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Why the Fed pays interest on bank reserves

The Fed's reason for paying interest on bank reserves has been addressed in previous TSI commentaries, but it's an important issue and worthy of additional commentary space. That's especially so because there is so much confusion surrounding the issue. In particular, the actual reason for the interest payments is at odds with the beliefs/assumptions of many journalists, newsletter writers and other commentators on financial matters.

Before getting to the real reason we'll deal with the two most common false beliefs. The first of these is that the Fed started paying interest on bank reserves to prevent the commercial banks from rapidly expanding their loan books in reaction to the Fed-generated ballooning of reserves from Q4-2008 onwards. The second is that the main purpose of the interest payments is to provide financial support to the banks.

There is no truth to the first belief, because the interest payments on reserves have no effect on either the ability or the willingness of banks to make loans. The facts are that a) reserves cannot be loaned into the economy, b) there has been no relationship between US bank reserves and US bank lending for decades, and c) even if the amount of bank lending were influenced by the level of reserves as wrongly explained in outdated economics textbooks, an increase in a bank's lending would not affect the amount of interest earned by the bank on its reserves. This last point is due to the fact that an increase in a bank's loan book could shift reserves from the "excess" to the "required" category, but wouldn't affect its total reserves. The Fed, however, pays interest on ALL reserves, not just "excess" reserves.

There is some truth to the second belief in that the payment of interest on reserves does provide some additional income to the banks. However, even with today's massive reserve levels the financial impact on the banks is trivial (at the current interest rate we are talking about $6B/year of reserve-related interest payments across the entire banking industry, which is a veritable drop in the ocean).

The real reason that the Fed began paying interest on bank reserves in late-2008 was to enable it to maintain control of the Fed Funds Rate (the overnight interest rate on reserves in the inter-bank market and the primary rate targeted by Fed monetary policy) while it pumped huge volumes of dollars into the economy and into the reserve accounts of banks.

To further explain, prior to the extraordinary measures taken by the Fed in late-2008 in reaction to the global financial crisis, the Fed Funds Rate (FFR) could be adjusted by making small changes to reserves. However, after the Fed began pumping hundreds of billions of dollars of reserves into the banks, the central bank was in danger of losing its ability to control the FFR. With the commercial banks inundated with reserves and with plans in place for additional rapid monetary expansion, it became clear to the Fed that even maintaining an extremely low FFR of 0.25% was going to be impossible. Furthermore, the Fed was thinking ahead to the time when it would have to start hiking the FFR. With reserve levels way in excess of what they needed to be to set the FFR at 0.25%, even the superficially minor task of pushing the FFR back up to 0.50% would, under the Fed's traditional way of operating, necessitate a large-enough contraction of bank reserves and the money supply to bring about another financial crisis.

Think of it this way: In October of 2008 the FFR was at 1% and the total level of US bank reserves was $315B. This suggests that $315B was consistent with an FFR of 1%. Today, the total level of bank reserves is about $2.5T. The implication is that to get the FFR back up to 1% the Fed would have to remove about $2.2T of covered money ($2.2T of money 'backed' by $2.2T of bank reserves) from the US economy, but there is no way that it could remove that amount without crashing the financial markets and the economy. Actually, we doubt that it could even remove a quarter of that sum without precipitating a stock market collapse and a severe recession.

This problem was obvious to Bernanke, and his solution was to pay interest on reserves. With this new tool in its kit the Fed gained the ability to set the FFR at whatever level it wanted without adjusting bank reserves and the economy-wide money supply. For example, if the Fed decides in the future that it wants the FFR at 1%, it could achieve this target by simply changing the interest rate on reserves to 1% while leaving reserve and money-supply quantities untouched.

A likely ramification of the Fed's ability to control the FFR via the interest rate on bank reserves is that the Fed's balance sheet has reached a permanently high plateau. There will be no traditional tightening of monetary policy in the foreseeable future.

Industrial Metals Update

Since making a short-term low about 2 months ago the Industrial Metals Index (GYX) has been oscillating within a contracting range. This price action could be part of an intermediate-term bottoming pattern or a consolidation within a continuing intermediate-term decline. It's more likely to be the latter.

The Stock Market

Europe

European equities have been very strong since early January. In the cases of the EURO STOXX 50 Index, Germany's DAX Index and France's CAC40 Index, this strength resulted in breakouts to new multi-year highs (a new all-time high in the case of the DAX). However, in some of the 'peripheral' markets the strength resulted in a test of last year's high, but no breakout to new highs, yet. Daily charts of Italy's MIB index and Spain's IBEX Index, the two best examples, are displayed below.

Our guess is that the MIB and the IBEX will make sustained upside breakouts within the next few months, but not within the next few weeks. Given that European equities have risen strongly over the past two months in response to more rapid monetary inflation and in anticipation of the new ECB money-pumping program that's due to start this month, the stage is set for the start of the ECB's new program to mark a short-term price top. This would be a typical "buy the rumour, sell the fact" scenario.

The World

The Dow Jones Global Index (DJW) is in a similar position to the two European indices shown above. It is also in a similar position to the NYSE Composite Index. We suspect that an intermediate-term peak is in place for the DJW or will be put in place via an upward spike to a marginal new high within the next few trading days.



As far as we can tell, only the US stock market is at a dangerously high valuation. In fact, by some measures the US stock market is more expensive than it has ever been, because, unlike in March-2000 when the average valuation was at an extraordinary height due to the stratospheric valuations of a fairly small number of large-cap tech stocks, the valuation of the average stock is much higher today. However, many of the markets that aren't over-valued have extreme short-term vulnerability. This is due to the fact that they have fully discounted a lot of good news on the monetary front and, in some cases, are precariously poised near important resistance levels.

Gold and the Dollar

Gold

With gold's correction having done as much as it needed to do (in US$ terms), this was a likely week for a short-term bottom in the US$ gold price. There is still a chance that a multi-week rally will begin before the end of this week, with Thursday's ECB meeting or Friday's US employment report acting as the catalyst, but with the HUI having just broken below its 50-day MA there is now a higher probability that the correction will extend into next week.

The monthly US employment report has almost no value as an economic indicator, but the Fed focuses on it so the markets focus on it. After all, nothing matters in the financial markets anymore except for the machinations of the monetary politburo, genuine price discovery having been eradicated many years ago.

According to Bloomberg, the average expectation is that the US economy added 230K jobs in February. Due to reduced activity in the oil industry and related businesses there is scope for a big negative surprise in the February data, but that's definitely not something we would bet on.

In any case, the only useful information associated with the employment numbers is how the markets react to them. For example, in gold's case a downward spike followed by an upward reversal in reaction to a strong employment report would be bullish, while an upward spike followed by a downward reversal in reaction to a weak employment report would be bearish.



2015 will probably turn out to be a decent year for gold as an investment. However, it's important not to have high expectations with regard to gold's likely performance over the remainder of this year's first half. A multi-week rally will probably soon begin, but with the true fundamentals still no better than 'mixed' a sustained break above $1300 is probably not going to happen during the first half. Also, when the S&P500 Index made a new all-time high last month it meant that the US$ gold price would probably have to test last year's low before commencing a major advance.

Gold Stocks

The HUI held support at 180 'by the skin of its teeth' on Wednesday. However, the first of the following daily charts shows that it broke below its 50-day MA, which it shouldn't have done as part of a routine short-term correction. Also, the second of the following daily charts shows that after holding up well over the preceding few weeks, the HUI/gold ratio dropped quite sharply this week.

When the HUI quickly rose to its 200-day MA in January, a pullback to support at 180 and/or the 50-day MA became likely. It was a predictable outcome. With the HUI having just broken below its 50-day MA while barely remaining above 180, a high-confidence short-term prediction is not possible. What we can say is that IF 180 continues to hold on a daily-closing basis then the next multi-week rally should result in a new 2015 high for the HUI even if gold bullion fails to move back above $1300. However, we do not have an opinion on whether 180 will hold.

If the HUI closes below 180 then the next multi-week rally will probably end at a lower high for the year.

The Currency Market

David Stockman noted earlier this week that $2T of European government bonds are now trading at negative yields. As Bloomberg further noted, 88 of 346 European sovereign debt issues tracked in its index are now trading at negative yields. As recently as 2 years ago no rational person would have believed this to be possible, but here we are. Furthermore, within the next two weeks the ECB is expected to begin a new bond monetisation program that will have the direct effect of putting additional downward pressure on euro-zone bond yields. More details about the new bond monetisation program are likely to be announced at the conclusion of the 5th March ECB meeting (later today, that is).

While the ECB's new money-pumping program will have the direct effect of putting additional downward pressure on bond yields, an indirect effect could be an increase in inflation expectations of sufficient magnitude to more than offset this downward pressure. In fact, this is what we think will happen. We think that the start of the ECB's new bond monetisation program will roughly coincide with an intermediate-term bottom for interest rates in the euro-zone. This would be similar to what happened following the kick-offs to the massive bond-buying programs implemented by the Fed over the past several years.

The start of the ECB's new pro-inflation program is also likely to coincide with an important turning point in the currency market -- a turn from down to up in the euro and from up to down in the Dollar Index.

Updates on Stock Selections

Notes: 1) To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html

Note on Dragon Mining (DRA.AX)

DRA trades on the Australian stock market. It is a former member of the TSI Stocks List and a current member of the TSI Small Stocks Watch List.

In the 25th January Interim Update we pointed out that, like Dalradian Resources (DNA.TO), DRA benefits from the strong rise in the euro-denominated gold price. Furthermore, we noted that DRA's benefit from gold/euro's strong rise was more direct and immediate than DNA's, because whereas DNA is an exploration-stage miner with a project in the euro-zone DRA is a current producer with projects in the euro-zone and Sweden (the Swedish Krona has been even weaker than the euro, meaning that gold/Krona has been even stronger than gold/euro).

Despite the fact that DRA.AX stands to benefit more than most junior gold miners from the changes in the gold and currency markets that have taken place over the past several months, prior to this week it hadn't rebounded far from its low and was trading well below its working capital (meaning: the market was valuing DRA's cash-flow-positive gold-producing assets at less than zero). However, prompted by the release of financial statements and drilling results on Monday 2nd March, the market has begun to pay a little more attention to DRA.

DRA earned a profit of A$7.8M in 2014 and should definitely be profitable at the higher euro-denominated gold price of today, and yet at the beginning of this week it was trading at a discount of more than 50% to its working capital. To be more specific, the financial statements issued on Monday showed that DRA had no long-term debt and about A$0.26/share of working capital, and yet the market price of the shares began the week at only A$0.10. Who claimed that the stock market is efficient?

The stock quickly gained 60%-80% of market value in response to the information released on Monday, but at A$0.16-A$0.18 it is still being priced at a sizable discount to the company's working capital.

We have no current intention of returning DRA to the TSI Stocks List, though, because it remains very illiquid and therefore very difficult to trade. The fact that the stock price gained 70% on Monday in response to only $25,000 of buying is indicative of the lack of liquidity.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html