Jim Hamilton gets deep into the Fed’s innovations. Among the best analysis I’ve seen — containing some gems like this:
…Where did the Fed get the resources to do all this? In part, it asked the Treasury to borrow on its behalf, represented by the pale yellow region in Figure 7 below, and a sum that last week amounted to a quarter trillion dollars. Note that magnitude is not part of the monetary base drawn in Figure 1. Some of the Fed expansion has shown up as additional currency held by the public, which made a modest contribution to the explosion of the monetary base seen in Figure 1. But by far the biggest factor was a 100-fold increase in excess reserves, the green region in Figure 7. These excess reserves mean that for the most part, banks are just sitting on the newly created reserve deposits, holding these funds idle at the end of each day rather than trying to invest them anywhere.
Figure 7. Factors absorbing reserve funds, in billions of dollars, seasonally unadjusted, from Jan 3, 2007 to March 25, 2009. Wednesday values, from Federal Reserve H41 release. Treasury: sum of U.S. Treasury general and supplementary funding accounts; reserves: reserve balances with Federal Reserve Banks; misc: sum of Treasury cash holdings, foreign official accounts, and other deposits; other: other liabilities and capital; service: sum of required clearing balance and adjustments to compensate for float; reverse RP: reverse repurchase agreements; Currency: currency in circulation.
That idleness, as I read the situation, was something the Fed initially actually wanted, and deliberately cultivated by choosing to pay an interest rate on excess reserves that is equal to what banks could expect to obtain by lending them overnight. As long as banks do just sit on these excess reserves, the Fed has found close to a trillion dollars it can use for the various targeted programs.
But what would happen if those electronic credits start to be redeemed for actual cash? Then we would have a concern, and the Fed would need to call the reserves back in by selling assets or failing to renew loans. But that presents a potential problem, as noted by Charles Plosser, President of the Federal Reserve Bank of Philadelphia:
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