Last modified: 2015-08-25
Abstract
The liquidity and solvency panic of 2008 led to a rescue effort by the Federal Reserve System (Fed) with three stages of "quantitative easing". Â Â The Fed purchased enormous amounts of Treasury and mortgage securities from banks. The result is that the Fed has $4,100 billion in Treasuries and mortgage backed securities (MBS) and the banks have $2,400 billion in excess reserves (up from only $2 billion in 2007). It is important to note that the excess reserves are due to the rescue effort to counter the bad behavior of the big financial institutions that caused the panic.
The huge amount of excess reserves and the severe recession drove short term interest rates to zero in 2008 where they remain today. Various officials and others say it is time for the Fed to raise interest rates even though the economy has not reached a sustainable 3% or so growth rate and inflation is not yet a problem. The question is how and when the Fed is going to do it. Selling the Fed's huge holdings of securities in the open market could cause a bond market crash.
The Fed has a new tool for managing interest rates put into action in 2008, paying interest on excess reserves (IOER). If Janet Yellen's June 17 conference long run fed funds projection of 3.75% is correct the IOER expense to the Fed (and loss of revenue to the Treasury) could be $100 billion per year. The banks would be getting a risk free $100 billion as a reward for their bad behavior which generated the huge excess reserves in the first place.
The problem of high excess reserves and interest rates at the zero bound has occurred before, from 1934 to 1942 with lingering effects past 1960. This period has some lessons that could be useful regarding the current situation. In 1936-7 the Fed doubled reserve requirements to get rid of excess reserves. The result was a disaster. Hopefully, the Fed will not commit another 1936-7 type mistake again.