Believe it or not I am trying to keep myself off the blog, but sometimes when I am taking care of my son and he falls a sleep for a bit, I am like – oh great time for a blog post – and here I go.
So, I have seen more than a few people worry about money coming off of the Fed’s balance sheet and creating hyperinflation in the United States. More often that not this is phrased as “Well right now banks are hording cash but as soon as they stop the Fed is going to be in trouble”
I want to respond to that but its difficult to find the exact framing.
On the one hand the issue of an exist strategy and effectively transitioning to a new monetary model is not trivial and shouldn’t be taken lightly. Fed officials are rightfully wringing their hands over the execution of such maneuvers.
On the other hand its not the kind blatant monkey business that I think some people are envisioning. It is overwhelmingly likely that the Fed is going to be successful at making this work.
So briefly lets think about why someone might suspect hyper-inflation or at least a very high level of inflation is coming and why the Fed will overwhelmingly likely to prevent.
So by law banks are required to hold reserves to back up their deposits. In the United States a bank must have $10 in cash on hand or at the Federal Reserve, for every $100 in deposits.
Now, typically banks don’t want to hold more in reserves than they have to. This is because cash just sitting in vault or on deposit with the federal reserve (traditionally) earns no interest. The entire point of being a bank is to earn interest and so if you have excess reserves you are really sleeping on the job.
Now the first place you are likely to look for lending opportunities is in your local area. You want to loan money to borrowers at an interest rate that will prove profitable. However, what if you don’t see any too many good lending opportunities. Maybe your local economy is depressed or maybe your borrowers are in really risky situations that have you nervous about their ability to pay you back.
What you can do is loan the money to some other bank. There are other banks out there that might be in areas with a strong economy or who specialize in lending to the type of customers who are good credit risks or in a promising industry. You loan the money to that bank and then that bank loans the money to its customers.
The market where banks loan each other money is of course the Federal Funds market.
Now as it turns out what usually happens is that small local banks loan money to big Money Center banks. As you may have noticed the big money center banks – Bank of America, JP Morgan, etc – can always find ways to lend out money. They have very smart people who spend all day thinking of new ways to make profitable loans.
So if First Bank of Main Street doesn’t see good opportunities in its local, it loans money to Bank of America.
Now, since we’ve already built up this structure is worth spending a few sentences on how the financial panic affected all of this.
We have First Bank of Main Street (FBMS) lending money to Bank of America (BAC). BAC is a big bank full of smart people who can always find ways to make money. But, wait a second! It looks as if BAC may have made some mistakes. They wound up making a whole bunch of bad loans that might not get paid back.
What should FBMS do? Well they don’t have super analysts on staff who can figure all of this out and even if they did the big boys on Wall Street got it wrong so who is to know what’s right. Well, in this case FBMS should stop lending to BAC and protect its customers.
But, now OMG! BAC is watching all of its reserves wash away. It needs to have a 10-1 ratio. Every dollar that FBMS pulls back means that BAC has to reduce its loan portfolio by $10. BAC is going to have to really start shutting down its loans.
But, many large corporations depend on BAC. That’s where they get money to meet payroll or pay vendors or other immediate needs. What are they to do? Are they going to be able to meet payroll this week?
Full scale panic ensues.
Now the Fed steps in and says hey BAC, we’ll loan you the money you need to cover your reserve ratio. You won’t have worry about borrowing from FBMS.
So the Fed injects all of these reserves into the banking system.
Now normally that would simply cause the Fed Funds rate to simply collapse to zero and indeed the Fed pushed the Fed Funds rate pretty close to zero. But, the Fed Funds rate is also a useful tool for monitoring the what’s going on in the banking system.
So the Fed said here is what we will do. We will pay interest on reserves. That way if anything crazy happens you can just keep your reserves and earn interest, you don’t have to run the risk of loaning them out to banks with shady books.
So where are we now? Well BAC got in the reserves it needed to keep its lending going. FBMS got back all the reserves it had loaned to BAC and so now FBMS has excess reserves sitting on the books.
Shouldn’t FBMS loan out those excess reserves?
Well there is really no reason to. Before the crisis started FBMS would have rather loaned their excess reserves to BAC than to customers in their local area. Now, after the new policy FBMS would rather just earn interest from the Fed than loan out reserves to folks in their local area. As far as FBMS is concerned nothing has really changed.
Well what if loan demand picks up in the local area? Won’t FBMS loan out its reserves? It will start to but then the Fed can simply raise the interest it pays on reserves. This means that FBMS could either make loans to customers or just hold the extra reserves.
This is the exact same trade off that FBMS would have faced if the Fed had raised the Federal Funds rate. It could have loaned out money to customers or it could have loaned the money to BAC.
In effect the interest of reserve policy lets the Fed stand in for BAC. This is important because BAC needs some time to get its act together. But as far as FBMS is concerned there is really no difference between the two scenarios. All that matters is the interest they are earning on their excess reserves. It’s the same whether those reserves go to BAC or are held by the Fed.
So, even though FBMS officially has more excess reserves on its books, its desire to lend is no different than under normal conditions. Thus, any increase in inflation that could be chocked off by raising the Federal Funds rate can be choked off by raising the interest rate on reserves.
