Unintended consequences of lift-off in a world of excess reserves
Bar a disastrous NFP print this coming Friday the US Federal Reserve will change the target range for the Federal Reserve (Fed) Bank’s Funds rate from the current level of zero – 25bp to 25 – 50bp on December 16th. The Fed will effectively raise the overnight interbank rate of interest to around 30bp from an average of only 12bp in 2015. Ironically, that will be seven years, to the day, when the Fed first lowered rates to the current band.
During the period of ZIRP madness, the Fed’s balance sheet ballooned 6.2 times its pre-Lehman size to allow the central bank to add monetary “stimuli” even at the zero lower bound. Consequently the financial system got stuffed with more cash than they knew what to do with; commercial banks thus ended up funding the very same assets they sold to the central bank through excess reserves held as deposits with the Federal Reserve bank itself
Source: Board of Governors of the Federal Reserve System – H.4, Federal Reserve Bank of St. Louis, Bawerk.netHistorically the Fed would meet their targeted interest rate in the interbank market by conducting open market operations, id est buying and selling securities on the margin from designated primary dealer banks to affect available reserves and hence the rate of interest. As a side note, in this ˈmarketˈ demand will indeed create its own supply. ˈMarket signalsˈ emanating from banks eager to expand their balance sheet will put pressure on interest rates, and hence prompt the Fed to buy securities in order to add reserves in order for them to maintain rates at their ˈappropriateˈ level. This Keynesian creation is thus the only ˈmarketˈ that actually operates according to Keynesian principles; whereby demand dictates the level of supply.
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