Are You A Victim Of The Bank Reserves Myth? 1

August 18, 2021

Are You A Victim Of The Bank Reserves Myth? 1

Does the Fed actually control interest rates? No, it does not.

Previously, we discussed the Fed’s supposed control over interest rates through the perspective of their policy actions, centered on the fact that their policy rate decisions are timed against prevailing economic conditions.

However, this discussion is based on an important assumption – that their policies actually work. What if, in reality, the Fed’s policies do not work?

As things stand, modern central banking orthodoxy is based on targeting a predetermined level of inflation, more often than not set at 2% in developed economies.

Central banks seek to keep inflation close to this target by deciding what level to set their policy rates at. This setting of policy rates is in turn widely believed to influence the level of interest rates throughout the economy.

But how do central banks go about setting policy rates?

There is a psychological and physical aspect to it.

Firstly, belief in central bank omnipotence is so widespread that markets buy or sell in anticipation of a central bank changing its policy rate(s). In this sense, the market does the work of the central bank for it.

However, should a central bank need to intervene directly in markets to adjust rates to where it wants them to be, they do so by adjusting the level of bank reserves in the financial system.

Theoretically, if a central bank wants rates to be higher, it sells some form of fixed income instrument (more often than not government bonds) to banks. In doing so, it lowers the amount of bank reserves in the system, since banks pay for these bonds with reserves.

Accordingly, the lower level of bank reserves means less “money” in the system, which pushes interest rates higher.

It is important to note that not all central banks target inflation, or a predetermined level of inflation. Some target exchange rate values, or both inflation and exchange rate values.

Different central banks have different mandates and execute their policies differently, although bank reserves tend to be key in how they interact with their domestic banking systems. Just think of how many base their monetary policies on setting a main policy rate and/or reserve requirement ratio.

Consequently, bank reserves are the basis underpinning modern central bank policymaking. This is evident from how the central banks of the world’s largest economies (Fed, ECB, BoJ) persist with continually adding reserves to their financial systems via more iterations of QE.

Unfortunately for central banks, more bank reserves have not solved their economic problems.

Why not? Simply because bank reserves do not play the role that they are supposed to play in today’s modern banking system.

Banks do not lend reserves, which means that central banks are not meaningfully influencing the creation of new money in the economy by stuffing it with more and more reserves.

To be continued…