06/03/2014 11:31 am ET | Updated Aug 02, 2014

Federal Reserve Officials Are Trying to Disarm the $2.58 Trillion Bomb They Built

It will be six years in October 2014 that Federal Reserve officials started building the monetary bomb. Now that the bomb has reached $2.58 trillion, some reporters and broadcasters have found a problem. Fed officials are now talking about plans to dismantle the bomb with no troublesome side effects. Some of their announced plans are ineffectual, harmful and ridiculous.

One month after the economic collapse that spread around the world and triggered massive unemployment in the United States, Fed officials began building the "bomb" in October 2008. They decided to pay interest on private bank reserves including excess reserves that banks were not required to hold.

The banks were happy to receive one-fourth of one percent interest risk-free on idle excess reserves. William T. Gavin, an economist at the St. Louis Federal Reserve, wrote in its March/April 2009 Fed publication: "first, for the individual bank, the risk-free rate of ¼ percent must be the bank's perception of its best investment opportunity." Paying banks to hold excess reserves instead of using the money to make loans to businesses and consumers increased unemployment.

Eighty-three percent of the $3.1 trillion currency and bank reserves that the Fed pumped into the economy since August 2008 sat idle in excess reserves of banks in April 2014. The banks held only $1.648 billion in excess reserves in August 2008. By April 2014 excess reserves had grown by $2.58 trillion.

The descriptions of the goodness of quantitative easing on financial television programs and the press reached metaphor heaven, leaving aside Fed officials' actions building a bigger bomb. Much of the news media that had followed the Fed's assertion about reducing unemployment changed when the Fed reduced the amount of money it pumped into the private sector. Although the Fed gave the reduction a pleasant name, "taper," there was acrimony and recently press criticism of the size of excess bank reserves.

Federal Reserve Governor Daniel Tarullo joined in on February 25, 2014 saying that:

A good bit of criticism has focused on the large expansion of the balance sheet and the sizable amount of excess reserves in the banking system. One oft-stated worry is that when it is time to normalize policy, we will be unable to withdraw reserves as quickly as needed to prevent an unwanted rise in inflation. (...) But we have a variety of tools (...) For example, we now pay interest on reserves; strong>raising that rate would put upward pressure on short-term rates. In addition, we can drain reserves by employing fixed-rate overnight reverse repurchase agreements, term deposits, and term repurchase agreements.

Fed Chair Yellen described the same plan on May 7, 2014 in response to a question during testimony before the Joint Economic Committee of Congress. Besides raising interest rates paid to banks on excess reserves, "she pointed to the 'reverse repo' facility the central bank has been experimenting with since September." (Victoria McGrane, Wall Street Journal)

Raising the interest paid on excess reserves to even three percent, for example, may be necessary to keep the bomb from rapidly exploding if market rates rise and banks begin rapidly investing the $2.58 trillion excess reserves in the non-bank private sector. Three percent would mean sending $77 billion in interest to the banks. It would be unlikely to mainly be passed on to the depositors given the concentration in a few large banks. It would be a great gift for bank stock holders from the public.

Yellen and Tarullo have both explained methods to reduce the bomb using reverse repurchase agreements (reverse repos). Reverse repos are similar to short-term loans from the private sector to the Federal Reserve. When the Fed's New York Fed trading desk sells reverse repos, they have a very short maturity, sometimes overnight as Fed Governor Tarullo suggests. This is a ridiculous method to reduce the $2.58 trillion bomb.

It is necessary to stop more rapid inflation and rising interest rates before the monetary time bomb explodes. Proper policy will avoid the debacle Paul Volcker faced when he became Federal Reserve Chairman in 1979. Rapid money growth produced a 13-percent rise in prices with interest rates rising to 15.51 percent on three-month Treasury bills by 1981. Volcker put on the brakes at the cost of a double-dip recession with unemployment reaching 10 percent. His actions ended the disaster and the economy grew without rapid inflation.

The interest the Federal Reserve pays to banks on excess reserves should be reduced to zero. The Fed must then start selling the securities it has bought from the public before the $2.58 trillion bomb explodes with trillions of dollars flowing into the non-bank private sector.