Right now, the Fed is paying 1.00% interest on excess reserves (which are the vast majority of bank reserves right now). This is equivalent to offering banks one-day T-bills at an interest rate of 1.00%. The current yield curve for T-bills starts at 0.01% for 3 months, rises to 0.28% for 6 months, then to 0.50% for 12 months, and then reaches 0.92% for 24 months. Given this, it is clear that the interest rate the Fed is offering on bank reserves is far above market for a risk-free investment.
Given that the Fed has been offering banks an above-market return for sitting on their money, it is not surprising to find that this has been exactly what they have been doing. Bank lending has plunged. The velocity with which money circulates through the economy has also plunged, taking demand, output, and employment with it.
What the Fed’s new policy has accomplished is to “sterilize” the massive increases in the monetary base the Fed has been engineering in an effort to prop up demand and the economy. From August 1 to November 1 (the last data point available) the monetary base increased from $871 billion to $1.482 trillion. This 70% expansion in just three months is more than the percentage increase over the preceding ten years.
The way that I understand it, is that when you put $1,000 into your checking out, a bank would normally try to find a business to loan some of that money at a higher rate of interest. Now, however, they can pick up arbitrage by paying 0.75% interest on your checking account deposits, then placing your money with the Federal Reserve earning 1.00% interest, and picking up a risk free return of 0.25%. This margin seems paltry, but for a bank, volume can make up for margin. Money isn't going into the economy because of this easy arbitrage.
This practice of the Fed paying interest on deposits is actually new, starting earlier this fall in response to the supposed Credit Crisis. Woodhill is imploring the Fed to stop the practice immediately because it is suppressing loan activity.