US banking system may have a problem

The Federal Reserve wants the banking system flush with cash to keep the economy humming, but there may be bottlenecks that undermine the U.S. central bank's credibility to influence interest rates.

Major U.S. banks stashed $1.2 trillion with the Fed as of January, even though they estimate they only need $700 billion in reserves, the central bank said here on Thursday, based on survey data covering much of the market.

Yet specific banks sometimes need more reserves than they have, pushing them to borrow. Strong demand for that funding could push the Fed's target federal funds rate up more than it wants, undermining its credibility.

Big banks required to meet strict liquidity requirements have been holding more reserves than regional banks that do not, Fed research here? earlier this year has found.

Since the aftermath of the 2008 financial crisis, when it flooded the banking system with funds, the Fed has controlled rates primarily by paying banks interest on those funds. In theory, rates should not trade much below what banks and other traders can earn risk-free. By controlling short-term rates, the Fed hopes to influence the broader economy to maximize employment and keep inflation at its target.

"One of the ways you determine whether there is abundant reserves is whether changes in supply and demand of reserves causes the interest rate to vary, and there's some evidence that we're getting closer to that part where the demand for reserves is going to be responsive to changes," Boston Fed President Rosengren told Reuters.

"Once we're worried that we no longer have an abundance of reserves we will have to actually increase our balance sheet, and I think, until we get further down the road, we're not going to know exactly where that is." After its May meeting, the Fed tweaked the interest on excess reserves (IOER) for a third time since June 2018 without changing the fed funds target in a bid to hold down borrowing rates. The Fed now pays banks 2.35% interest on excess reserves.

(Graphic: U.S. Federal Reserve policy rate - tmsnrt.rs/2IzOkma) Records from that meeting, released on Wednesday, showed the Fed was concerned that some "banks were operating with reserve balances closer" to the least amount they reported would be comfortable.

Eric