In-depth analysis on Credit Writedowns Pro.

What about all those excess reserves at the Fed?

…[S]ome people think [the US Federal Reserve is] running an inflationary policy because an extra $1 trillion of reserves are in the banking system.

[...]

For the Federal Reserve, as with most central banks, reserves ordinarily serve only one purpose: to help it establish a target interest rate. In ordinary times, some banks have more reserves than they need and lend them to those that have too little. The rate on those interbank loans is called the fed funds rate. If the Fed wants a higher fed funds rate, it drains reserves. If it wants a lower one, it adds reserves. The quantity of reserves, per se, is irrelevant to the Fed. It’s the interest rate that affects spending and it’s spending that drives both the demand for credit and, ultimately, inflation.

These are, of course, extraordinary times. The Fed’s orthodox means of boosting the economy is exhausted because the federal funds rate is at zero. It has increasingly turned to unorthodox means. It has bought Treasuries in an effort to lower long-term interest rates. For a while, it behaved more like a commercial bank than a central bank by making loans to banks, financial institutions, companies, and homeowners (by purchasing mortgages). These actions would only be inflationary if they stimulated demand and elevated the growth of credit; yet overall credit is contracting; the Fed’s actions have only served to stop it from contracting even more quickly.

-The truth about all those excess reserves, Grep Ip, The Economist, December 2009 (emphasis added)

Greg Ip gets it. The quote above was written in late 2009 when credit was contracting. But it is expanding now. Does that change anything though? Let’s go back to the Krugman-Keen debates from a few weeks ago to see.

Here’s what I wrote about progress on the monetary policy and banking debate in summary:

Under present institutional arrangements, the Fed Funds rate is dependent on the Fed’s supplying the required amount of reserves at any given reserve ratio to keep the interest rate at its target or within its target band.  The Fed can’t target a rate unless it supplies banks with all the reserves that the banks need to make loans at that rate. This means that central banks must be committed to supplying as many reserves as banks want/need in accordance with the lending that they do subject to their capital constraints. Failure to supply the reserves means failure to hit the interest rate target. So in practice, if a banking system as a whole is at the reserve limit, central banks always increase the level of reserves desired by the system in order to maintain the interest rate. Not doing so means at once that the Fed cannot hit its target or that transactions fail as the payments system breaks down.

In sum: In a nonconvertible, floating exchange rate system, the amount of credit in the system is determined by the risk-reward calculations of banks in granting loans and the demand for those loans. Banks are not reserve constrained. They are capital constrained. Financial institutions grant credit based on the capital they have to deal with losses associated with that activity.

Doesn’t look like anything’s changed.

Here’s the question though: how do we get the economy on the right track then?

My argument has been that US household debt is still excessive, having quadrupled in the over 60 years since the Great Depression and World War II ended. The root cause of the problems in the US is private debt. The US is suffering from a balance sheet recession in which households are attempting to increase net savings in order to pay down the debt to levels that are covered by the now depreciated assets which serve as collateral. Businesses have already done the heavy lifting. As long as household financial assets provide insufficient collateral for the debts that depend on them, the household sector will continue to maintain a reduced level of consumption and investment as a percentage of income. According to (notably bearish) prognosticators like Comstock Partners, the growing optimism on housing is not justified; property prices are likely to fall further, meaning that asset price depreciation will continue, making a continued balance sheet recession a near certainty. How do you deal with that?

Most analysts will tell you they are concerned about relative debt metrics like debt service costs or debt/income for households. These relative debt metrics are ratios that contain a numerator and a denominator. So, to decrease the ratio, one can either decrease the numerator (the debt) or increase the denominator (income). In our credit system, trying to increase the denominator is a reflationary response to a debt crisis, while decreasing the numerator is a deflationary response. For example, if I want to decrease my relative debt burden, I could save more and pay down debt (balance sheet recession) or I could work nights and use the extra income to maintain the debt load with less risk (employment and income growth).

The goal should be to allow both forces to play out, to allow increased savings and debt and debt interest reduction to combine with increased income to accelerate the deleveraging process. In my view, monetary policy does next to nothing here.

Last August I told you that the Fed has already begun its third easing campaign with rate easing replacing quantitative easing as the policy tool of choice. But, this policy lever would not have been utilised if rates were not at zero percent. The Fed is out of bullets on interest rate policy and has turned to other nonconventional measures like targeting medium-term inflation and interest rates and using a communications strategy as an expectations anchoring mechanism to increase its influence on medium-term outcomes. Good luck!

