There have been some interesting side discussions at various venues including Naked Capitalism about the recent essay which I had posted titled When At First You Don't Succeed, Bring in the Reserves.
Let me clarify some points.
Yes, banking reserves in the US are a function of the Fed's Balance Sheet, by definition, because they are in the narrowest sense merely an accounting function, an entry on the books of the Fed reflecting actions undertaken by the Fed.
With purpose, I put the formal definitions of Reserve Bank Credit and Reserve Balances at the bottom of each chart. I had hoped this would make that point clear.
The essence of the essay was to point out the enormous increase in bank reserves which the Fed has created through their "New Deal for Wall Street" style banking programs. Because of this, the Fed has created a new function by which it pays interest on banking reserves, which to my knowledge it has never done before.
It is a new function at the Fed, and it does serve a important purpose. The purpose is to place a 'floor' under interest rates, in the face of a surfeit of liquidity which the Fed has created, and which shows up in the Adjusted Monetary Base, the Reserve Bank Credit figures, and so forth.
Now, some people have taken issue with my bringing the notion of excess Reserves to your attention for a variety of reasons. Even the mighty NY Fed has written a paper which attempts to defuse the notion that the excess reserves are indicative of anything that might be impeding lending.
Let me be clear about this.
The excess reserves are absolutely indicative of the Fed's having added substantial amounts of liquidity to the financial system. If the Fed were not paying interest on reserves, this liquidity would crush their target interest rates, since the banks are loath to hold reserves that are not generating some return. This is what they do, generate a return on capital. Capital has a price, even if it is an opportunity cost.
By establishing a floor, the Fed is setting a more blatant artificial level for interest rates, moreso than merely tinkering with drains and adds to the system. They are offering a riskless rate of return, and crowding out other competing requests for capital. Not necessarily a bad thing, but a reality of what they are doing.
What would happen if the Fed raised the interest rate it pays on reserves to let's say, twenty percent?
Economic activity in the US would grind to a halt, as banks placed every available dollar idly with the Fed's program, eschewing all other deals, liquidating assets if necessary, to place capital where it would receive the highest risk adjusted return. In essence, the Fed would 'crowd out' all other transactions that offered a lower risk adjusted return.
What if the Fed subsequently lowered the interest rate from twenty percent to zero? It would then enable more lending from the banks, as they sought to deploy their capital at higher risk adjusted rates.
There are some by the way that claim the excess reserves are so high because there is no demand for loans. This is a point of view only supported by those who a) have no understanding of finance and b) are seeking to support an extremely odd and mistaken view of the economy which seeks to justify their bets on a serious deflation.
There is always a demand for loans as long as there is economic activity; what varies is the price! Money is not particularly inelastic; that is, there is a rather high threshold at which people say, "I have too much!" It is rather a question of price, relative to return. Make the opportunity cost high enough and they will come (or be fired).
I hereby assert that I will borrow ALL funds the Fed might loan to me with no collateral at zero interest, and gladly so, as long as the short term US Treasury bills are paying more than 25 basis points interest. I reserve the right to defer on this offer if the Fed should make the policy error of hyperinflation a reality.
I hate to make points like this in the extreme with distorted examples, but sometimes it is what it requires to pierce through obfuscation to common sense.
So to summarize, what is the Fed likely to do if economic activity falters?
They are likely to lower interest rates paid on excess reserves closer to zero. They could even charge a 'haircut' on excess reserves which would highly motivate the banks.
These are all things which have been discussed before, often in the context of consumers! In fact, it is well known among bankers that as the Fed lowers interest rates money flows out of lower paying instruments like bank deposits and money markets, and into higher paying instruments that might be deemed too risky at high rates of riskless return. Such higher paying instruments are known as "stocks" and "corporate bonds." As former central banker Wayne Angell gleefully chortled in 2004, the Fed can indeed drive the public out of their savings and money market funds and into the equity markets by manipulating interest rates.
Does the Fed always 'create' excess reserves? It may be more correct to ask, does the Fed always create money, since excess reserves are an accounting function.
No. Banking reserves normally lag the creation of money, which is accomplished by lending, either from banks or more recently by neo-banks like Fannie, Freddie, GMAC, GE and so forth.
But at a time when economic activity is contracting, and the credit markets were seizing, the Fed took the lead in money creation by "monetizing" various types of debt. And they are going to enormous pains to maintain 'confidence' in the system and in particular the US dollar and debt. But we may ask, at what point does the confidence game become a con game? I would submit that it is when the Fed and Treasury purposely intervene in markets, beyond their normal interest rate targeting, and statistics and spread disinformation to manage perception.
There are other ways in which the Fed might address the failure of the productive economy to 'pick up the ball and run with it.' But most, if not all, of them involve the monetization of something, which is what happens when the Fed (and US Treasury) are taking the lead in money creation and not the productive economy.
Deflationists do not want to hear this, and central bankers do not wish you to know this, but it is the major factor in a fiat currency that it can be created literally 'out of nothing.'
This is why we have said long ago, and repeated since, that the limiting factor on the Fed's ability to create money is the value of the US Dollar and the sovereign debt.
As long as there is debt which can be monetized, then the Fed can monetize it and create money 'out of nothing.' For now they are acting with some reestraint, and channeling that money primarily to their cronies in the banking system, still able to mask the effects of their monetary inflation. CFTC Moves to Rein In Small Investors From Commodity ETFs
But the time is coming when they will not. And as they did when they demanded $700 billion in bailout money, the financiers will once again make the Administration and the Congress an offer which they think that 'we' cannot refuse, if only because the Congress will not listen if we tell them what we wish them to do, again.
The banks must be restrained, and the financial system reformed, and the economy brought back into productive balance, before their can be a sustained recovery.