The Fed has complete power to slow the expansion of lending and hence the emergence of hyper-inflation as it did before and it doesn’t have to remove its reserve injections to make it happen.

10 comments
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Friday ~ September 9th, 2011 at 1:04 pm
georgesblog360
The statement from Alan Greenspan that the Fed must print currency to the point of hyperinflation suggests interest in playing with fire, if not diving headfirst, into it. The Doomsday button has always been there. I wrote about that in “Federal Reserve: Too Big To Fail: and in “Purchasing Power Limits”
http://georgesblogforum.wordpress.com/2011/06/19/federal-reserve-too-big-to-fail/
http://georgesblogforum.wordpress.com/2011/06/19/purchasing-power-limits/
Friday ~ September 9th, 2011 at 1:20 pm
Curt Doolittle
Please don’t keep your self from the blog. You’re one of the best people out there. You’re lucid and general. You don’t bias heavily to the investor or the state, and you tie politics into economics without being nihilistic about it or evangelical.
It may not be obvious that the reason you do not attract a lot of comments is precisely because you’re so well rounded and avoid too much advocacy. Controversy attracts attention.
I read something on the order of 200 papers, articles and postings a day. There isn’t anyone marginally better out there. And if you’d pick a political position (neo classical liberalism to favor monetary policy, or bleeding heart libertarian to favor political policy) you’d rapidly get into the top ten. You’re that good. Even if you simply did it as a foil to propagate your opinions.
Affectionately.
Curt
Friday ~ September 9th, 2011 at 3:02 pm
sum luk
ditto Curt’s comments …. except the political part
Friday ~ September 9th, 2011 at 5:24 pm
Karl Smith
Thank you both for your kind words
Friday ~ September 9th, 2011 at 1:28 pm
Johnnie Linn
Would not the higher interest rates paid by the Fed have to come out of the Fed’s capital? The Fed would have to scrounge up some cash by selling some of its assets at (it is hoped) a higher price than it bought them for but that will be difficult if interest rates have gone up.
Friday ~ September 9th, 2011 at 4:41 pm
How Can the Fed Avoid Hyper-Inflation? « Modeled Behavior | Executive Loans
[...] reading here: How Can the Fed Avoid Hyper-Inflation? « Modeled Behavior Posted in loans • Tags: a-strong-economy, are-good, are-other, areas-with, banks, banks-out, [...]
Friday ~ September 9th, 2011 at 5:57 pm
Jared
Karl, you’re beginning to sound like an MMTer (which is a good thing). Your post lays out what the MMT crowd has been saying for years now, that the quantity of reserves in the banking system, thus QE, is irrelevant when it comes to inflation or lending. What matters is the price of reserves, and as you point out, the Fed is in complete control of that.
But if you follow your own logic further, you should also come to the MMT conclusions that 1) deficit spending actually puts downward pressure on interest rates, 2) debt issuance is purely a monetary operation, not a fiscal one, and 3) auctions for U.S. debt will NEVER fail.
First, if the gov’t deficit spends without issuing debt, the spending will add deposits and reserves, $ for $, into the banking system. Since we have a 10% reserve requirement, 90% of those added reserves will be excess, which, as you explained in your post, will push the Federal funds rate close to zero (thus, deficit spending lowers interest rates). And as you also pointed out, those added reserves will not be inflationary. From this we can see that the only financial reason to issue debt for a sovereign gov’t with its own currency is to help the central bank maintain a positive interest rate (bond issuance sucks the excess reserves out of the banking system). But if we’re at ZIRP, we don’t want a positive interest rate, so no need for debt issuance at all.
But if the gov’t chooses to issue debt, do we ever have to fear the bond vigilantes? No! As we saw, the deficit spending by itself adds excess reserves into the system. As long as U.S. debt yields a higher rate of return than a bank receives from sitting on reserves, then the U.S. will have a buyer. Deficit spending creates the demand for sovereign debt.
Friday ~ September 9th, 2011 at 6:27 pm
beowulf
“Would not the higher interest rates paid by the Fed have to come out of the Fed’s capital?”
Nope, its subtracted from the Fed’s earnings rebate to Tsy.
If IOR ever exceeded Tsy rebate, the Fed would allocate IOR to its new “negative liabilities” account, which, in theory, makes it a liability of Tsy.
But since it doesn’t count against the debt ceiling (and Congress has the legal right to take over the Fed anyway), its the financial equivalent of putting it on top of a rocket and shooting it into the Sun.
http://www.economicpolicyjournal.com/2011/01/hot-fed-hides-major-accounting-change.html
Monday ~ September 12th, 2011 at 10:57 am
Johnnie Linn
Thanks for the cite. Perhaps in the anti-universe there is an anti-Fed that has just invented “positive anti-liabilities”. If there is a collision of these liabilities and anti-liabilities will we have a massive explosion and emission of two sets of gamma rays?
Saturday ~ September 10th, 2011 at 9:43 am
Darren M
This may be a different topic, but doesn’t the interest paid to FBMS on excess reserves make it even less likely that they will choose to loan locally? You have a guarantee from the Fed or you can risk it in the local market… the premium to the local market would have to be pretty high to be worth the trouble.