Bottom line: The Fed’s excess reserves are not inflationary. As Greg Ip noted in 2009, "Reserves have not been a relevant constraint on bank lending for decades, if ever. Bank lending is constrained by customer demand and by capital." Forget about excess reserves. The Fed’s easing simply doesn’t have a lot of influence in a world of overleveraged households lacking in credit demand. And Fed communications of inflation and interest rate policy is not going to be a make-or-break policy tool. If we want to get the economy on the right track, we will need to focus on jobs.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

31 Comments

  1. David_Lazarus says:

    Another solution is to loosen the bankruptcy laws. If people can write those debts off then that will free up their income rather than simply paying debts that will default eventually. 

  2. Dannyb2b says:

    The current monetary arrangement is a disaster. Commercial banks create loans, these loans enter the economy in a misguided manner causing excesses in some areas of the economy and tight credit in other sectors. When commercial banks feel euphoric they overextend lending excacerbating business cycle upswings and later not lending enough exacerbating downcycles.

    IMO Profit oriented entities shouldn’t be allowed to create money. The central bank can deal directly with the public and bypass the banking system in conducting monetary policy. 

    • Good luck with that one :-) You’re never going to be able to eliminate private banks

    • hutrade says:

      agreed.
      The currency of a nation is a public good that all citizens of that
      nation are entitled to. If you are a citizen of the US, then you should
      have WHOLESALE access to your nation’s currency. The institutions that
      we the people create cannot justifiably constrain our sovereignty over
      those institutions without our consent.

      If you don’t want to do a JG for whatever reason, then at least give
      people access to wholesale dollars so they can start their own business.

       

  3. Norme says:

    Bravo, Mr Harrison. Jobs.

    • You know, everyone is so fixated on the Fed. There is only do much monetary policy can do. Clearly it’s about getting income into people’s hands.

  4. Dave Holden says:

    Not sure I agree with this, it’s my view that not only can QE cause inflation (lessen deflation) it has done and I suspect It’s done this mainly through changing investment incentives. 

    • Actually I agree with you 100%, Dave. The Fed’s excess reserves are not inflationary but QE (and zero rates) can be by changing private portfolio preferences. Just look at commodity prices and how they have been pushed up by risk seeking return. The point here however is that the excess reserves themselves have nothing to do with the inflation. That has the process backwards whereby reserves create loans when we know that credit creates the deposits that increase reserves in the system. See the difference.

      • Dave Holden says:

         OK, I understand and I agree it’s not the reserves per se that are inflationary in our current context.

  5. joebhed says:

    Ed’s always inching closer to the truth.

    But he confuses the discussion by using personal/household examples for national economic problems.

    As in, I can go out and get another job – ostensibly in order to “expand” aggregate demand without increasing debt.
    Sorry, Ed. There WAS a job. Somebody was going to have it and that is the extent of economic activity relative to that job, whether you have it, or me.

    Then Ed wrote:

    “The goal should be to allow both forces to play out, to allow increased savings and debt and debt interest reduction to combine with increased income to accelerate the deleveraging process. In my view, monetary policy does next to nothing here.”

    So I remind Ed that the greatest mind of the century found the monetary system of debt-based money to be a “confidence trick”(Dr. Frederick Soddy: Cartesian Economics – The Bearing of Physical Science on State Stewardship.)

    Sorry, the ONLY way to have enough debt-based money to make the interest payments on the debts already out there is………….. to increase the debt-based money.
    The confidence trick.

    The problem is not monetary policy, Ed.
    It is the monetary system.
    Good luck with that.

    • Dave Holden says:

       ”Sorry, the ONLY way to have enough debt-based money to make the interest
      payments on the debts already out there is………….. to increase
      the debt-based money.”

      I don’t think this is correct – Steve Keen’s has demonstrated how this is possible, I’ll try and find the video he’s done showing this.

    • Dave Holden says:

       OK if I recall correctly I think he describes it in his crash course see – http://youtu.be/75kFhBAI8Bo

      It’s three parts – all are worth watching.

    • RodgerMitchell says:

      Now he has become “the greatest mind of the century”?  Amazing how people will follow something they don’t understand.  Why?  Because they don’t understand it, so assume it must be important.  I have a bridge I’d like to talk with you about.  It’s a Cartesian bridge.  You’ll love it.

