This is a very important and hotly debated question. In my recent post (March 2010), I already discussed how the Federal Reserve’s unprecedented actions to respond to the financial crisis caused an increase in the quantity of reserves of depository institutions. As you clearly noticed, this increase has been substantial- on the order of over $1 trillion. Given the traditional role of the supply of reserves in the Fed’s conduct of conventional monetary policy, many worry that an increase this large will lead to higher inflation.
As I emphasized in my previous column, the recent increase in excess reserves was linked to the Fed’s use of unconventional policy actions, in particular quantitative easing, taken in response to the financial crisis. In this column I discuss why the recent increase in excess reserves associated with the Fed’s unconventional policy actions has far different implications for inflation than steps to increase reserves as part of conventional monetary policy. I will also walk you through what tools the Fed will use to manage excess reserves when the time comes to start removing monetary accommodation.
An increase in reserves could lead to inflation
As I discussed in March, and as this is written today (May 2010), depository institutions continue to hold large quantities of excess reserves. A macroeconomics textbook would tell you that such a situation results in much larger increases in the monetary base and the broader monetary aggregates (see July 2002 Dr. Econ on measures of money supply). This is known as the multiplier effect (see Keister and McAndrews for a detailed discussion of the multiplier effect). This faster money growth can eventually lead to inflation.
However, the new authority to pay interest on reserves allows the Fed to mitigate inflationary pressures from excess reserves
When the money multiplier is operational, there are little or no excess reserves in the banking system. The large quantity of excess reserves that we are seeing now indicates the multiplier effect is irrelevant at this time (for a more detailed explanation, see Keister and McAndrews 2009). Note that for the multiplier process to be in effect, depository institutions must have an incentive to lend out their excess reserves. Prior to October 2008 they did because the Federal Reserve paid no interest on reserves. Thus, holding excess reserves had an opportunity cost (by holding reserves, depository institutions gave up earning interest). However, when the central bank pays interest on reserves, this opportunity cost is reduced or perhaps even removed altogether. Therefore, our depository institutions have less of an incentive — or even no incentive — to lend excess reserves. Thus the multiplier effect is not as powerful. It is conceivable to think that a central bank can pick an interest rate on reserves that eliminates the incentive to lend completely, thereby stopping the multiplier process and eliminating the link between excess reserves and money supply growth (and, therefore, inflation).
In addition, the Fed is developing and testing ways to drain the large volume of reserves.
Some worry that paying interest on reserves makes for an incomplete exit strategy. That is, the worry is that, even with interest on excess reserves, a substantial volume of excess reserves may limit the degree of precision the Fed has in influencing short-term interest rates when the appropriate time comes to raise interest rates and remove monetary accommodation. To guard against that risk, the Fed is developing and testing ways to reduce the stock of excess reserves. These new tools include (1) a proposal to offer term deposits to depository institutions; (2) a vehicle for expanding the range of counterparties for reverse repurchase operations beyond the primary dealers; and (3) redemption or sales of securities being held on the Fed’s balance sheet, such as US Treasury securities, mortgage-backed securities (MBS), or federal agency obligations (Agencies) (for more details see Bernanke 2010).
Under the term deposit facility, the Fed would offer interest-bearing term deposits to eligible institutions as a way to reduce excess reserves that depository institutions would have available for short-term lending. Importantly, term deposits could not be used by depository institutions to meet reserve requirements or unexpected, large withdrawals by their customers. The interest rate paid would be established through an auction mechanism. Note that this would not change the size of the Fed’s balance sheet (but only the composition of liabilities), because excess reserves will be replaced with term deposits. As things currently stand (May 2010), the Federal Reserve Board anticipates the maturity of these deposits to be in the one-to-six months range, but not to exceed one year.1
Another tool to temporarily reduce excess reserves in the system is large scale reverse repurchase agreements (reverse repo). In a reverse repo, the Fed would sell a security (i.e. Treasuries, agencies, MBS) to a financial institution with an agreement to repurchase it at a future date. These reverse repurchase agreement liabilities would replace excess reserves held by depositories, thereby changing the composition of the Fed’s liabilities, but not the size of the Fed balance sheet.2 In terms of the impact of these tools on the level of excess reserves, Chairman Bernanke said that “the use of reverse repos and the deposit facility would together allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system quite quickly, should it choose to do so” (see Bernanke 2010 b).
Finally, the Fed can sell portions of its holdings of mortgage-backed securities, federal agency debt obligations, and U.S. Treasury securities. Unlike the two already mentioned ways to reduce the quantity of reserves (term deposits, reverse repos), this option would shrink the overall size of the Fed balance sheet. However, it is important to keep in mind that such transactions would represent an unwinding of the quantitative easing undertaken as part of monetary policy response to the financial crisis. The Fed’s selling of assets also might lead to market disruptions and unintended increases in interest rates such as those on mortgage-backed securities (see FOMC Minutes of January 26-27 2010). Thus, Chairman Bernanke said he does not expect “that the Federal Reserve will sell any of its security holdings in the near term, at least until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery” (see Bernanke 2010 b).
Yet, the Fed is in unchartered waters and needs to remain flexible
While several tools for eventual withdrawal of policy accommodation have been identified, the optimal combinations and sequences of employing these tools are still being debated (as of May 2010). The severity of the financial crisis that we have experienced during the past several years is unprecedented and the Fed responded with some unconventional policies. In the words of current Vice Chairman Donald Kohn: “The calibration of our exit from these policies is complicated by a paucity of evidence on how unconventional policies work. We will need to be flexible and adjust as we gain experience” (Kohn 2009).
Many worry that the buildup of reserves in the U.S. banking system during the financial crisis will prove to be inflationary. However, the rise in excess reserves as part of the Fed’s quantitative easing is much different from the Fed’s injection of reserves as part of conventional policy. In addition, the Fed’s authority to pay interest on reserves is an important tool for alleviating potential inflationary pressures stemming from the high level of excess reserves in the banking system. As a further precaution, the Fed is working on strategies to reduce excess reserves. These strategies include the term deposit facility, large-scale reverse repurchase agreements, and possibly asset sales. Yet, the Fed needs to remain flexible, as the exit strategy is surrounded with a great deal of uncertainty.
Bernanke, Ben.(2010a). “Prepared Statement,” in Federal Reserve's Exit Strategy., hearing before the Committee on Financial Services, U.S. House of Representatives, March 25, 2010.
Bernanke, Ben. (2010b). “Prepared Statement,” in Federal Reserve's Exit Strategy, hearing before the Committee on Financial Services, U.S. House of Representatives, February 10, 2010.
Keister, Todd, and James J. McAndrews (2009). “Why are Banks Holding So Many Excess Reserves?” Current Issues in Economics and Finance. Volume 15, No. 8. Federal Reserve Bank of New York.
Kohn, Don (2009). “Opening Remarks,” speech delivered at “Monetary Policy in the Crisis: Past, Present, and Future,” a forum sponsored by the American Economic Association Annual Meeting, held in Atlanta, Georgia.
1. For more on the proposed term deposit facility, please check the Federal Reserve Board web site.