…[S]ome people think [the US Federal Reserve is] running an inflationary policy because an extra $1 trillion of reserves are in the banking system.
[…]
For the Federal Reserve, as with most central banks, reserves ordinarily serve only one purpose: to help it establish a target interest rate. In ordinary times, some banks have more reserves than they need and lend them to those that have too little. The rate on those interbank loans is called the fed funds rate. If the Fed wants a higher fed funds rate, it drains reserves. If it wants a lower one, it adds reserves. The quantity of reserves, per se, is irrelevant to the Fed. It’s the interest rate that affects spending and it’s spending that drives both the demand for credit and, ultimately, inflation.
These are, of course, extraordinary times. The Fed’s orthodox means of boosting the economy is exhausted because the federal funds rate is at zero. It has increasingly turned to unorthodox means. It has bought Treasuries in an effort to lower long-term interest rates. For a while, it behaved more like a commercial bank than a central bank by making loans to banks, financial institutions, companies, and homeowners (by purchasing mortgages). These actions would only be inflationary if they stimulated demand and elevated the growth of credit; yet overall credit is contracting; the Fed’s actions have only served to stop it from contracting even more quickly.
–The truth about all those excess reserves, Grep Ip, The Economist, December 2009 (emphasis added)
Greg Ip gets it. The quote above was written in late 2009 when credit was contracting. But it is expanding now. Does that change anything though? Let’s go back to the Krugman-Keen debates from a few weeks ago to see.
Here’s what I wrote about progress on the monetary policy and banking debate in summary:
Under present institutional arrangements, the Fed Funds rate is dependent on the Fed’s supplying the required amount of reserves at any given reserve ratio to keep the interest rate at its target or within its target band. The Fed can’t target a rate unless it supplies banks with all the reserves that the banks need to make loans at that rate. This means that central banks must be committed to supplying as many reserves as banks want/need in accordance with the lending that they do subject to their capital constraints. Failure to supply the reserves means failure to hit the interest rate target. So in practice, if a banking system as a whole is at the reserve limit, central banks always increase the level of reserves desired by the system in order to maintain the interest rate. Not doing so means at once that the Fed cannot hit its target or that transactions fail as the payments system breaks down.
In sum: In a nonconvertible, floating exchange rate system, the amount of credit in the system is determined by the risk-reward calculations of banks in granting loans and the demand for those loans. Banks are not reserve constrained. They are capital constrained. Financial institutions grant credit based on the capital they have to deal with losses associated with that activity.
Doesn’t look like anything’s changed.
Here’s the question though: how do we get the economy on the right track then?
My argument has been that US household debt is still excessive, having quadrupled in the over 60 years since the Great Depression and World War II ended. The root cause of the problems in the US is private debt. The US is suffering from a balance sheet recession in which households are attempting to increase net savings in order to pay down the debt to levels that are covered by the now depreciated assets which serve as collateral. Businesses have already done the heavy lifting. As long as household financial assets provide insufficient collateral for the debts that depend on them, the household sector will continue to maintain a reduced level of consumption and investment as a percentage of income. According to (notably bearish) prognosticators like Comstock Partners, the growing optimism on housing is not justified; property prices are likely to fall further, meaning that asset price depreciation will continue, making a continued balance sheet recession a near certainty. How do you deal with that?
Most analysts will tell you they are concerned about relative debt metrics like debt service costs or debt/income for households. These relative debt metrics are ratios that contain a numerator and a denominator. So, to decrease the ratio, one can either decrease the numerator (the debt) or increase the denominator (income). In our credit system, trying to increase the denominator is a reflationary response to a debt crisis, while decreasing the numerator is a deflationary response. For example, if I want to decrease my relative debt burden, I could save more and pay down debt (balance sheet recession) or I could work nights and use the extra income to maintain the debt load with less risk (employment and income growth).
The goal should be to allow both forces to play out, to allow increased savings and debt and debt interest reduction to combine with increased income to accelerate the deleveraging process. In my view, monetary policy does next to nothing here.
Last August I told you that the Fed has already begun its third easing campaign with rate easing replacing quantitative easing as the policy tool of choice. But, this policy lever would not have been utilised if rates were not at zero percent. The Fed is out of bullets on interest rate policy and has turned to other nonconventional measures like targeting medium-term inflation and interest rates and using a communications strategy as an expectations anchoring mechanism to increase its influence on medium-term outcomes. Good luck!
Bottom line: The Fed’s excess reserves are not inflationary. As Greg Ip noted in 2009, "Reserves have not been a relevant constraint on bank lending for decades, if ever. Bank lending is constrained by customer demand and by capital." Forget about excess reserves. The Fed’s easing simply doesn’t have a lot of influence in a world of overleveraged households lacking in credit demand. And Fed communications of inflation and interest rate policy is not going to be a make-or-break policy tool. If we want to get the economy on the right track, we will need to focus on jobs.