The Fed versus the Banks: Who Will Blink First?
During recent months, the Fed has flooded the banking system with reserves, which the banks have chosen to accumulate as (legally) excess reserves, rather than using the funds to add to the volume of their outstanding loans and investments. The Fed’s recently adopted policy of paying a small rate of interest on bank reserves accounts for some of this accumulation, but the amount is so gigantic that it seems much more likely that the banks have greatly increased their assessment of the risk involved in lending and investing as usual and therefore have chosen the lower yielding but less risky alternative of accumulating more and more reserves. Since August, the amount of excess reserves has risen from $2 billion to $559 billion. A graph of this astonishing development shows an abrupt transition from a virtually horizontal line (approximately zero excess reserves for decades) to a virtually vertical line (a quick jump of $557 billion in three months).
So far, this explosive increase of reserves has had only a small effect on the growth of the money stock as measured by the conventional monetary aggregates, such as M2, although the rate of growth of the monetary aggregates is beginning to increase substantially, as shown in this graph.
Because the public’s demand for cash balances has also risen, the recent increases in the money stock have not given rise to increased prices in general. In fact, the major price indexes have fallen slightly in recent months, although the bulk of this decline has occurred because of the decline in the price of oil and related products since July. Price indexes for goods other than energy have declined very little - certainly not enough to justify the many expressions of fear of impending deflation (setting aside whether an actual deflation ought to be feared or not).
At matters now stand, by far the greater threat is rapid inflation, notwithstanding the ongoing recession. When the banks begin to feel more comfortable with expanding the volume of their conventional loans and investments, they will have more than $550 billion on hand to employ for that purpose. The multiplied effect of such a vast amount of lending, as newly created deposits make their way through the fractional-reserve banking system, portends a gargantuan increase in the money stock and hence a correspondingly enormous jump in the general price level. As the public responds to the acceleration of inflation by reducing its demand for cash balances, the increased velocity of monetary circulation will contribute to even more rapid price inflation.
So much potential new money is now impounded in the commercial banks’ holdings of excess reserves that it is difficult to see how the Fed will be able to stem the flood once the banks begin to transform those excess reserves into normal loans and investments. If the Fed attempts to sell enough government securities to soak up the growing money stock, it will drive down the prices of Treasury bonds and hence drive up their yield, increasing the government’s cost of borrowing to finance the huge budget deficits the government will be running because of its various bailout commitments and so-called stimulus programs. This scenario holds the potential for a complete monetary crackup.
I have never been inclined toward touting doomsday financial scenarios. I raise the possibility now only because, as I consider the situation portrayed in the graph of excess reserves linked above, I am unable to foresee how the Fed and the Treasury can navigate through these treacherous waters - waters that their own previous actions have whipped to a foam - without creating terrible financial and economic harm. If the dollar survives the ministrations of Bernanke, Paulson, Bush, and the Obama gang, its survival will be something of a miracle.
Bill Woolsey - 12/28/2008
The "monetarist" approach to central bank policy is that it should keep the money supply growing at a slow steady rate by changing the quantity of base money enough to offset changes in the money multiplier. These can occur due to changes in the currency deposit ratio (say in the aftermath of bank runs) or increases in the reserve deposit ratio. The monetarist critique of Fed policy during the Great Depression is that it failed to do its duty and expand base money to offset the decrease in the money multiplier. It failed to keep the money supply growing at a slow steady rate during the thirties.
If the Fed failed to increase base money at this time, the effort of banks to increase their reserves rather than lend would have resulted in a signifcant drop in the money supply. As old loans are repaid, a single bank deposits the loan repayment into its reserve account, and refrains from making new loans. Since new loans would deplete the banks reserve account, it thereby accumulates reserves. Those repaying the loans have less money. The banks don't make new loans, creating new money for the new borrowers. So, the process reduces the money supply.
I will grant that this theory is all based on the notion that banks care about ratios, though I think that if they demand a certain level (or growth path) of reserves it works just as well.
If it is really true that banks are holding reserves because they have nothing better to do with the money--the liquidity trap argument, more or less--then the quantity of base money doesn't matter now, and there is no need for the Fed to increase base money. The money multiplier is passively adjusting to changes in the monetary base.
In the past, the orthodox monetarist response to this argment (and my unorthodox monetarist one) is that banks should purchase T-bills. Oh.. but the interest rate on reserves has been higher than that on T-bills.
So, you see, those of us influenced at least by these monetarist arguments put a lot of weight on the interest on reserves argument.
The Fed's holdings of T-bills is a little bit shy of being able to sop up all of these excess reserves. (Last I checked.) However, a large
portion of these new reserves have been lent to the banks.
This is actually very consistent with the traditional theory of lender of last resort. To some degree, the focus of orthodox monetarists on open market operations developed in response to the claim that banks might not want to borrow from the central bank even if the central bank charged very low interest rates. The banks might reduce lending to build up reserves, rather than just borrowing them from the central bank.
Open market purchases of securities will increase bank reserves even if banks aren't interested in borrowing. Banks can accumulate reserves without reducing lending and the money supply. They can raise the ratio of reserves to deposits, if that is what they want to do, without reducing lending and the money supply.
But, in the current situation, the Fed hasn't had too much of a problem in convincing banks to borrow. They are borrowing a lot from the Fed.
There are actually terms on most of these loans. By failing to renew these loans, reserves will disappear as the banks pay all that money back.
I don't think it makes much sense for banks to borrow reserves and just hold onto them. Presumably, the banks borrowing from the Fed are lending the funds. The borrowers spend the money and the sellers deposit the checks. The sellers' banks deposit the checks in the Fed. It seems likely that it is those banks that are holding onto the reserves rather than lending them out.
As I see it, the banks that are borrowing from the Fed might not be able to pay the Fed back. While the banks that have the excess reserves might decide to lend them. And so, we would be back to the Fed selling off its remaining T-bills. And, incredibly, with the Fed needing a bailout. (Of course, the Fed could save face if the Treasury directly bailed out the banks that owe the Fed money, so that they can use the taxpayer funds to pay the Fed back.)
As for the worry that open market sales will raise interest rates on government debt, and combined with the large increase in the national debt, this will lead to national bankruptcy... well, I wouldn't worry so much. Of course, the long run fiscal health of the U.S. is bleak with the aging population and government transfers to the elderly. I guess it could all fall apart now. I agree that inflationary default is the most likely long run scenario. But, I don't think the increase in banks reserves is a likely trigger.