Taps Coogan – July 30th, 2022

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One of our first bailiwicks here at The Sounding Line was pointing out the implications of the ‘Excess Reserves’ monetary policy regime that emerged after the Global Financial Crisis (GFC).

Prior to the GFC, banks maintained as close to the minimum required reserves and used borrowing in the overnight market in order to bridge day-to-day shortfalls.

When the Fed started doing Quantitative Easing (QE) during the GFC, it had the effect of radically expanding the amount of excess reserves held at banks. In fact, the reserves increased by so much, many trillions of dollars, that it all but negated the need for most banks to borrow at the overnight rate.

That risked the Fed Funds rate becoming a rate at which nobody particularly important actually traded, i.e. an irrelevant benchmark. It also risked the Fed Funds rate getting pegged at zero regardless of whether or not the Fed tried to raise it. On the other hand, if banks decided to loan out all of their excess reserves, it could prove highly inflationary.

So, the Fed invented a policy of paying banks to not lend out their excess reserves. Generally, that has meant paying banks the Fed Fund rate, or something near to it, on reserves that banks choose to warehouse at the Fed. It is worth noting that the Fed recently has dropped the distinction between ‘required’ and ‘excess’ reserves as what constituted truly ‘excess’ reserves has been confusing.

When interest rates were very low, the policy was not particularly controversial (except here at The Sounding Line), but now that interest rates are non-trivial again, banks, including foreign banks, stand to make hundreds of billions of dollars for doing nothing but parking money at the Fed, money that they wouldn’t have if not for the Fed.

Dr. Judy Shelton, controversial former Fed Board Nominee and Senior Fellow at the Independent Institute, discusses this phenomenon and what the Fed should do about it, namely end the policy and end the excess reserve regime.

While this debate may seem esoteric, it has very real implications. The existence of large excess reserves means that banks really don’t need to compete for depositors’ savings to fund themselves. If you’re wondering why your saving deposit rate hasn’t gone up nearly as much as the Fed Funds rate, this is why.

Furthermore, the Fed uses the money it makes on its balance sheet to fund itself and pay interest on reserves. It then returns whatever is left over to the US Treasury, a major source of revenue for the Federal Government. As the Fed Funds rate rises above the low yield on the Fed’s now shrinking portfolio, they are not going to be able to return much of anything to the Treasury. That amounts about a hundred billion dollars of missing revenue for the Federal Government.

Here is some back of the envelope math. The Fed made about $122 billion in net revenues in 2021 on a balance sheet that averaged around $8 trillion. That means, very roughly, the yield on their portfolio is 1.5%. At the time of writing, there are $3.2 trillion of reserves parked at the Fed costing the Fed 2.4% and rising ($76 billion). While reserves are shrinking faster than the Fed’s balance sheet, the Fed may start running a loss at a Fed Funds rate somewhere between 3%-4%. In any event, the Fed is likely to remit next-to-nothing to the Treasury this year.

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