Post QE – The Fed and the Banks

I thought this article by Bloomberg provided a clear and simplified explanation why the Fed or the central bank in US is in a deadlock and unable to adjust the US economy easily.

1. During the period of Quantitative Easing to stimulate the economy, the Fed bought back US Treasuries/Government Bonds (The US Government sold it to the banks when issuing it) and mortgage back securities(MBS) from the Banks.
2. The Fed pays the banks in the form of credits from the Reserves.
3. This cause the banks to have “excess reserves”. When the Fed tries to implement a contractionary monetary policy by selling US Treasuries, the banks do not have problems buying new US Treasuries without borrowing more money. They can use the excess reserves to pay for it.
4. Thus, the regular monetary policy of the Fed to sell Treasuries and reduce money flow in the economy is not working.
5. The banks can continue to hold the “excess reserves” because the Fed pays interest to the banks. It would only be profitable if they can lend out the money at a higher interest rate than the “excess reserves” interest rate.
6. On the other hand, the Fed is also getting interest from all the treasuries and MBS it bought from the banks. But all these interest it gets are going back to the banks for holding the “excess reserves”. The interest could have help to reduce the yearly deficits in the reserves.

The gist of it is…. the Fed is in quite a deadlock on how to reduce these excess reserves and the cost of paying the banks. What would be the right rate of treasury issuance to ensure that it will not be too “massive and disruptive to the economy”?

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