Wednesday, April 20, 2011

Why Are Banks Holding So Many Excess Reserves And Will Those Reserves Fuel Future Inflation?

The chart above shows how the monetary expansions known as QE1 and QE2 have expanded the monetary base (blue line) in about the same proportion as the increase in the excess reserves that banks are holding (red line, data here). Why are banks holding so many excess reserves, and will those reserves eventually translate into higher inflation?

Here's one explanation from the conclusion of a NY Fed research paper titled "Why Are Banks Holding So Many Excess Reserves?":

"We also discussed the importance of paying interest on reserves when the level of excess reserves is unusually high, as the Federal Reserve began to do in October 2008. Paying interest on reserves allows a central bank to maintain its influence over market interest rates independent of the quantity of reserves created by its liquidity facilities. The central bank can then let the size of these facilities be determined by conditions in the financial sector, while setting its target for the short-term interest rate based on macroeconomic conditions. This ability to separate monetary policy from the quantity of bank reserves is particularly important during the recovery from a financial crisis. If inflationary pressures begin to appear while the liquidity facilities are still in use, the central bank can use its interest-on-reserves policy to raise interest rates without necessarily removing all of the reserves created by the facilities."

In a blog post, Donald Maron summarizes the paper this way:

"Some have expressed concern that the excess reserves are fuel for future inflation. The authors argue, quite rightly in my view, that this concern is also misplaced. The key reason is that the Federal Reserve gained a new power in 2008 — the ability to pay interest on reserves. That ability breaks the traditional link (in U.S. monetary policy) between reserves, bank lending, and inflationary pressures."

Update: For some excellent commentary on this topic see Scott Grannis, who points out that excess reserves are a close substitute for T-bills now that the Fed pays interest on reserves.  And in fact, the Fed is currently paying 0.25% on excess reserves, which is higher than the rate on 3-month T-bills (0.06%), 6-month T-bills (0.12%), and even 1-year T-bills (0.23%).  No wonder banks are holding $1.4 trillion of excess reserves!

18 Comments:

At 4/21/2011 1:41 AM, Blogger PeakTrader said...

Excess reserves reflect excess purchasing of bonds by the Fed (to increase the money supply).

Bank credit, which declined and remains low, may determine future inflation.

The hostility of Obama and Congress toward corporate America and the rich, along with little real fiscal stimulus for the masses and expensive failed economic policies, offset much of the monetary stimulus by the Fed.

 
At 4/21/2011 2:19 AM, Blogger Stone Glasgow said...

This comment has been removed by the author.

 
At 4/21/2011 3:09 AM, Blogger Stone Glasgow said...

Inflation occurs when banks issue loans for overvalued things, like homes and higher educations. It does not occur when bank reserves rise, or with quantitative easing, per se. Inflation occurs when money creation outpaces wealth creation; when banks fail to accurately assess the value of the wealth that they consider collateral for new dollars.

For example, if I went to the bank and received a $1 million loan to buy a lump of coal, spent the money on cars and vacations, and later burned the coal and declared bankruptcy, the new money I spent would create inflation; the bank handed me a million dollars for wealth that did not exist.

If a bank holds reserves in its vaults, that money does nothing. If a bank issues loans in a "reasonable" manner, and the wealth that is tied to those loans does not plummet in value (and is not destroyed), inflation does not occur.

 
At 4/21/2011 4:48 AM, Blogger rjs said...

you wont see inflation becuase no one is getting pay raises, so there isnt "too much money chasing too few goods"...and to top that, credit is also down...

http://research.stlouisfed.org/fred2/series/REVOLSL

 
At 4/21/2011 5:04 AM, OpenID Sprewell said...

Stone has written one of the best concise explanations of the possibility of inflation due to the current reserve expansion that I've ever seen. However, I will note that the fear is that as banks start to lend again, Bernanke will not have the political will to fight all the critics who will say he's "crushing the nascent recovery" if he pulls those reserves back out again. I don't think Ben's that stupid, as the resulting inflation will be very damaging and he knows it, but it is an open question as I can't guarantee that.