      • joebhed says:

         Rodger

        I’d be glad to have a discussion on your site about what it is of Soddy’s lecture that you think I don’t understand. It has become the foundation of modern ecological economics. For good, physical reasons.

    • Joe,

      I really have no idea what you’re talking about. I know the ‘truth’ in that I understand how the current monetary system works quite well. Moreover, I am not confusing the discussing one iota. It is a very good example that clarifies for people the difference between paying debt down (the numerator) and increasing income (the denominator). 

      We’re not ever going to agree here. The goal is to understand the constraints of the current system. There is zero chance this system will change unless it collapses first. So keep on harping on the ‘system’. It makes you sound like a crank.

      And no, the problem is not monetary policy; At least that  we can agree on. The problem is jobs.

      • RodgerMitchell says:

        Actually, the problem is the false belief that the federal deficit and debt are too big.

        Is it because the federal government will run out of dollars to pay its debts?  No.  The federal government is Monetarily Sovereign, which means it has the unlimited ability to create dollars.  It can pay any debt of any size at any time. It never bounces an check.So, is it because federal deficit spending causes inflation? No. Ever since the federal government became Monetarily Sovereign on 8/15/71, there has been zero relationship between federal deficits and inflation. (Actually, inflation is related to oil prices, not deficits.)So, is it because federal deficits lead to recessions and depressions? No. Every depression in U.S. history (there have been six), has come on the heels of a series of surpluses, not deficits.  And almost every recession has come on the heels of reduced deficit growth.  Further, every recession is cured by increased deficit growth.If federal deficits do not strain the federal government’s ability to pay its bills, and do not cause inflation, and do not lead to recessions and depressions, and in fact, cure recessions and depressions — exactly what is it about deficits that needs reducing? By the way, here is the evidence for the above:Proof that every depression in U.S. history was introduced by a series of federal surpluses: See Item 3 athttp://rodgermmitchell.wordpress.com/2009/09/07/introduction/Proof that recessions begin with reduced deficit growth and are cured by increased deficit growth:  See Item 4. at http://rodgermmitchell.wordpress.com/2009/09/07/introduction/Proof that deficit spending does not cause inflation: See: http://rodgermmitchell.wordpress.com/2010/04/06/more-thoughts-on-inflation/ Thanks for clearing thiings up.Rodger Malcolm Mitchell

      • joebhed says:

        Let’s see, Ed.
        The fundamental problem is private debt.
        We are in a ‘balance-sheet’ cum deflationary recession.
        The goal is to understand the constraints of the current (monetary) system.
        There is zero chance this system will change unless it first collapses.

        Soddy’s Cartesian Economics paper lays out the “physical reality” of money and debt.
        The constraint of the present system is so in your face that you can’t seem to discern it from up so close.
        It is this.
        Under the debt-based SYSTEM of money, you (me, WE, the world) cannot have any more money – to do all the good things the MMTers want to do – Yes, Ed, like JOBS, unless we have more debt.
        No debt = no money.

        You can numerate and denominate til the cows come home.
        That is not a constraint of, or on, the system.
        That is a physical reality.
        It transcends economics and finance.
        And it will collapse the global political economy while Ms. Lagarde keeps on looking for a solution – within this system.

        But even when it collapses, we will need a new money system.
        And it doesn’t need to collapse.

  6. Dan Lynch says:

    “The Fed’s excess reserves are not inflationary but QE (and zero rates) can be by changing private portfolio preferences. Just look at commodity prices and how they have been pushed up by risk seeking return”

    Agree.   

    Also, are banks allowed to use their excess reserves to invest in stocks and commodities ?   Because that could be inflationary.

    Also, does the Fed’s QE merely purchase treasuries, or does it purchase MBS and other questionable investments from the banks ?

    Agree with the MMT take on QE, but also agree with Ed Harrison that QE can and does influence stock and commodity prices, resulting in a transfer of wealth. 
    There are also allegations that QE has served as a “cash for trash” scheme to let the banks unload toxic securities, in effect propping up the value of those securities since the market has seen that the Fed will not let the price of those securities crash.   Again, this would be a transfer of wealth.So . . . saying that QE is ineffective is not entirely true.   QE *is* effective at transferring wealth.   What if that is the whole idea, and the stimulus claim is just a cover ?

    • David_Lazarus says:

      I do think that the other impact of real estate not being allowed to fall to its natural level is also another problem. Real estate and shares are being helped to maintain bubble prices yet the wages are falling even before inflation is accounted for. Many have had stagnant wages yet 5% inflation is reducing the household ability to sustain asset prices. The asset values are being held up all while QE is decimating  household income driving up the leverage on housing. 

