Excess reserves and heightened uncertainty

Much has been made about the uncertainty that hangs over the economy.  Consumer sentiment has languished, the upturn that began over a year ago has come to a halt and the recovery that began 15 months, according to the NBER, has produced few jobs.

However, the excess reserves sitting at the nation’s banks is among the most concrete signs that financial institutions, consumers and small businesses are feeling extremely queasy when it comes to looking at how the current recovery may play out.

Normally, excess reserves – those over and above what the Fed requires be held in the event of some unexpected need such as customer withdrawals – are minimal.


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Prior to the credit crisis that hit its zenith in September and October of 2008, excess reserves held steady at between $1 to 2 billion, a paltry amount given the size of the economy.

Banks normally have very little reason to hold extra cash because of the low rate of return and the incentive to earn income by lending out the funds.

This held true until September 2008, when excess reserves jumped from $1.8 billion in August to nearly $60 billion, and then continued its run before peaking in March 2010 at just under $1.2 trillion – no paltry amount!

A liquidity trap?
Former Fed Chairman Alan Greenspan correctly pointed out in a recent comment printed by Bloomberg News, “There is a heavy weight of uncertainty on the system such that we are not getting the impact of a trillion dollars already on the books into the marketplace.”

Consumers, worried about their own financial predicament are in no mood to take risks, even with rock bottom interest rates. And banks, still trying to repair battered balance sheets, aren’t in any mood to lend.
Consequently, what we have looks like a “liquidity trap”  - where flooding the system with money no longer has any impact on interest rates.

An economist would argue that the demand for money is completely elastic, i.e., the demand curve for money is horizontal. Or a layman might say that conventional monetary policy is no longer effective because adding more money works about as well as pushing on a string.

Let’s not forget, however, that the Fed is now harping on deflation and longer-term Treasury yields have come down.  That has knocked mortgage rates to record low levels, so it does appear that the Fed still has ammo in its arsenal.

Credit markets seize up
We got to this point after the crisis that was precipitated by the failure of Lehman Brothers and the near collapse of the financial system.  Among other things, the Fed opened up the spigots and flooded the system with money to keep credit markets from disintegrating – see chart below.


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Horrendous inflation did not ensue because the velocity of money – or how often it turns over in the economy – plummeted.

If consumers began demanding and banks began lending, the excess reserves on hand would send economic activity into the stratosphere and eventually cause a huge run-up in inflation.

To prevent such a scenario from causing a new burst of unwanted inflation, the Fed has already telegraphed it would begin withdrawing reserves and hiking rates in order to prevent the economy from overheating.

All of this is theoretical, of course, and a roaring economy, coupled with rising inflation, is unlikely at this point.

As already mentioned (as well as the major thrust of this article), the excess reserves sloshing around the system underscore the uncertainty that pervades the economy.