The “Abundant Reserve” System Crushes the Fed
Fifteen years ago, in 2008, the Federal Reserve started an experiment in monetary policy, switching from a “scarce reserve” system to one based on “abundant reserves.” This switch has created massive problems that are hitting not just the private banking system but the Fed itself.
During the 2008 Financial Panic, the Fed argued that the financial system was so frail it required a bigger Fed balance sheet. Afterwards, the Fed said the non-inflationary growth from 2009 - 2019 showed the system worked. During COVID, the Fed doubled down with even more Quantitative Easing (QE). The result? Inflation at a forty-year high and government agencies bailing out banks and depositors.
More importantly, the Fed apparently hadn’t anticipated what would happen to its own financial situation when it couldn’t hold interest rates at artificially low levels anymore. The Fed’s most recent year-end financial report showed that the Fed has a $1.1 trillion unrealized loss on its massive bond portfolio, easily dwarfing its capital. And because the Fed now pays interest on bank reserves it is losing roughly $25 billion every quarter, a run rate of a $100 billion loss per year. At the same time, the Fed’s operating budget requires $9 billion a year.
What we’d like to know is how the Fed is paying for its operating budget? Where is it getting the money to pay for wages and salaries? Does the Fed print new money to pay for its budget? Does the Fed borrow from the Treasury without authorization from Congress? Or does the Fed borrow from banks, using the repo market to pay its salaries? We’ve been trying to contact the Fed to find out, but no one has responded.
To understand this new system, it is important to compare it to the old system. Under the “scarce reserve” model, when a bank got a $100 deposit, it would keep roughly $10 in reserves at the Fed. At the end of 2007, banks had $7.5 trillion in deposits (measured by M2) and the Fed’s balance sheet was $850 billion. So, the Fed’s balance sheet (bank reserves plus its capital) was roughly equal to 11% of bank deposits.