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Jim Hamilton has another nice piece on Federal Reserve deposits. I have a couple of quibbles but mostly they are a matter of perspective. Hamilton says
I’ve been emphasizing that the U.S. Federal Reserve has not been printing money in the conventional sense of creating new dollar bills that have ended up in anybody’s wallets. Instead, the Fed has been creating new reserves by crediting the accounts that banks maintain with the Fed
This is probably a workable framework for people who think of printing money and inflation as being synonymous. Though its not how I think about it. I think of issuing reserves as printing money.
Both reserves and cash are what we think of as “high powered money.” High powered money is the ultimate base for all the assets that we use for buying stuff, such as our checking accounts. The more high powered money out there the more checking accounts there can be.
Issuing a new checking account is how a bank makes a loan and this increase in lending increases demand in the economy. So, printing more reserves would tend to increase demand. That was pretty much how things worked up until the Fed started paying interest on excess reserves.
Once a bank issues a new checking account the law says that you have to dedicate some of your reserves to backing that account. These reserves are required reserves. Required reserves do not get interest payments from the Fed.
Thus when a bank decides to make a loan it has to switch some of its interest paying excess reserves over to non-interest paying required reserves. The fact that they loose the interest payment is what discourages them from doing this.
My overarching point is that there will be some people who suspect that Hamilton is shifting definitions to hide the Fed “true printing of money.” Yet, even if you think of issuing reserves as printing money – which is the frame that I use – Hamilton’ logic still follows through. It follows because the interest on reserves policy breaks the traditional link between printing reserves and increasing demand in the economy.
Hamilton goes on
Many banks are still afraid to make any but the very safest of loans. In such a setting, the Fed could create all the reserves it wants, and it’s not clear that much if anything has to change as a result.
However, the situation is not going to stay like this forever. When banks do start to see something better to do with their funds, one could imagine the situation changing pretty quickly. The Fed’s plan when that starts to happen is to remove some of those reserves by selling off some its assets, and preserve the incentive for holding reserves by raising the interest rate paid on them.
So this is correct but one could easily confuse very wonky concerns with a breakdown in monetary policy.
So before all of this interest on reserves business the Fed managed the money supply by targeting the Fed Funds market. That is, the Fed kept the price at which banks loaned reserves constant.
Now suppose I am the manager at BigTime Bank. I decide for whatever reason that I want to make trillions of dollars in loans. To do this I need to acquire more reserves. I go into the Fed Funds market and start borrowing these reserves from other banks. This will tend to drive up the interest rate on reserves, which is the Fed Funds rate.
However, the Fed is targeting the Fed Funds rate. This means that in response to my action the Fed will increase the supply of reserves in order to push the interest rate right back down. The result is that the Fed automatically accommodated my desire to make a bunch of loans by increasing the supply of reserves.
So what stops me as the manager of BigTime Bank from flooding the market with new loans and driving up demand? What stops me is that I have to pay interest on all of these reserves. If the interest I am getting on loans is not competitive with the interest I have to pay to borrow all of these reserves then its not worth it for me to do this.
So, the ultimate control on how willing BigTime Bank is to make loans, is the Fed Funds rate. That’s why changes in the Fed Funds rate were historically a big deal.
Now, lets think about the current world. Here what is stopping BigTime Bank from making a bunch of loans? Its that by making a bunch of loans BigTime Bank has to move some of its reserves from excess to required and thereby lose the interest payment the Fed is offering on excess reserves.
From the BigTime Bank’s point of view this is the same cost. Issue more loans and either pay out more money from borrowing in the Fed Funds market or loose out on interest on reserves. In both cases it’s the interest rate that is holding the BigTime Bank back.
If the Fed wants to cool down the economy then, what it does under the current policy is to raise the interest rate on reserves. That will function just like raising the Fed Funds rate on the old policy.
So in terms of core monetary policy there is no real difference between regimes. There are a wonky concerns about making sure that the entire system functions without a hiccup since it hasn’t been done this way before.
There are also concerns about managing the Feds balance sheet. The Fed expanded the amount of excess reserves that banks had and then paid interest on those reserves. However, that wasn’t just a give away from the Fed to banks. In exchange the banks had to give the Fed some of their interest bearing assets including lots of Mortgage Backed Securities in the beginning and Treasury Bonds now.
The Mortgage Backed Securities and Treasury Bonds are both paying higher interest rates than the Fed is currently paying on reserves. So in terms of immediate cash flow the Fed is making more money now. However, Mortgage Backed Securities and Treasury Bonds are also “riskier” than reserves. They are risky because they pay a fixed interest rate, while the interest on reserves will theoretically fluctuate with the economy.
