More on the Federal Reserve’s effect on stock markets

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More on the Federal Reserve’s effect on stock markets

Monday, August 24th, 2009 | Economics |

Jesse’s Cafe Americain - Why Is the Fed Creating Excess Reserves in the Banking System and Paying Interest on Them?

The essence of the essay was to point out the enormous increase in bank reserves which the Fed has created through their “New Deal” style banking programs. Because of this, the Fed has created a new function by which it pays interest on banking reserves, which to my knowledge it has never done before.

It is a new function at the Fed, and it does serve a important purpose. The purpose is to place a ‘floor’ under interest rates, in the face of a surfeit of liquidity which the Fed has created, and which shows up in the Adjusted Monetary Base, the Reserve Bank Credit figures, and so forth.

Now, some people have taken issue with my bringing the notion of excess Reserves to your attention for a variety of reasons. Even the mighty NY Fed has written a paper which attempts to defuse the notion that the excess reserves are indicative of anything that might be impeding lending.

Let me be clear about this.

The excess reserves are absolutely indicative of the Fed’s having added substantial amounts of liquidity to the financial system. If the Fed were not paying interest on reserves, this liquidity would crush their target interest rates, since the banks are loath to hold reserves that are not generating some return. This is what they do, generate a return on capital. Capital has a price, even if it is an opportunity cost.

These are all things which have been discussed before, often in the context of consumers! In fact, it is well known among bankers that as the Fed lowers interest rates money flows out of lower paying instruments like bank deposits and money markets, and into higher paying instruments that might be deemed too risky at high rates of riskless return. Such higher paying instruments are known as “stocks” and “corporate bonds.”

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