Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / The Real Cost of Zero Interest on Reserves
Transcript
- Lucas: Let’s start with a number that doesn’t make headlines but dictates the price of every business loan in America. As of October twenty third, two thousand twenty six, the Federal Reserve holds roughly eight trillion dollars in total assets, and nearly all of that is sitting as reserves at commercial banks. Luna: That sounds like a lot of idle cash waiting for a signal to move. Lucas: It is idle until it isn’t. The key here is that those reserves earn interest. When the Fed pays interest on reserves, or IOR, it changes the behavior of banks. They no longer need to rush out and lend every extra dollar they have to keep pace with competitors who might offer slightly better deposit rates. Instead, they can park funds safely at the Fed and still earn a return. Luna: So essentially, you’re saying that paying banks to hold money actually stabilizes the system rather than draining it? Lucas: Exactly. But there’s a catch. By giving banks a risk-free floor on their returns, the Fed inadvertently raises the hurdle rate for new lending. If a bank can earn four percent risk-free from the Fed, why take the credit risk of lending to a mid-sized manufacturer unless you can charge seven or eight percent? It tightens the margin between what banks pay out and what they bring in. Luna: That feels counterintuitive. I would think more reserves would mean more ability to lend, not less. Lucas: In a world where banks are forced to lend to avoid losing money, yes. But in a world where they are paid to wait, the incentive structure flips. We saw this play out during the last cycle. Banks stopped competing on deposit rates because they didn’t have to. They kept the spread wide. And that widens the cost of capital for everyone else. Luna: So the benefit to the bank becomes a tax on the borrower. Lucas: Precisely. And this is where it gets tricky for policymakers. When inflation runs hot, the Fed raises rates. Usually, that cools demand. But if they raise the interest on reserves too aggressively, they might be encouraging banks to sit on their hands even harder. It creates a liquidity trap where money exists but refuses to circulate. Luna: Does that mean the Fed is accidentally stifling economic activity by trying to protect its own balance sheet? Lucas: Not necessarily stifle, but distort. Look at the shadow banking sector. Money market funds and other non-bank lenders don’t get paid interest by the Fed directly. They have to go out and find yield. So when bank deposits become unattractive because banks are earning enough from the Fed, those borrowers flee to the shadow system. That pushes up yields there, making borrowing even more expensive for smaller firms. Luna: So the policy meant to stabilize big banks ends up squeezing the little guys who rely on alternative funding. Lucas: That’s the structural reality. And it’s why we see so much volatility in short-term rates. When the Fed adjusts the IOR by just ten basis points, it sends shockwaves through the repo market. Lenders suddenly have to reassess whether parking money at the Fed is truly better than lending it overnight to a hedge fund. Luna: It sounds like the Fed is playing chess while the rest of the market is playing checkers. Lucas: Maybe. But the pieces are moving fast. Let’s pause here for a moment to talk about how we keep this conversation going. If walking through the economy with us has made something click, consider supporting the show directly. It keeps these deep dives ad-free and ensures we can keep bringing you clear, specific analysis without compromise. You can find us at buy me a coffee dot com slash fexingo — that's F. E. X. I. N. G. O. Luna: Yeah, and your support literally lets us dig into the weeds like this instead of skimming the surface. Lucas: Back to the mechanics. There’s another layer here that most people miss. The interest on reserves isn’t just a tool for controlling the federal funds rate anymore. It has become a primary driver of global liquidity. When the Fed changes its IOR, it affects the entire world because international banks hold trillions in dollars at American institutions. Luna: So a decision made in Washington effectively sets the baseline cost of dollar funding for a company in Tokyo or London? Lucas: Absolutely. It anchors the global dollar system. If the Fed raises IOR, those foreign banks face a higher opportunity cost for holding dollars. They might pull back on dollar lending globally. That squeezes trade finance. Importers and exporters feel it before domestic consumers ever do. Luna: That’s a huge transmission channel. Most people only think about mortgage rates. Lucas: Right. Mortgages are downstream. This is upstream. It’s about the raw material of finance. And here is the thing that worries me about the current setup in late twenty twenty six. We have massive reserve balances, but the velocity of that money is slowing down. Banks are comfortable. Borrowers are struggling. Luna: Is that comfort justified though? If banks aren’t lending, are they really safe? Lucas: They are safe in terms of solvency. Their balance sheets are loaded with high-quality assets. But safety isn’t the same as health. A bank that doesn’t lend