If economic growth picks up the Fed will be forced to raise the interest it pays on reserves. This is just like it would have to raise the Fed Funds rate in an overheating economy.
If the economy is growing fast enough then interest on reserves will have to be raised to a higher rate than the interest the Fed receives on Mortgage Backed Securities and Treasury Bonds. This would result in losses for the Fed. Its not exactly clear what “losses for the Fed” will mean, but for the sake of calm markets its best if we just don’t go there.
This means that the Fed will want to get out of the business of holding all of these securities at some point and its not clear how or when that might happen.
I have been meaning to do a post of the “huge surge” in money the Fed has printed and its implications for the future.
Jim Hamilton has a nice wonky discussion of it, though I am a bit confused by his point about there being no safe interest bearing overnight loans. This is a function of monetary policy not a constraint.
Anyway, I thought I would discuss the issue in a bit more pedestrian way:
Early on I thought the concern over the huge spike in bank reserves was limited to Peter Schiff and his crew. While they are passionate they aren’t really that big a part of the conversation.
However,I have heard more and more economists and policy folks worry out loud about the tons of cash on bank balance sheets and whether it could spark hyperinflation.
I believe those folks are unaware that the conduct of monetary policy changed in October 2008. The Fed moved away from a straight forward “minimum reserve system” to a new a “floor system”
The old system depended critically on the minimum reserve requirement. By law, banks have to have a minimum of 10% cash in reserve. That is, take the value of all checking accounts the bank has open. Take 10% of that number. That’s how much cash you have to hold in the vault or on account with the federal reserve.
Banks didn’t want to hold extra cash in the vault because it paid no interest. Getting paid interest is how they make their living. So, you could pretty much bet that banks were going to try to have exactly 10% in reserves, no more, no less.
Indeed, to facilitate this, banks would loan each other money overnight to make sure that they always hit the target exactly. This overnight market is the Fed Funds market.
When the Fed shrank the supply of money it became harder for all banks to hit the target simultaneously and the interest rate charged in the Fed Funds market rose. Its important to note that this rise occurs naturally through the buying and selling agreements of banks. The Fed does not dictate the Fed Funds rate.
However, banks are usually very predictable. And, so the Fed is able to target a Federal Funds rate. That is, the Fed would increase or decrease the supply of money until the Fed Funds rate landed where the Fed wanted it to.
During the Summer of 07 the Fed Funds market began to act erratically. Things went really wild one day in August, I don’t remember the exact date off hand.
I was preparing a talk on Medicaid one morning, when my phone starting buzzing with alert after alert. The Fed Funds market had spiked the previous night and some institutions were scrambling for for Funds. There was widespread chatter about what was going to happen the next night. Were major banks going to miss their targets?
This is the moment I mark as the official beginning of the Global Financial Crisis.
In the following year the Fed took bunch of steps to try to alleviate the crisis. Each step would tamp down the panic for a while but it would flare up again.
In October of 2008 the Fed began paying interest on reserves. What this did was set a floor in the Fed Funds market. That is, the Fed said it was always willing to pay you a certain interest rate on any reserves you had and so why even bother loaning to banks for less?
Why would they want to do this when the Fed Funds and other important market rates were racing out of control?
They wanted to do it because they intended to flood the Fed Funds market with money. So much money that any spikes would be drowned out. However, they didn’t want banks to go out and loan out that money for fear that a rapid increase in loans would cause runaway inflation.
So they created a floor and then flooded the market. This essentially brought an end to the liquidity crisis in the daylight banking system. The daylight banking system still had a solvency crisis and that’s where TARP came in.
The shadow banking system was all jacked up beyond repair and there wasn’t a whole lot that anyone could do about it except to try to keep it from bringing down the rest of the financial system with it.
This move to end the liquidity crisis also severed the link between the amount of reserves in the system and the amount of money banks were loaning. Money is created not so much when it is printed but when it is loaned. As long as it sits in the vault gathering dust, its not going to drive up prices.
So this is why the amount of reserves has skyrocketed but there has not been a massive increase in lending.
Now yes, there are a lot of questions about the interest on reserves program and whether it cuts off an important channel of monetary policy. I don’t think so. Scott Sumner would disagree.
However, there is no particular reason to expect that “any day now” money will come flooding out of banks and create hyperinflation.
The system was redesigned to make banks keep a larger fraction of the money inside the vault.
