Richard Fisher explains why excess reserves can create velocity

What are excess reserves?

Richard Fisher also discussed the impact of quantitative easing (or QE) on excess reserve balances held by depository institutions at his speech at the London School of Economics on Monday, March 24.

Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities. Depository institutions must hold reserves in the form of vault cash or deposits with Federal Reserve Banks. Excess reserves by depository institutions are surplus balances held by banks at the Federal Reserve over and above the statutory balance requirements. Depository institutions are banks such as Citigroup (C), JP Morgan (JPM), and Wells Fargo (WFC). Usually, excess reserves signify a weak lending environment in the sense that banks prefer to hold deposits with the Federal Reserve Banks at very low rates of interest instead of lending to businesses at a much higher rate.

Why has expansion in the monetary base not led to commensurate job creation?

According to Fisher, the Fed has exhausted the efficacy of quantitative easing. Before the crisis, the norm for the monetary base was less than $900 billion. This has now risen to about $4 trillion, of which ~$2.7 trillion is in the Fed’s books by way of reserves.

The build-up in reserves means the monetary base has really “yet to be activated, or to see velocity pick-up” that would translate to job creation, which the Fed (in its dual mandate) is responsible for assisting. As there has been “no velocity pick-up” due to lack of commensurate bank lending, expansion in the monetary base hasn’t led to job creation as planned. The next phase will be transforming the monetary base while anchoring the base interest rate.

On interest paid on the excess reserves held by banks

Congress has mandated that the Fed pay banks for excess reserves at 0.25%. The Fed didn’t do this before. However, Fisher believes banks aren’t holding excess reserves with the Fed for the return. Instead, they’re holding it because they don’t believe they have sufficient demand for the excess liquidity they have. “We would have to move it (interest rate on excess reserves) massively… for it to have an impact on their behavior and I don’t think it will be well received,” said Fisher.

Excess reserves as a tool to generate velocity once asset purchase program ends

Fisher also said that excess reserves are “a tool we can use particularly in the exit side… once we start.” This implies that the Fed, by changing the rate it pays on excess reserves, should have depository institutions hold reserves at a level appropriate for monetary policy. So, this would provide an important exit strategy tool that would allow the Fed more control over excess reserves when it tapers.

Tapering would mean ending the monthly asset purchase program of purchasing longer-term treasuries (TLT) and agency-backed securities (MBB) at $55 billion per month—which is estimated to end this fall. This would impact demand for longer-term treasuries (TLT) and agency-backed securities (MBB).

To find out Fisher had to say about normalization of the Fed’s balance sheet and monetary policy, read on to Part 6 of this series.