The Fed Is Paying Banks Not to Lend

The Federal Reserve is paying U.S. banks not to lend, and has promised to continue doing so through at least 2014. Banks have well over a trillion dollars in reserve balances at the Fed, which wants them to keep the funds there instead of the market.

Banks are required by regulation to maintain capital minimum reserves. Above those minimums, they can loan money out, or they can put it somewhere for safe keeping. That's where the Fed comes in. In the financial crisis of 2008, the Fed took on additional powers. The same legislation that gave us the TARP bailout also gave the Fed the power to pay interest on any funds banks wanted to store with the Fed in excess of required reserves. Within months, banks desperate for a safe haven for their assets deposited nearly $800 billion at the Fed, and the money kept rolling in. The figure peaked just above $1.6 trillion in 2011.

The Fed gives banks an interest of just .25 percent, but we can figure out, from chairman Ben Bernanke’s past statements and from the minutes of Fed meetings, that the Fed isn’t planning to cut them off anytime soon. When the economy improves enough for the central bank to tighten the money supply, the Fed will get around to reducing the rate only when it’s ready to raise interest rates on short-term debt.

The Fed has announced, however, that it is planning to keep short-term rates at the current zero percent level through 2014, as a way of assuring markets that credit will super cheap for a long time to come. Accordingly, the trillions of dollars banks have earning interest at the Fed won’t go anywhere before then, either.

Why is the Fed willing to reward banks for keeping loanable funds on the sidelines? Beacuse doing so gives them more control over the money supply, to supplement its normal tool, the federal funds rate. The federal funds rate, which is the short-term interest rate most commonly referred to in the media, is the price banks charge each other to lend loans to help settle their accounts overnight. The Fed intervenes in this market to set short-term rates.

As the economy raced off a cliff in late 2008, the limitations of the federal funds rate as a tool became apparent as the Fed progressively cut the rate all the way to zero, without arresting the economy’s freefall. Based on the models the Fed usually follows for monetary policy, the Fed actually would have had to engineer steeply negative short-term rates in order to maintain a stable economy.

The Fed has explained that negative nominal interest rates aren’t feasible for logistical reasons. The rules governing money market funds, Treasury auctions, and the federal funds market weren’t written to accommodate negative rates, making it anyone’s guess as to what would happen if rates dipped below zero.

That’s where the .25 rate for reserves comes in. By offering banks a small amount of interest for reserves, the Fed has made it impractical for financial institutions to accept a return much lower than that, effectively setting a zero lower bound on short-term rates. The Fed sees its payments for banks for their reserves as a tool for making sure that rates don’t go far below zero.

The price of this policy is that banks are not forced by the market to spur borrowing by businesses throughout the economy by offering to pay them for taking out loans. Instead, they simply hold their assets at the Fed, risking nothing.

In other words, the federal funds rate constitutes a ceiling for interest rates and the price of liquidity: right now, the Fed won’t let rates rise above zero. The interest rate on reserves creates floor: the Fed won’t let rates dip below zero. (Right now, confusingly, the ceiling is slightly above the floor because of obstacles to arbitrage.)

To boost output, the Fed has stated it will keep short-term interest rates at zero through 2014. This promise could, itself, be a very significant form of stimulus. The forecasting firm Macroeconomic Advisers estimated that extending the market’s perception of the duration of the zero-rate policy by six months is equivalent to about $760 billion of bond purchases -- larger than the famous QE2.

To support that stimulus, the Fed will need to continue paying interest on reserves and preventing a trillion-plus dollars in reserves from flowing into the broader economy. So we’re looking at another two years, at least, of the Fed paying banks not to lend.