Moreover, since the level of bank reserves in the banking system does not determine how much money is created, it also does not determine money supply in the broader economy.

As a result, the level of bank reserves does not really influence the level of interest rates in the broader economy. 

Central banks adding reserves will influence the interest rates for overnight interbank borrowing of reserves for daily settlement purposes, as seen by the rock bottom Effective Fed Funds rate. But, this is ultimately a purely interbank market, as banks are the only ones who can (or need to) borrow/lend reserves.

What happens in the Fed Funds market (market for borrowing/lending bank reserves) has little to do with the level of interest rates in the broader economy, again because bank reserves are not lent out.

Consequently, interest rates are not set by central banks.

Instead, they are set by real economic forces; that is, by levels of supply and demand for loans, not levels of supply and demand for bank reserves. This is corroborated by how the Fed really follows, rather than leads, interest rate markets.

From the chart above, it can be observed that the level of loans originated by the US banking system does not have the relationship with bank reserves that central banks think it has (and would like it to have).

Starting with the first highlighted period, the Great Financial Crisis in 2008, you can see bank reserves first start to move much higher from their previous levels in 2007 as the Fed embarked on what is now widely referred to as QE 1.

Even as bank reserves moved up to what were then record highs in 2009, bank loans still kept falling.

After finally making its low in 2010, loans started to pick up, and the Fed went on to implement even more QE in the years after that, which takes us to the second highlighted period, that of 2014’s tapering.

Here, as bank reserves decreased quite substantially, bank loans kept rising.

The Fed’s argument here would be that the economy was strong enough for them to withdraw reserves from the system, which would explain why loans increased even as reserves fell.

But, that argument contradicts itself, since an economy that is strong enough for banks to expand their loan books is one that, by definition, does not require any kind of external support.

Withdrawing support under such circumstances and claiming that the support was helpful assumes that the economy could not have gotten there itself. Which simply isn’t true, as shown by the first highlighted period (2008 to 2010).

During this period, the economy desperately needed banks to expand the money supply by making more loans, but the banks did not oblige. Instead, they shrank their loan exposure, and with it, money supply.

All this while the Fed kept increasing the level of bank reserves!

Pandemic 2020 drives this point further home, as the exact same thing happened again, and is still ongoing. The economy needed banks to expand money supply as businesses were shutting down at an alarming rate, taking millions of jobs with them, but the banks did no such thing.

Again, they chose to shrink their loan books instead, even as the Fed pumped, and continues to pump, trillions of bank reserves into the financial system.

That’s trillions in reserves, only for total loans to decrease. Not once, but twice, in the last 13 years.

Reserves really are not what they are thought, taught, or made out to be.

Since bank reserves are not the lynchpin that everyone thinks they are, doesn’t that imply that the Fed’s policies do not work?

And if their policies do not work, does that not then invalidate their entire current policy framework?