month to the balance sheet. Monetary-policy doves tell us that all this money creation is not inflationary because the banks park most of it at the Fed, as excess reserves. In other words, the dollars do not circulate and therefore do not push up prices.
Yet there is a reason that banks keep most of those funds at the Fed: It pays them 25 basis points annually to do so. That may sound stingy but in a low-growth, low-interest-rate economy with significant tax, regulatory and monetary policy uncertainty, the riskless Fed offer is juicy.
However, it's not free. Taxpayers are picking up the tab. At current levels the Fed will pay the banks $5.75 billion over the next twelve months. Those payments will reduce the Fed's profits, which are sent to the U.S. Treasury every year by law. Another way to think about these interest payments is that they are a transfer out of the pockets of the U.S. taxpayers and into the pockets of the banks.
Fed remittances to the Treasury in 2012 were $88.4 billion. So one could argue (using estimates) that the excess reserves are consuming only about six percent of profits. As Washington waste goes, that's not such a big deal. Not now, anyway.
The trouble is that if loan demand starts to pick up, banks will naturally want to increase their lending as they identify new opportunities. That will cause them to draw down their reserves at the Fed and put them into circulation. With so much money sloshing around, an inflation spiral would be the likely result. Under those circumstances the Fed might feel compelled to raise the rate it pays on excess reserves in order to make keeping them at the Fed more attractive than lending them out.
A return to even a normal 2% rate on excess reserves of $2.3 trillion would cost U.S. taxpayers $46 billion. As former New York Fed legal officer Walker Todd—who authored a May paper titled "The Problem of Excess Reserves, Then and Now"—pointed out to me this week, if we hit a period similar to 1994-1995 when the Fed funds rate increased by 3.25 percentage points over one year, the cost of containing $2.3 trillion in excess reserves would reach $80 billion annually.
The danger presented by large excess reserve positions is not new. But the numbers are getting frighteningly large. Is anyone paying attention?
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Thu Oct 24, 2013 9:01 am
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