stops growing. It loses market share. And eventually, it becomes vulnerable to disruption from fintechs or private credit firms that don’t have the same regulatory burdens or the same luxury of waiting for the Fed’s signal. Luna: So the very tool designed to prevent panic might be breeding long-term stagnation. Lucas: Stagnation is a strong word, but complacency fits. Think about the last time a major regional bank failed. Was it because they ran out of reserves? No. It was because they lent too aggressively into risky sectors while ignoring the fact that their core deposit base had shifted. They couldn’t compete with the risk-free yield the Fed offered elsewhere. Luna: It sounds like the market is punishing banks for being too cautious. Lucas: Or for being misaligned with the new reality. In the past, banks were taught to maximize asset utilization. Now, the optimal strategy is often liability management. They want cheap deposits and they want safe returns on reserves. The middle ground—actual productive lending—is getting squeezed. Luna: How do investors see this right now? Are markets pricing in a shift away from this model? Lucas: They are starting to. Look at the bond spreads. Credit spreads are widening slightly for lower-rated issuers. Investors are demanding higher compensation for taking risk because they know the banks aren’t stepping in to absorb it. The Fed’s monetary policy is creating a vacuum in the middle tier of credit markets. Luna: A vacuum filled by private equity and hedge funds? Lucas: Exactly. Which brings us back to the shadow banking system. We talked about it earlier, but this is the direct consequence. When traditional banks stand still, the shadow sector moves in. And they move faster, with less oversight, and higher fees. It’s a trade-off. You get liquidity, but you lose stability. Luna: So the consumer gets a loan, but it comes with a different set of risks than before. Lucas: And those risks are opaque. Traditional bank loans come with covenants and relationships. Private credit loans are often covenant-lite. If things go south, the recovery process is messier. We saw flashes of this during the pandemic disruptions. Private lenders had to decide quickly whether to roll over debt or force restructuring. Banks had the Fed’s back. Private lenders did not. Luna: That asymmetry seems dangerous for the overall financial architecture. Lucas: It is. And it highlights why the interest on reserves policy is so pivotal. It’s not just about controlling inflation. It’s about deciding who gets to intermediate risk in the economy. Right now, the answer is largely the largest, safest institutions. Everyone else is operating in the margins. Luna: Do you think the Fed realizes how much power they’re concentrating by doing this? Lucas: I think they prioritize stability over concentration. In their view, having four or five mega-banks dominate the lending landscape is safer than having fifty medium-sized banks that might fail in a crisis. It’s a systemic choice. But it comes with political and economic costs that we are still working through. Luna: And those costs are likely to show up in slower GDP growth for the next few years. Lucas: If we assume the status quo holds. But history shows us that policies evolve. The interest on reserves framework was experimental for a long time. It became standard practice. Who knows what the next iteration looks like? Maybe they introduce tiered systems where small banks get higher rates to encourage them to lend more. Luna: Tiered systems sound complicated to implement. Lucas: They are. Complexity is the enemy of good policy. But simplicity often ignores nuance. The challenge for the Fed is finding that balance point where they control the price of money without strangling its flow. Right now, in October twenty twenty six, the needle is tipped toward control. Luna: So for the listener running a business, what’s the takeaway? Should they be worried about bank lending standards? Lucas: You should be observant. Watch your local bank’s relationship managers. Are they pushing products or asking questions? If they are pushing, there might be a temporary glut of capital. If they are pulling back, the IOR effect is biting hard. Adapt your financing strategy accordingly. Diversify your funding sources. Don’t rely solely on traditional banking lines. Luna: Diversification is always good advice, but it’s especially critical when the main source of water is throttled. Lucas: Exactly. And keep an eye on the broader market signals. Bond yields, credit spreads, and the volume of private credit issuance. Those are the canaries in the coal mine. If those numbers shift, it means the Fed’s tool is working differently than intended. Luna: It’s a reminder that central bank policy isn’t just abstract macroeconomics. It’s the actual plumbing of our daily financial lives. Lucas: It is. And understanding the plumbing helps you navigate the pressure. Next time you hear about a minor adjustment to the federal funds target range, remember that it’s likely changing the calculus for every bank branch in the country. Luna: Thanks for breaking that down. It makes the invisible machinery feel a lot more tangible. Lucas: Always happy to pull back the curtain. Let’s see where the plumbing leads us next week.