Liquidity Stress Fractures Begin to Show in the Federal Reserve System
Liquidity Stress Fractures Begin to Show in the Federal Reserve System by David Haggith for The Great Recession
In my January Premium Post, “An Interesting Interest Conundrum,” I laid out how the Federal Reserve was losing control over the Fed funds rate — a loss of control over its bedrock interest rate that indicates financial stresses are building in the banking system that increase the risks from runs on the banks:
After the financial crisis, when there was a risk of runs on banks, the Fed … require[d] the banks to hold more money in reserves … as a regulation safeguard when the Fed was trying to avoid total economic collapse. Deposits, after all, are liabilities because depositors are guaranteed they can demand instant cash at will. Depositors get extremely unhappy if this guarantee is not fulfilled. That looks something like this:
And you don’t want that.
The Fed funds rate is the Fed’s target rate for the amount of interest banks charge each other to make overnight loans to each other from their reserves. In a crisis, when banks need their reserves, the interest they charge each other will naturally skyrocket. To keep the monetary system from freezing up because banks won’t loan to each other, the Fed tries to push that rate down.
During the Fed’s Great-Recovery bond-buying program (quantitative easing), aimed at pushing that rate down, the Fed deposited huge amounts of money created out of thin air into bank reserve accounts to make sure they remained flush so there would be no panic runs on banks, but banks don’t like just sitting on huge piles of money, instead of making even more loans with those piles, especially after the crisis abates. The Fed, however, wanted them to continue to maintain those reserves in case crisis returned.
Because the Fed doesn’t typically operate by just mandating that its member banks do something, it had to find a way within the so called “free market” to entice banks to sit on those piles of new reserve money so the money would remain “in reserve.” My Premium Post went on to explain,
…This became too difficult to manage during the huge bond buying the Fed was doing during the Great Recovery. So, the Fed invented another tool to avoid having to manipulate the Fed funds rate that banks charge each other so that the rate stays within the Fed’s chosen range. In 2008 the US government approved this new power for the Fed, which allowed it to start paying banks interest on excess reserves (IOER) to entice them to keep more money in reserves than their Liquidity Coverage Ratio requires.
The Fed can use the IOER to give banks incentive notto loan their excess reserves to other banks, even as they keep those reserves up, because they can earn the IOER rate the Fed has set with absolutely no risk just by holding on to their reserves and collecting the Fed’s interest payments.
Since its creation, the IOER rate has been set at the top of the Fed funds target rate as a way to keep the Fed funds rate from exceeding the Fed’s stated target for that rate.
Now, however, the Fed funds rate is constantly pressing up near the top of that range, probably because banks are drawing down their reserves to buy and hold government treasuries, leaving them with less in excess reserves to lend to other banks.
Banks, I noted were now soaking up government treasures at the Fed’s request because the Fed was no longer refinancing many of the government bonds as they matured due to its bond roll-off (as a way of tightening money supply). Banks buy those treasuries by transferring money from their reserve accounts to the government’s reserve account at the Fed. I believed the Fed’s loss of control over its most basic interest rate would intensify later this year: