THE BLOG

The IMF's Prediction, the Federal Reserve and the $2.6 Trillion Time Bomb

06/09/2015 05:30 pm ET | Updated Jun 09, 2016

The International Monetary Fund, with Managing Director Christine Lagarde, changed their estimate of the rate of growth of the United States domestic product in 2015 from 3.1 percent to 2.5 percent. Under these conditions, the IMF announced that the U.S Federal Reserve should not raise short-term interest rates until 2016.

The Federal Reserve, with Chair Janet Yellen, first indicated they would increase short-term interest rates in June 2015 and then changed to sometime soon. The Fed targets the interest charged by banks loaning to other banks. This short-term loan rate, called the federal funds rate, affects interest rates throughout the U.S. financial markets. Even though the Fed does not talk about worldwide effects, the IMF correctly says that changes in U. S. interest rates affect financial markets around the world:

"... asset price volatility could last more than just a few days [around the world] and have larger-than-anticipated negative effects on financial conditions, growth, labor markets, and inflation outcomes." ("IMF Urges Fed to Wait on Interest Rates Until 2016," Ian Talley, (Wall Street Journal, June 4, 2014 http://www.wsj.com/articles/imf-cuts-u-s-2015-economic-growth-forecast-to-2-5-1433424601 )

The federal funds rate was targeted down to be between zero and a quarter of a percent in November 2008 two months after the U.S. financial collapse that spread around the world. The U.S. encountered high unemployment with the labor force participation rate continuing to fall.

"The number of long-term unemployed (those jobless for 27 weeks or more) held at 2.5 million in May [2015] and accounted for 28.6 percent of the unemployed." (Bureau of Labor Statistics, http://www.bls.gov/opub/ted/2015/labor-force-participation-rate-little-changed-in-may-2015.htm )

A main problem impairing employment began one month after the federal funds rate was lowered. The Fed began building a monetary time bomb by paying private banks to hold onto their excess reserve that they are not required to hold. The Fed paid them a quarter of one percent for holding excess reserves instead of loaning the money to businesses and consumers. Jim McTague, the Washington D. C. editor of Barrons, wrote in his January 31, 2009 article:

"University of Texas Professor Robert Auerbach, an economist who studied under the late Milton Friedman, thinks he has the makings of a malpractice suit against Federal Reserve Chairman Ben Bernanke, as the Fed is holding a record number of reserves: $901 billion in January as opposed to $44 billion in September, when the Fed began paying interest on money commercial banks parked at the central bank. The banks prefer the sure rate of return they get by sitting in cash, not making loans. Fed, stop paying, he says."

Although I certainly do not believe in legal action, the policy of paying private banks interest to hold excess reserves was detrimental. That policy of reducing loans to businesses and consumers during a deep and long recession with a meager recovery continues to impair employment.

The banks held only a small amount of excess reserves on August 8, 2008, $1.87 million. On May 13, 2015 the banks had increased their excess reserves to $2.6 trillion.

Consider that by May 15, 2015 the Fed had pumped the monetary base (currency in circulation and bank reserves) up to $4.075 trillion while the banks held sixty-four percent ($2.6 trillion) idle in their excess reserves. The $2.6 trillion is the monetary time bomb that they cannot burst into the economy rapidly without causing inflation and severe financial problems. If the Yellen Fed raises interest rates, they must pay the banks more money to hold on to their $2.6 trillion. Milton Friedman thought that would be a good idea if the money paid to the banks was transferred to depositors due to competition for deposits between the banks. That will not happen now with a few large banks holding over half of the assets of the banking system. With competition reduced, most of the money paid to banks on excess reserves that banks are not required to hold may be transferred to the investors.

The correct policy for the Fed is to slowly reduce interest paid to banks on their excess reserves and carefully raise interest targets on the federal funds rate if the growth rate of U.S national income continues to follow the IMF predictions of 2.5 percent this year. Holding the interest rate target on federal funds near zero for almost seven years has produced grave problems for those living on interest income from bonds. It will also cause severe problems for businesses that borrow on loans connected to the prime rate that can change rapidly. This damaging result occurred in the early1980's, driving many businesses into bankruptcy as interest rates rose.