The banking system and its "reserves"

I came upon a fascinating discussion of the ambiguities in the word "reserve" as commonly used in discussions of banking. Okay, the word "fascinating" is subjective, perhaps especially in that context. Still, this is from a fellow calling himself Dwain Dibley, about whom I know nothing else, commenting in a thread to a post about US monetary policy in Mises.com, a blog on Austrian economics.

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Reserves' is one of those ambiguous Fed doublespeek terms that has different meanings and or functions, dependant upon the context in which it is being used. So let's cover some of what the Fed considers 'reserves'.

1) Reserves are: Cash held in bank vaults.
2) Reserves are: Bank assets held on deposit at the Fed.
3) Reserves are: Assets purchased by the Fed in its open market operations.
4) Reserves are: The liquidity provided by #2 and #3 in the interbank settlements system.

When the Fed talks about adjusting bank reserves, it's talking about using #3 to effect changes in #4 and because the interbank system is a closed system, under normal conditions, the Fed could affect the overnight interest rates by buying and selling its reserve assets, which affected available liquidity in the interbank system.

That's not the case anymore. With the banks holding excess reserves providing liquidity to the interbank system, the Fed's ability to affect interbank interest rates in the traditional manner has been effectively naturalized. This is because the Fed's share of the liquidity is proportionally insignificant to the liquidity provided via the banks' reserve assets parked at the Fed. The only thing the Fed can do is arbitrarily set interbank interest rates, as it has been doing, and hopefully temper the pavlovian responsiveness of the markets and Wall Street by dazzling them with bullshit.

One of the primary reasons the Fed is reluctant to reduce it's balance sheet is because they know full well that the banks that buy those assets will turn right around and park them in their reserve accounts, effectively increasing their interbank liquidity while decreasing the Fed's.