The Federal Reserve increase in interest rates to the 5.25-5.5% level in July 2023 was unnecessary and unwise. Inflation is now falling and will continue to fall. Having come in at 3% in June, the real rate of interest is now more than 2% and rising. This is after having been negative for many years.
The Federal Reserve Economic Data graph that I constructed here shows the real interest rate in black, it being equal to the market rate minus the inflation rate.
The real rate fell to a low of minus 8% in March 2022. It has been negative for 12 of the last 13 years ending in 2022, as the graph shows. Now at more than 2% and rising quickly as inflation falls, the Fed needs to stop raising rates and begin a gradual decline.
None of this control of interest rates by the Fed would be necessary if the Fed stopped paying interest on reserves. Reserves owned by private banks but held at the Fed because the Fed pays interest on reserves were $3.3 trillion in June 2023. The Fed is paying banks to not lend out money, to not intermediate savings into investment, and to decrease economic growth. Why? Supposedly for banking insurance policy. But the Fed cannot use any of these funds for any bailout since the Fed does not own them.
Stopping the payment of interest on reserves, which was authorized during the banking crisis of 2008 through the The Emergency Economic Stabilization Act (EESA) of 2008. All excess reserves had been zero (or as close as was feasibly possible) before 2008, with only about 1% of deposits held as required reserves coming into 2008. Essentially 1% of deposits held as reserves meant close to zero required reserves and zero excess reserves. The Fed was in a bind with the 2008 investment bank crisis, hit negative reserves without counting their borrowing through swaps, and instituted the policy of paying interest on reserves. This is a pure diversion of the inflation tax seigniorage from the US Treasury to private banks: a subsidy on the scale of billions of dollars that grows each time the interest rate rises and these reserves stay the same.
The bigger problem is that it disconnects the monetary policy of the Fed buying Treasury debt to finance the government spending through money supply increases from the market interest rates. The two are now set separately. The money supply does not automatically enter circulation. Part of it goes into these excess reserves held at the Fed. Therefore the interest rates are no longer market determined. The money supply entrance into markets and into inflation pressure is no longer known or determined by the Fed. What enters into circulation from reserves is determined by private banks. So the Fed money supply policy is determined in part by private banks, who get paid to keep the money sterilized but can renege on this deal at any time and lend out the reserves so that the money enters circulation.
With the Fed by diktat setting market interest rates, it is now setting them too high since inflation is falling fast.
Max Gillman 