Industrial Insight

Interest on Reserves is the only thing holding back inflation… | November 11, 2010

http://www.realclearmarkets.com/articles/2010/11/11/why_the_feds_qeii_will_not_work__98753.html

November 11, 2010

Why the Fed’s QEII Will Not Work

By Louis Woodhill

Imagine a bus packed with passengers. The driver has the gas pedal floored and his left foot hard on the brakes at the same time. The engine is roaring. The bus is vibrating. The transmission is overheating. And, the bus is going nowhere.

Unfortunately for America, the bus is our economy, the passengers are the 14.8 million unemployed Americans, and the bus driver is Ben Bernanke. At the same time the Fed is pouring on the monetary gas with “quantitative easing” (QE), it is pushing hard on the monetary brakes with its “interest on reserves” (IOR) program. And, the economy is going nowhere.

Now, because the market players have the alternative of buying or selling Treasury securities, the financial markets also arbitrage all other investment opportunities against the Treasury yield curve on the basis of maturity, liquidity, and credit risk. If market players (e.g., banks) saw corporate bonds or small business loans as being more attractive investments, on the margin, than Treasuries, they would sell Treasuries and buy the other investments until interest rates adjusted so that this was no longer the case. Accordingly, we can be sure that banks currently view making an incremental loan as no more (or less) attractive than buying a 90-day T-bill paying 0.12% interest.

Now, here is the problem. Under IOR, the Fed is currently paying 0.25% on what amounts to a one-day T-bill. This is far above the current Treasury yield curve. Accordingly, there is no more attractive investment available to the market than bank reserve deposits at the Fed. Therefore, as soon as a new dollar is created via QE, it goes into bank reserves and then it just sits there. No endless chain of transactions is initiated, no loans get made, no “money multiplier effect” occurs, and no new demand is created.

Just as it makes no sense for a bus driver to floor the gas pedal and the brake pedal at the same time, it makes no sense for the Fed to do QE and IOR at the same time. Unless IOR is ended, the Fed’s $600 billion of QE2 will do little to stimulate demand in the general economy.

Advertisements

Posted in Uncategorized

Leave a Comment »

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: