The Fed’s exit strategy
Randy Wray says:
The Federal Reserve on Monday proposed allowing banks to park their reserves at the central bank, a move aimed at weaning the economy off extraordinary infusions of cash and curbing inflation. The Fed would create the equivalent of a certificate of deposit that pays interest to banks for keeping some of their reserves — which are currently estimated at more than $1 trillion — for up to one year. That would help offset some of the $2.2 trillion the central bank has fanned out into the economy during the financial crisis. It also would allow the Fed to quickly entice banks to take more money out of circulation in case inflation emerged as a serious threat in the near future. The proposal was the latest sign the Fed is intensifying its efforts to scale back the vast amounts of money it pumped into the economy at the height of the crisis.
This blog has published a number of pieces explaining why there is no need to worry about the trillions of dollars of reserves and cash created by the Fed to deal with the run to liquidity set-off by this crisis (see here and here). As and when banks decide they do not want to hold reserves, they will retire their loans at the discount window and will begin to purchase higher-earning assets. As this pushes up asset prices (reducing interest rates), the Fed will begin to unwind its balance sheet—selling the assets it purchased during the crisis. Retiring discount window loans plus purchases of assets from the Fed will eliminate undesired reserve holdings. It is all automatic and nothing to worry about or to plan for. And it will not set off a round of inflation. The old "money multiplier" view according to which excess reserves cause banks to lend, which induces spending, which causes inflation, was abandoned by all serious monetary theorists long ago. Chairman Bernanke ought to abandon it, too.
This is a good article despite the calls for more fiscal stimulus – a position I am moving away from because of the likelihood of malinvestment. I have to admit to falling prey to the money multiplier fallacy mentioned here. It is maddeningly easy to do. I too have written about inflation worries regarding the Fed’s exit strategy. These worries were unconsciously based on the discredited reserves-lead-to-credit view of fiat money which Bernanke seems to follow.
In reality, only the demand for credit can increase inflation, not the amount of reserves in the system. With a huge amount of excess capacity and structurally high unemployment, I suspect the only things which will inflate any time soon are asset prices. And the only way this will lead to consumer price inflation is through commodity prices, as oil is trading for almost $80 despite 2009 U.S. oil consumption demand being at its weakest in over a decade. Gold is not the only commodity acting like money.
Source
Fed Offers New CD; Chairman Bernanke is still confused – L. Randall Wray
As Wray writes, the Fed is proposing the issuance of more debt and nobody is concerned, which is a good thing, but makes one wonder why the care so much about other forms of federal debt (e.g. Treasuries)…
Wray, I believe, would favor immediate government job creation, the kind we saw in the CCC 1930s. Although I’m hardly an expert and utterly unqualified to comment at that level, its my understanding that Wray and others like him – Auerbach and, perhaps, Hudson – would see such job initiatives as critical to any genuine recovery. In my view, even CCC type programs are but a beginning. We need something akin to a Ten Year Plan aimed at the reindustrialization of the United States and that at all costs.
What Exit Strategy?
Normal Times:
If I have a deposit for 1 dollar and I loan that and multiply it to 10 dollars of loans, then that is inflationary.
If I make no more loans and the 10 dollars in loans gets repaid, that is deflationary, bringing the money supply back to 1.
If I continue to perpetually loan out my money because times are good and the monetary base continues to grow, we don’t have deflation ever, the policy makers’ goal.
Pre FDIC times:
If I have a deposit for 1 dollar and I loan that an multiply it to 10 dollars of loans, then that is inflationary.
If I make no more loans and the 10 dollars in loans gets repaid, that is deflationary, bringing the money supply back to 1.
If my loan goes bad, my bank fails, then my dollar reserve disappears due to bankruptcy. Not only do loans contract because I have less reserves, but my deposit disappears as well, shrinking the monetary base, amplifying the deflationary effects.
Today:
If I have a deposit for 1 dollar and I loan that an multiply it to 10 dollars of loans, then that is inflationary.
If I make no more loans and the 10 dollars in loans gets repaid, that is deflationary, bringing the money supply back to 1.
If a loan goes bad, the Fed buys it. They write me a check, my reserves do not shrink, I can still loan on that reserve. The bad asset in the Fed’s balance sheet has no market value so they are never able to “automatically” retire the asset through repayment nor are they able to sell the asset because it has no value. The dollar printed stays in my reserve and I can still loan on it. The money has been printed and given away.
Given the probability that many of the assets the Fed bought, or has been buying are bad, primarily MBS, they will never be able to retire the debt naturally and stabilize the monetary base. The money multiplier is still in effect. This is Hussman’s view as well as the many ever scorned Austrian leaning analysts views. With little faith in the shell game called accounting, I have to favor the pessimistic view that the $2 Trillion the Fed is sitting on will probably never be steralized due to the effect that would have on the economy, or more likely, the Fed is not going to be able to steralize it because they need assets to sell to draw money out of the economy and they have less assets than they claim to have because their assets are bad, deeming them impotent. This is why they need CDs because if they had a marketable product to sell, they would just do that. They wouldn’t have to strongarm banks into leaving money in reserve.
Still love ya Ed, but don’t lose sight of the mechanics (I’m no expert so I could be wrong too),
Scott
The point I am making is that the causality goes from loan to reserves and not the reverse. This means that when the demand/supply of credit is reduced by banks in fear of uncreditworthy borrowers or borrowers unable or unwilling to take on more debt, the multiplier diminishes. The Fed can pump all the reserves into the system it wants but they will pile up as excess reserves as they have done over the past year.
Reserves are useful only as a means of hitting a specific fed funds target rate. But when the fed funds rate is zero, the central bank doesn’t have this need and so reserves pile up.
See my post On Debt Monetizaton:
https://pro.creditwritedowns.com/2009/11/on-debt-monetization.html
Also see Free Exchanges post on this same topic today:
https://www.economist.com/blogs/freeexchange/2009/12/the_truth_about_all_those_exce