Last month, I posted a piece on bank excess reserves and the federal funds rate.  I was basically saying that the Fed was not really holding down the fed funds rate.  It makes this announcement after every FOMC meeting that it is keeping the rate at between zero and .25 percent.  This has been going on for a couple of years.  But because the banks have massive amounts of excess reserves, there is very little need for overnight lending.  Therefore, this keeps the federal funds rate low and the Federal Reserve’s monetary expansions or contractions have little to do with their target rate right now.

In my piece, I also cited an article by Kel Kelly.  In his article, he says that the only way that the Fed can raise rates is by paying the banks significantly higher rates on their excess reserves and that this is unlikely because it would lead to a recession.

I received a comment in response to my post.  The comment says, “The Fed can [lower] rates only by paying banks interest on reserves.  In your article, you addressed it as ‘raising’ rates, which is not the case.”

I understand this comment, but I maintain what I said in my post and that Kel Kelly is correct in his article.  It is a bit counter intuitive, so let’s go through it.

If the banks had virtually no excess reserves, as was common before 2008, then the Fed could more easily control its target rate.  Therefore, the commenter is right in one sense that if the Fed put a negative interest rate on excess reserves (charged banks for holding money instead of lending it), then this would force down the excess reserves.

But it does go the other way too.  The reason that the Fed started paying interest on excess reserves was so that it had more manipulation power.  It is no coincidence that the rate paid on excess reserves right now is a paltry .25%.  Let’s say that the Fed raised this to 5% tomorrow morning.  What would happen?  The banks would tie up their money in excess reserves and there would be very little money there for banks to lend overnight.  This would actually increase the Fed’s target rate.

Ben Bernanke himself is quoted as saying, “In principle, the interest rate the Fed pays on bank reserves should set a floor on the overnight interest rate, as banks should be unwilling to lend reserves at a rate lower than they can receive from the Fed.  In practice, the federal funds rate has fallen somewhat below the interest rate on reserves in recent months, reflecting the very high volume of excess reserves, the inexperience of banks with the new regime, and other factors.  However, as excess reserves decline, financial conditions normalize, and banks adapt to the new regime, we expect the interest rate paid on reserves to become an effective instrument for controlling the federal funds rate.”

The rate paid on excess reserves actually puts a floor on the federal funds rate.  It is not an exact science as even Bernanke struggled with this when the tool became available.  The Fed did not know exactly where to set the rate on excess reserves and it was throwing off their target rate.  So if the Fed announced a significant increase in the rate paid on excess reserves, this would in fact raise the fed funds rate.

So the Fed can control the federal funds rate, but it is unlikely to do so right now.  If it raises the rate on excess reserves, this would really hamper lending and it would likely lead to a quick and sharp recession.  If the Fed puts a negative interest rate on excess reserves (charges a fee), then banks will start to lend out their reserves and we will see massive price inflation very quickly.

The Fed will keep walking a tight rope between recession and inflation.  It will eventually run out of room and we will probably get both at the same time, if we don’t already.