 
At 4/21/2011 5:18 AM, Blogger PeakTrader said...

In "St. Louis Fed: Monetary Trends" (Published Issue) on page 14, "Bank Credit" is well below the pre-recession level.

Also, on page 10, the "Actual and Potential Real GDP" chart shows the huge output gap (3% annual real growth will close the gap slowly).

 
At 4/21/2011 8:36 AM, Blogger Tom said...

Abolish the Fed. The massive, accountable power to fabricate money, excess money, is foolish in the extreme. They are the Chernoble of finance, blindly testing the limits of the safety systems, far beyond the imagination of the designers of our financial laws.

The Fed is vainly propping up an unsustainably big government and its unsustainable debts and annual borrowing. Annual borrowing is now about half the federal government's annual spending. The Fed is the chief enabler of the fiscal alcoholics in Washington DC. Put them all in mandatory rehab.

 
At 4/21/2011 9:35 AM, Blogger Che is dead said...

"For example, if I went to the bank and received a $1 million loan to buy a lump of coal ..."

Of course, the banks would only make such loans if they were able to turn around and sell them to a GSE, say Fannie or Freddie, but let's not get ahead of ourselves ...

 
At 4/21/2011 10:51 AM, Blogger PeakTrader said...

People like Tom prove politicians are competent shifting blame to the Fed, Wall Street, and even the American people.

 
At 4/21/2011 11:31 AM, Blogger Benjamin said...

Actually, many argue now the Fed should stop paying interest on reserves to encourage more lending.

Great post by Dr. Perry.

 
At 4/21/2011 12:25 PM, Blogger PeakTrader said...

QE2 is a more effective stimulus than reducing the interest rate on excess reserves from 0.25 to zero.

 
At 4/21/2011 1:05 PM, Blogger Benjamin said...

Inflation is about a serious as Billy Barty trying out for the Lakers.

Go to QE3 Mr. Bernanke!

 
At 4/21/2011 1:14 PM, Blogger PeakTrader said...

Banks seem to have little confidence in the U.S. economy or its people (e.g. consumers and homebuyers more than businesses). So, they've kept additional reserves.

This lack of confidence is reflected by the Obama Administration, which doesn't seem to trust the American people with a large tax cut.

 
At 4/21/2011 1:34 PM, Blogger PeakTrader said...

These small regulated tax cuts aren't enough to jolt the economy into stronger growth, i.e. a virtuous cycle of consumption-employment.

Also, many states raised taxes, fees, fines, fares, tolls, etc., which offset the tax cuts (and more regulation didn't help).

 
At 4/21/2011 2:01 PM, Blogger PeakTrader said...

The weak tax cuts reminds me of that movie "Sleuth." As part of the plan, Olivier needed a bump on the head by Caine.

When Caine was about to give Olivier a big bump, Olivier out of fear stopped Caine, and Caine said should I tap on your head lightly until a bump appears?

 
At 4/21/2011 3:07 PM, Blogger James E. Miller said...

@ Benjamin

I doubt Bernanke would be stupid enough to opt for QE 3 when there is such a large supply of excess reserves that may be let loose.

 
At 4/21/2011 5:56 PM, Blogger Ron H. said...

"This lack of confidence is reflected by the Obama Administration, which doesn't seem to trust the American people with a large tax cut."

The Obama administration, and progressives in Congress, like progressives everywhere, don't "trust" the American people to tie their own shoes. That's why thy believe they must guide our every move. They usually speak of "spending" on tax cuts, as if they were using their own money.

Beyond that, they don't believe that people can make the best use of their own money, and therefore it must be spent for them, often for the benefit of people who are unable to make money on their own.

 
At 4/21/2011 9:48 PM, Blogger Stone Glasgow said...

"Of course, the banks would only make such loans if they were able to turn around and sell them to a GSE, say Fannie or Freddie, but let's not get ahead of ourselves ..."

Yes, exactly.

 

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