Are Abundant Reserves Paying for the CFPB?

Back in 2008, the Federal Reserve made important changes in the way it handles monetary policy. We’ve written about them several times, but few really understand. The press won’t ask questions about it and few economists discuss them. They seem nuanced and arcane, and they are, but they are also massively important, and potentially dangerous.

With Quantitative Easing, the Fed shifted from a scarce reserve model to an abundant reserve model. The flood of new money grew the Fed’s balance sheet from $870 billion in August 2008 to its current level of $7.4 trillion. That’s a 747% increase. The Fed was just 5% of the size of the economy in 2008, today it exceeds 25%.

In order to contain the potential inflation from all this money the Fed has raised banks’ capital requirements and increased liquidity demands. Despite being flush with reserves, banks are constrained in making loans, holding three to four times more reserves as a share of deposits than they did in 2007 before all these changes happened.

One result of this is that banks no longer trade federal funds. They don’t need to because they all have excess reserves, the system as a whole is flooded with them.

When banks had scarce reserves, interest rates were a signal about the demand for money because banks borrowed and lent reserves every day. With reserves now piled everywhere, there is no market for federal funds and the Fed sets rates wherever it wants them…with or without regard to the demand for money.