On Monday, August 27th the FRBNY Liberty Street Economics blog posted a story entitled “Interest on Excess Reserves and Cash “Parked” at the Fed”. Written by Gaetano Antinolfi and Todd Keister, it basically says that lowering Interest on Excess Reserves (IOER), not unlike what the ECB did recently, won’t really make a difference. Well, in our humble opinion, yes and no.
We wrote about IOER in a post on August 16, 2012 entitled, “The future of the Fed Funds market looks pretty grim” as well in Finadium’s recent paper, “Repo Indices, Overnight Index Swaps and Other Alternatives to LIBOR”. The point we made in the paper and the post was the Fed Funds market is pretty much dead. Banks keep cash at the Fed in the form of excess (and required) reserves, where they earn more than they could in the Fed Funds market. The only lenders in Fed Funds, ironically, are those institutions that can’t earn interest at the Fed: the GSEs. As a benchmark, Fed Funds has become irrelevant, and by extension, OIS — the derivative based on the Fed Funds daily effective rate — isn’t great either.
Below is a chart showing the explosive growth of excess reserves.
The LSE post says that lowering the IOER rate to zero wouldn’t do anything to the Fed’s balance sheet. The cash might shift from one bank to another, but the system as a whole would not be impacted. Fair enough. But is this a good reason not to do it? The 25bp rate paid by the Fed is above the market-clearing rate. Its hard not to believe that there aren’t perverse unintended consequences to this manipulated rate. We wonder if the decisions banks make aren’t impacted by the desire to take advantage of the artificially high rate?
The conversation does beg the point that the Fed keeps lots of cash out of the securities market by paying 25bp on IOER. If that money was unleashed, would it create an asset bubble? You have to go out to 2 year notes before UST rates match the 25bp that the Fed is paying. This seems like a situation which started out as a good idea but may have morphed into something altogether different.
It is ironic that that Fed uses the excess reserves deposited by the banks to fund their large scale asset purchases. The Fed is engaging in a huge maturity transformation trade – funding short, lending long. Banks used to do that for a living, but regulations like Basel 3 (LCR in particular) make that more expensive. Maturity transformation is actually a positive and necessary thing for the economy – despite its association with shadow banking and various other evil empires — so it’s good that the Fed takes up the slack. In reality, one might argue that the Fed is paying too much for their funding.
If IOER went back to what it was originally intended – a rate pegged at below where Fed Funds actually cleared in the market – it might be a first step toward banks thinking more clearly about how to put their cash to work, restore Fed Funds credibility as a market benchmark, and allow the Fed to start to get out of the box they’ve painted themselves into. Its just an idea but what if the Fed lowers IOER to zero then does repos to fund their securities portfolio? The balance sheet impact at the Fed is nill since money is just shifting from Excess Reserves to repos, but the rates would be market driven instead of artificially pegged (above market)?