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.