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Has the Federal Reserve lost its Mojo?



Federal Reserve President Jerome Powell speaks in Washington, May 1.


Photo:

Ting Shen / Xinhua / ZUMA Press

When the Federal Open Market Committee meeting ended last month, journalists focused on the federal movement, announcing that it would be kept constant at 2.25% to 2.5%. Unnoticed by even the financial media and beyond the main content of the FOMC's statement, its decision to reduce the interest rate paid by the Federal Reserve on bank reserves was a rate that, unlike the interest rates of the math funds, still has a direct effect on the money supply. . The Fed lowered the rate paid on reserves because the market yield on one-year Treasurys had fallen below it, allowing banks to build up excess reserves. When the banks expand the reserve rooms, the money supply contracts – so the Fed was forced to act.

But that wasn't enough. Because market rates have been declining since the last FOMC meeting, the lower rate the Fed is currently paying on reserves is 0.35 percentage points higher than Friday's annual Treasurys dividend and 0.25 points over 10-year Treasurys dividends. The return difference has led banks to increase excess reserves by 5.5% or $ 65bn. In the past month. The size of these yield spreads and the build-up of excess reserves virtually ensure that the Fed will again reduce interest rates on reserves at Tuesday's FOMC meeting.

The rate paid on reserves receives too little attention. Due to the unprecedented monetary easing of the Obama era, when the Fed bought or offset 45% of all federal debt issued – more than five times the amount it bought in support of World War II, commercial banks now took massive excess reserves . By paying interest on reserves, the Fed effectively converted them into revenue-generating assets, giving the banks an incentive to hold excess reserves instead of extending credit and money supply. As the banks became liquid in liquidity, they all stopped lending and borrowing in the overnight fed-funds market. The food market has signed a 80% contract since 2008, which means that the price of fed funds has no direct impact on monetary policy.

The rate paid by the Fed on reserves has darkened the matrix as its main monetary tool, with a much more direct impact on the money supply. If the interest rate on reserves is set close to the market rate, other things are the same, the money supply will remain unchanged. If market rates rise above the rate that the Fed pays on bank reserves, banks will expand loans and the money supply will increase. If the Fed puts the rate it pays on reserves over the market option for banks, they will expand their excess reserve team and the money supply will fall.

Before the Fed began to pay interest on reserves and before the banks had more reserves than they have demand-outstanding outstanding, the money supply changed as the Fed traded. Now that the market rate changes, the money supply also changes unless Fed actions.

When Fed acquired assets in its three monetary easing, the interest it paid on the reserves gave the banks the ability to keep the resulting surplus reserves pumped into the banking system. Reserves then earned an average of 0.095 percentage points more than the yield on annual Treasurys. After quadrupling the balance over eight years, the Fed began selling its assets on the balance sheet in October 2017. The Fed sold Treasurys and mortgage bonds and fixed the interest it paid on reserves so that one-year Treasury paid 0.43 percentage points more than reserves and 10-year cash supplies paid 1.08 points more.

As a result, the banks reduced their reserve holdings enough to compensate for Fed asset sales on the bank reserves and money supply. In what was a clear police success, the Fed succeeded in selling the $ 300 billion of assets and induced banks to reduce surplus reserves by $ 467 billion in the first year of the Activity Reduction Program. This has modestly expanded the money supply without disturbing prices or lowering interest rates.

Yield on 10-year Treasurys has fallen to 2.12% this month from 3.24% in November 2018 – perhaps due to the buoyancy of foreign earnings being returned after 2017 federal tax cuts, the influx of foreign capital attracted by the rise in US growth or the decline in domestic investment triggered by massive trade uncertainty. In the past month, banks have increased excess reserves by more than $ 64 billion while the Fed reduced total bank reserves by selling $ 33 billion of assets.

To prevent a direct downturn in the money supply and the economic disturbance it could cause, FOMC will be forced on Tuesday to either dramatically reduce the interest the Fed pays on reserves or terminate its debt settlement and start buying securities on the open market. The Fed is also likely to reduce the upper limit of the math rate to signal its goal of further monetary easing.

Never in Fed's 105-year history has it had less control over the market rate than it has today. As long as the Fed maintains its inflated balance and the banking system has massive surplus reserves, the Fed will be obliged to respond to changes in market interest rates either by adjusting the rate it pays on reserves or by using other policy tools to compensate for the impact market – rate changes have on bank reserve holdings and money supply. Expecting the Fed to keep interest rates above or below market rates under these circumstances is not only naive but dangerous.

Mr Gramm is a former chairman of the Senate Banking Committee. Mr. Saving is a former director of the Private Enterprise Research Center at Texas A & M University.

Published on June 18, 2019, printed edition.


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