      As for the wealth transfer from the taxpayer to the super rich who will leave if their taxes are raised means that QE is a tax on ordinary americans who are less able to up and move to some offshore tax haven with all their wealth. This might be sustainable for a while but I suspect that the recent announcement that the Volcker rule will be delayed for two years means that the Tax payer has two more years to pay up for banks mismanagement. 

      • fresno dan says:

        Agree 100%
        One always sees in these discussions generalized comments and formulas.  I agree IF there were debts declining through inflation while wages were increasing, that those two things together would more rapidly reduce debt.  But other than finance, how many industries are doing well (and please, let’s use 2005 – or any specific year -  instead of year over year comparisons against crappy years to make it appear there is some big improvement)?
        What percentage of people’s wages are keeping up with inflation?  Indeed, how many people underwater with a mortgage, besides with no actual payment or debt reliet, are now further behind due to…oh, health insurance, gasoline, food, local “fees” etcetera?

        • David_Lazarus says:

          That is why I think that the only sustainable solution is a massive writedown of debts. Forcing banks to take their losses will free up the consumers spending power, Though it will need legislation to clamp down on credit bubbles in future to stop people being priced out of their area because of a housing bubble. Strict rules on who can grant mortgages and the terms, ie only repayment mortgages. An end to any other mortgage product so that consumers cannot be misled into high fee debt. A cap on terms so that no mortgage can be for more than 3 times single income and more than 25 years. Even a cap on mortgages so that the tax payer never has to bail out jumbo loans. Lenders can only lend from savings so that will end the access to wholesale markets and make for a much more stable savings environment and also stop bubbles. This will lead to a drop in price of homes but if combined with a new bankruptcy code that wipes out a lot of debt at the same time then it could stabilise the housing market without the need for bailouts. 

  7. hutrade says:

    agreed. The currency of a nation is a public good that all citizens of that nation are entitled to. If you are a citizen of the US, then you should have WHOLESALE access to your nation’s currency. The institutions that we the people create cannot justifiably constrain our sovereignty over those institutions without our consent.

    If you don’t want to do a JG for whatever reason, then at least give people access to wholesale dollars so they can start their own business.

  8. “The root cause of the problems in the US is private debt.”
    NO!  The root cause of the problems in the US is stagnant wages, which in turn forces the middle class into excess debt.  For some thirty years we have followed policies which allow the finance, health and defense sectors in particular and corporate management across sectors, to extract ever increasing rents at the expense of wages. And now the chickens are coming home to roost.

    • David_Lazarus says:

      Unfortunately raising wages will be treated as inflationary and stamped on. Look at the current legislation going through GOP dominated states such as an end to equal pay for women or the right to join unions etc. All of which are any growth in wages. The neoclassical doctrine is that these are bad for society and only increases through productivity are acceptable. Yet when these productivity gains are made by the masses they are drained away by management who have seen a huge increase in their wages even though their productivity improvements are minimal. 

    • Christopher, you’re right that the debt is really a substitute for income due to stagnant wages. Now clearly, if the financial sector hadn’t been allowed to accommodate those increasing levels of debt, we would have been forced much sooner to realise we needed income growth to sustain economic growth. But your basic point is valid.

  9. Sulaiman says:

    (reposting from my comment on your ‘Endogenous or exogenous money?’ post. Interested in your (others) thoughts on this)

    “Thanks for your post Ed.

    The debate here is centered around the operational realities of the Fed (and CBs in “developed markets”) and banks in the US/DM. How does the PBOC (China) conduct its monetary policy differently (or not)? It seems to be successful in controlling credit creation through its tweeking of the RRR (quantity setting)?”

    • Sulaiman, China thinks it can control lending by tweaking reserve ratios but it faces the same constraint other central banks do in needing to accommodate the desired lending of credit institutions. Central banks don’t have very much control over the quantity of deposits. The reserve ratio does not address this. So they too must set interest (price) targets. And that means supplying the required amount of reserves at any given reserve ratio to keep the interest rate at its target or within its target band.

  10. Dave Holden says:

    I’m not sure Keen comes to different conclusion I think his model just shows that it is possible for a debt based system not to blow up. But thanks for the links I’ll look into those.

  11. Dave Holden says:

    Seems Yamaguchi is a for a debt free money system – that’s definitely something I can get on board with.