Excess Reserves and the Federal Funds Rate

There was an article on LewRockwell.com by Michael Pollaro.  The full article can be read here.  He is obviously a supporter of Austrian economics, or at least he likes to use it for his analysis.  I think he makes many valid points and I certainly don't want to step on someone's toes who is promoting Austrian economics.

With that said, I would like to point out a disagreement I have with something he wrote and I believe it is relevant in studying the current economy.  About halfway through his article he writes, "First, the Federal Reserve may be ending its current QE II asset monetization program, but it's not it seems looking to hike its zero to 25 basis point targeted federal funds rate any time soon.  And that means it will more than likely be having to supply at least some base money to the banking system (whether that be through Federal Reserve loans or asset purchases) to keep the federal funds rate in check."

He goes on to say, "Second, and far more important, the private banking system will by June's end be sitting on somewhere between $1.6 and $1.7 trillion in excess reserves, meaning the fuel for the banking system to expand the money supply is in a word explosive."

This guy knows what is happening on the one hand, but then contradicts himself on the other.  Let me explain.  He is right that there are massive excess reserves held by the commercial banks.  Usually, banks are only required to keep about 10% of deposits on reserve.  They would typically loan out the rest and hope that not everyone comes to withdraw their money all at once.  This is fractional reserve banking.

Since the Fed started creating massive amounts of money in the fall of 2008, most of this new money has gone into banks as excess reserves.  In addition, the Fed now pays interest on money held at the Fed as excess reserves.  Although the rate is currently .25%, it is still better than nothing for these banks.  With the economy still shaky, banks are afraid to lend and are keeping huge excess reserves instead of what they have typically done, which is lend out 90% of the money on deposit.

Now, what is the federal funds rate?  It is the rate charged on overnight borrowing for banks.  If a bank falls below their required reserve ratio of 10%, then it will borrow money overnight to settle its accounts and remain in compliance.

But since most of these banks have huge piles of reserves, why would they need to borrow money so that they don't fall below their reserve requirement?  The answer is, they wouldn't.  Therefore, contrary to what Pollaro says, the Fed will not have to supply base money in most cases to the banking system.  The Fed doesn't have to do much of anything right now to keep the federal funds rate near zero because most banks don't need overnight loans as long as there are huge excess reserves.

This point was made in an article by Kel Kelly.  He says that "the banks - not the Fed - are in charge of interest rates."  He basically says that the only way the Fed can raise rates is by paying the banks significantly higher rates on their excess reserves.  He also points out that this would likely cause a recession.

I think the biggest thing to take away from this whole thing is that we should not pay too much attention to the federal funds rate right now.  This is not driving the Fed's monetary policy.  We should pay attention to what the Fed is doing directly and what the banks are doing.  In other words, monitor the adjusted monetary base and the excess reserves held by banks.  Don't pay much attention to the federal funds rate, especially now with the banks holding huge amounts of excess reserves.