BEE Partner, South Africa Economy Watch

Reserves

The deposits and currency created by the Federal Reserve are the reserves of the modern system. It would seem that if the Fed could control the amount of these reserves, it could thereby limit the ability of banks to lend, and thus control their ability to create deposits. By controlling reserves, the Fed could control the total quantity of money. As we saw earlier, real reserves did constrain banks. It has seemed plausible, and monetarists everywhere have believed, that modern, nominal reserves could provide a similar constraint. But central banks all around the world, including the Federal Reserve, have tried to exercise such control, most recently in the late 1970s and early 1980s, and, in virtually every case, their attempts have failed.

The reasons behind this failure are complex (Goodhart, 1984). At a minimum, a central bank is responsible for orderly markets, for efficient clearing, and for regulation that ensures the safety and solvency of the system. Maintaining orderly markets requires the smoothing out of basic interest rates, seeing that seasonal factors and tax collections, for example, do not unduly affect financial markets. Clearing of all valid checks is necessary if bank deposits are to serve as part of the currency. Safety and solvency mean that sound banks must not be allowed to fail because of liquidity shortages. These points add up to the fact that the Fed cannot refuse to provide reserves if they are needed. First, a reserve deficiency or excess will have a strong and immediate impact on the Federal funds rate. (Because reserves earn zero interest, an excess will drive the rate down strongly, while a shortfall puts a bank in violation of the laws, causing it to bid urgently for funds.) Second, checks written against valid deposits cannot fail to clear because the bank is short of reserves;if this were likely to happen it would inhibit the use of bank deposits as currency. So the Fed must provide reserves. Finally, to safeguard the system and ensure its orderly working, reserves must be available to protect sound banks against temporary liquidity shortages.

Let’s consider this more closely. The Fed’s calculation of the amount of reserves that a bank requires is based on the average amount of deposits and reserves available over roughly the preceding six-week period. If a bank is short of reserves, it has two days to make them up. It cannot change the amount of reserves that it needs, for that amount is dependent upon the reserves it had in the past. Instead, the bank in question must get more reserves. If an individual bank is short of reserves, it can always borrow from another bank that has more reserves than it needs. This is called ‘borrowing Federal funds.’ But if all banks are short of reserves, reserves can only be obtained from the Fed. If banks are forced to scramble for reserves, problems will develop and check clearing may be disrupted, driving interest rates up sharply. This is exactly what the Fed is supposed to prevent. To meet its responsibilities, the central bank has little choice but to provide the necessary funds.

Too large a supply of reserves can also be a problem. For banks, reserves are assets, but they are assets that earn the bank nothing. Deposits at the Federal Reserve earn no interest and, of course, currency earns nothing. Having currency and deposits at the Fed is necessary and useful, but no bank will want to keep more than it needs. A bank with more than it needs will seek to lend reserves to banks that are short of reserves. As long as there are banks wishing to borrow, this is fine. But if all banks taken together have an excess, the interest rate on these funds (called ‘the Federal Funds rate‘) will fall. Yet this may not eliminate the excess, at least not in the short term. Lower interest rates may eventually increase the need for reserves, but only after banks have lowered their own rates and increased the amount of loans. So in the short run, an excess of reserves could drive the Federal Funds rate to zero. To avoid this, the Fed steps in to sell some of its assets to the public, which are paid for out of banks‘ reserves. Managed properly, such sales will reduce the amount of reserves to what is needed by the banking system.

This does not mean that the Federal Reserve has no ability to influence the process. But its influence is indirect. The Fed chooses an interest rate at which it will buy or sell certain types of short-term assets. This is its target interest rate. Because of its ability to buy as much as it pleases (or sell vast amounts), it can effectively set this interest rate. If it raises this rate, other rates, including those changed by banks on loans, will also rise. The higher interest rates will discourage borrowing and will reduce the amount of reserves that banks require. If the Fed lowers this rate, borrowing will increase and so will the amount of reserves that banks need.

The Fed also has other tools at its disposal. It regulates the banking system, and it can apply pressure to banks by strict enforcement of regulations. It also serves as an information conduit and as a coordinator; it can use these positions to exercise behind-the-scenes influence.

Thus, effectively, banks are not constrained by their need for reserves. The Federal Reserve and other central banks influence the amount of deposits indirectly through their ability to influence interest rates. The overall constraint on a modern banking system in a mass production economy is the availability of bank capital.

Now for the ‘punch line.’ This means that expansion and contraction of lending is not tied to levels of reserves, indicating that the previous equations for interest rates do not hold. The supply of money does not depend on reserves. It is constrained only by bank capital; but banks need not economize on capital, the way they had to economize on reserves. Therefore, interest rates are no longer determined by a market process.

The interest rate must now be pegged, since the central bank is required to maintain orderly markets, and has to intervene to prevent seasonal and regional fluctuations. The central bank has to smooth out interest rates. It cannot allow volatility, particularly when fluctuations could lead to unstable patterns of movement. With no supply constraint, financial markets are liable to extreme movements. In short, the central bank has to exercise control over financial markets, so it had better ensure that the level of the interest rate is appropriate.

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