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The First Fed Rate Cut is Already Behind Us

Let's talk about the "excess reserve interest rate."

Image: iStock.com/BanksPhotos

The first rate-cut happened on May 1: Five measly basis points. That’s all. Here’s how it happened.

I had seen the balance sheet monthly cap rate go from $50 billion to $35 billion with the difference being picked up by Treasury holdings (while the mortgage holdings unwind rate remained constant). I glanced over the cut in the excess reserve interest rate. Such changes were announced in the implementation note, which is separate from the FOMC statement and, in that regard, it was easier to miss.

The excess reserve interest rate went from 2.40% to 2.35%: See the little dip in the blue line, below.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

For most of the history of this great experiment in central banking called “quantitative easing,” the excess reserve interest rate was above the fed funds rate, by design. The reason for this slight advantage of the excess reserve interest rate over the fed funds rate is so that excess reserves do not multiply in the fed funds market the way they typically do when there is no interest on excess reserves paid. If a bank is making more money holding its excess reserves in their account at the Federal Reserve Bank of New York, why would it lend them in the fed funds market? Or so the theory went.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Then, as the Federal Reserve began to unwind its balance sheet and hike the fed funds rate, it also hiked the excess reserve interest rate, but at a slightly slower rate to the point that they converged in 2018 and on May 1, 2019 the Fed cut the reserve rate to 2.35% but left the fed funds rate in the range of 2.25% to 2.50%. On a chart, one can see that the effective fed funds rate is slightly above the excess reserve rate.

This is a big deal. This basically means that the Fed is trying to resuscitate the credit multiplier in the U.S. fractional reserve banking system. They said so themselves in their implementation note on May 1:

“The Board of Governors of the Federal Reserve System voted unanimously to set the interest rate paid on required and excess reserve balances at 2.35 percent, effective May 2, 2019. Setting the interest rate paid on required and excess reserve balances 15 basis points below the top of the target range for the federal funds rate is intended to foster trading in the federal funds market at rates well within the FOMC’s target range.”

Valid Points from My Alert Readers

When I discussed similar issues a couple of months ago, I got several lengthy emails from a couple of banking professionals who explained to me that I “don’t understand” the fed funds market. While many of their points were technically correct, they did not necessarily contradict what I was saying.

If there were no credit multiplier effect, why did fed funds volumes go down so much when the excess reserve interest rate was above the fed funds rate for so long? (For more, see Bloomberg, December 11, 2018, “The Death of Fed Funds? As Market Dries Up, FOMC Asks What Next.”)

Some notable points from one of those emails are very interesting, though: “If the Fed were not paying interest on reserves, the Fed Funds rate under QE would be zero. All the excess reserves in the system would be offered at whatever bid they could find, but there would be no bids because with $3T of excess reserves in the system, all the banks already have more reserves than they are required to have and are not looking to borrow any more. They are looking to swap their reserves for bonds, which pay interest. While an individual bank can do that, banks in the aggregate cannot, and so excess reserves drive bond rates toward zero as well. And when bond rates are near zero, investors flee to stocks, and that is why the stock market has been supported by QE. (And why QT would be bad for stock prices. See October 2018, when Powell threatened to continue QT, and January 2019 when he took it back.)”

My alert reader continued: “The Fed Funds rate is equal to the interest on reserves rate because interest on reserves puts a floor under the Fed Funds rate. A bank receiving 2.4% on its reserves is not going to lend them for any less than 2.4%. That would be stupid. Nor is a bank going to borrow reserves (that pay 2.4%) at any higher interest rate. That is why the Fed Funds market has dried up.”

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

There is no disagreement that the above-described dynamics were designed to push asset prices higher and help not only the U.S. but the global economy that way. This is the equivalent of force-feeding credit on a system that was under pressure to deleverage under heavy debt burdens. Ben Bernanke stopped that deleveraging process. Current Fed Chair Jerome Powell is trying to normalize the way the U.S. banking system works, but he has hit some financial market turbulence, complicated by the occupant of the White House and global economic developments. Will he succeed in normalizing it? The jury is still out.

By the Fed’s own statements, the U.S. financial system has been changed for good. Excess reserves will now be a permanent monetary policy tool as well as interest on excess reserves. They remain part of the system and will be with us for as long as there is a Federal Reserve.

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Equities Contributor: Ivan Martchev

Source: Equities News