Accelerated excess reserves

Accelerated Excess Reserves

Accelerated excess reserves refer to a rapid and significant increase in the amount of funds that depository institutions hold at their central bank beyond what is legally mandated by reserve requirements. This surge in reserves often stems from extraordinary monetary policy actions undertaken by the central bank, such as large-scale asset purchase programs or emergency liquidity provisions. The concept of accelerated excess reserves falls under the broader category of central banking and macroeconomics.

History and Origin

Historically, commercial banks maintained minimal excess reserves because these balances did not earn interest, making them a costly holding. Prior to 2008, central banks, like the U.S. Federal Reserve, typically operated in a "limited reserves" regime, where small adjustments to the supply of reserves could significantly influence the federal funds rate.¹⁰

The landscape of excess reserves changed dramatically following the 2007-2009 financial crisis and the subsequent Great Recession. In response to the crisis, the Federal Reserve embarked on unconventional monetary policies, most notably quantitative easing (QE). Through QE, the Fed purchased vast quantities of U.S. Treasury securities and mortgage-backed securities, which injected substantial amounts of reserves into the banking system.⁹ This led to an unprecedented increase in the total volume of reserves held by banks, far exceeding their required levels. The Federal Reserve's consolidated balance sheet more than doubled during 2008, largely due to these actions, transforming its role in financial markets.⁸ This period marked the emergence of what could be termed "accelerated excess reserves," as the accumulation of these reserves occurred at a rapid pace due to deliberate policy interventions. Furthermore, in 2008, the Federal Reserve began paying interest on reserves (IOR), which fundamentally altered banks' incentive to hold excess balances.⁷

Key Takeaways

• Accelerated excess reserves denote a swift and substantial increase in banks' holdings at the central bank beyond regulatory requirements.
• This phenomenon is often a direct result of unconventional monetary policies like quantitative easing or emergency lending.
• A high level of accelerated excess reserves signifies ample liquidity in the banking system.
• Central banks can influence financial conditions by adjusting the interest rate paid on these reserves.
• The accumulation of accelerated excess reserves has implications for monetary policy transmission and potential inflationary pressures.

Formula and Calculation

The fundamental calculation for excess reserves is straightforward:

Where:

• Total Reserves: The total amount of funds a depository institution holds at the central bank, plus any vault cash that counts towards reserves.
• Required Reserves: The minimum amount of reserves that a depository institution is legally mandated to hold, typically as a percentage of its eligible deposits (known as the reserve requirements).

The "accelerated" aspect refers to the rate of change or the magnitude of the increase in these excess reserves over a relatively short period, often driven by significant central bank open market operations. While there isn't a specific formula for "accelerated" in this context, it implies a steep upward trend in the "Excess Reserves" value.

Interpreting the Accelerated Excess Reserves

When accelerated excess reserves are present, it indicates that the banking system is flush with liquidity. In an "ample reserves" framework, which the Federal Reserve formally adopted in January 2019, the central bank primarily influences the federal funds rate by adjusting administered rates, particularly the interest on reserves rate.⁶,⁵

A large volume of accelerated excess reserves means that banks have more funds available than they are required to hold, and potentially more than they are willing to lend immediately. This environment allows the central bank greater control over short-term interest rates through the interest it pays on these reserves, rather than through traditional open market operations that directly manage the scarcity of reserves. A high level of excess reserves suggests a financial system with significant capacity to meet unexpected demands for funds or to increase lending if economic conditions warrant.

Hypothetical Example

Consider a hypothetical economy where commercial banks collectively hold $100 billion in total reserves with their central bank, and the central bank's reserve requirements mandate $20 billion in required reserves. This means the banks have $80 billion in excess reserves.

Now, imagine the economy experiences a severe downturn, and the central bank decides to implement a large-scale quantitative easing program to stimulate economic growth. The central bank purchases $500 billion worth of government bonds from commercial banks. In exchange for these bonds, the central bank credits the banks' reserve accounts.

After this intervention, the total reserves held by banks jump to $600 billion ($100 billion initial + $500 billion from QE). Assuming required reserves remain at $20 billion, the excess reserves now stand at $580 billion ($600 billion - $20 billion). The rapid increase from $80 billion to $580 billion in excess reserves due to the central bank's aggressive asset purchases exemplifies accelerated excess reserves. This flood of new reserves provides banks with ample liquidity.

Practical Applications

Accelerated excess reserves are a critical component in how modern central banks implement monetary policy, particularly in regimes of "ample reserves."

• Interest Rate Control: With abundant excess reserves, central banks can effectively manage short-term interest rates by setting the interest on reserves rate. Banks have little incentive to lend reserves in the federal funds market at a rate lower than what they can earn risk-free from the central bank. This sets a floor for short-term market rates.⁴
• Financial Stability: A large buffer of accelerated excess reserves enhances financial stability by providing banks with significant liquidity to meet withdrawals or other funding needs, reducing the risk of a liquidity crisis.
• Quantitative Easing Implementation: The creation of accelerated excess reserves is a direct byproduct of asset purchase programs like quantitative easing, which aim to lower long-term interest rates and stimulate lending and investment. Information on the Federal Reserve's balance sheet, which reflects these reserves, is publicly available.³

Limitations and Criticisms

While accelerated excess reserves can be a powerful tool for monetary policy, they are not without limitations and criticisms.

• Inflationary Concerns: A significant and prolonged accumulation of accelerated excess reserves has sometimes raised concerns about potential future inflation. The argument suggests that if banks decide to aggressively lend out these reserves, it could lead to an excessive expansion of the money supply and inflationary pressures.²
• Ineffective Transmission Mechanism: Critics argue that if banks are unwilling to lend despite holding large excess reserves, perhaps due to weak demand for credit or risk aversion, the monetary policy transmission mechanism can be weakened. In such scenarios, increasing reserves further may have limited impact on the real economy.¹
• Moral Hazard: Some argue that consistently maintaining very high levels of reserves, especially in conjunction with the lender of last resort function, could foster moral hazard, potentially encouraging banks to take on more risk knowing they have a substantial liquidity backstop.

Accelerated Excess Reserves vs. Excess Liquidity

While often used interchangeably in casual conversation, "accelerated excess reserves" and "excess liquidity" are distinct, though related, concepts in finance.

Accelerated excess reserves are a specific component of the broader pool of excess liquidity in an economy. A surge in accelerated excess reserves directly contributes to higher excess liquidity within the banking sector.

FAQs

What causes accelerated excess reserves?

Accelerated excess reserves are primarily caused by aggressive monetary policy actions by a central bank, such as large-scale asset purchases (e.g., quantitative easing) or significant emergency lending to depository institutions.

Why do central banks allow accelerated excess reserves?

Central banks may intentionally create accelerated excess reserves, especially during economic crises or periods of low inflation, to inject liquidity into the financial system, lower interest rates, and encourage lending and investment to stimulate economic growth. It also supports their "ample reserves" framework for interest rate control.

Are accelerated excess reserves inflationary?

Not necessarily, but they can contribute to inflationary pressures if banks significantly increase lending as a result, leading to an expansion of the money supply that outpaces economic output. However, central banks can manage these pressures by adjusting the interest on reserves rate.

How do accelerated excess reserves affect interest rates?

In a system with ample or accelerated excess reserves, the central bank uses the interest on reserves rate as a primary tool to control short-term interest rates like the federal funds rate. Banks will not lend to each other at a rate lower than what they can earn by simply depositing their reserves at the central bank.