Monday, November 2, 2009

Goldman: Excess reserves do not matter!

Below is an email I just received from Warren Mosler, which contains a very good explanation by a Goldman Sachs executive on why excess reserves in the banking system DO NOT portend incipient inflation.


Francesco Cafagna
Managing Director
Goldman, Sachs & Co.
Vice Chair - SIFMA Funding Division
Executive Committee

1. Do excess reserves really matter and does the FED really need to drain them?
The short answer is: I don't think so. The total amount of reserves currently in the banking system is the sum of all Required Reserves (including a certain amount that banks hold for precautionary reasons) and Excess Reserves. The FED HAS to provide the banking system with the amount of Required Reserves it needs otherwise rates spike higher (potentially to infinity if the discount window or other forms of “marginal lending facilities” did not exist): the amount required is the result of banks’ individual credit decisions (how many loans they make) and the FED’s job is to estimate that amount and provide it to the system. But the FED does not control this number. When it comes to Excess Reserves, lots of people worry about the potential long-term inflationary impact they may have. The truth is that they don’t matter because they bear no weight in banks’ credit decisions (how many new loans they make). They simply appear on banks’ balance sheets as an Asset that gets “invested” every night in the form of a deposit that they leave at the FED and on which they currently get a 25bps remuneration. If the FED decided to drain excess reserves via Reverse Repo the impact on the system as a whole would be zero because the system as a whole is “self contained”. To understand this let’s think of the most extreme case: the FED drains all excess reserves via one giant Overnight Reverse Repo executed with all the
banks in the banking system. At a macro level all that’s happened is that each bank has changed its Excess Reserve asset (which is effectively an O/N asset) into and O/N Reverse Repo and the two are virtually identical. Another way to think of this is that Excess Reserves are ALREADY being drained every night because banks leave them on their account at the FED every night. The only thing that will change is the liquidity profile of banks IF the FED decided to execute Reverse Repos longer than 1 day: in that case a 1-day assets (excess reserve) would be transformed into a longer asset (Reverse Repo longer than 1 day). Whilst this may affect individual institutions, the system as a whole is unaffected because this amount “extra cash” in the system (excess reserves) is NOT being used for anything. It just sits at the FED every night. So effectively it’s being “drained” already every night. So all this talk about excess reserves and their potential inflationary impact seems misplaced: they are just irrelevant and the FED simply does not need to drain them because they are “self-drained” every night anyway.

Happy to discuss live if people have specific questions.
Hope this helps

Finally!! Someone from mainstream economics (and Wall Street: Goldman Sachs, no less) that understands what is going on! We have a chance!!

Please distribute to your friends and colleagues!



Mike Sandifer said...

Mike, I don't know why you bother with the economic luddites. They're gonna believe high inflation is cominig no matter what. Some of these idiots are on the FOMC.

I do appreciate your persptives though, as you seem to understand actual economics very well. Some people look at the Peter Schiff garbage and think he knows about economics. He correctly saw the problems in the banking sector, but says the stupidest things about the current economy since the liquidationists of the 30s. Why don't hosts of the various shows that invite him bring this up?

Unknown said...

Mike & Mike

I'm glad I'm not the only one that thinks Peter Schiff has the current economic picture wrong.