Fed walks the tightrope

July 29, 2009

economist

(Cartoon from The Economist, click to enlarge)

NEW YORK, July 29 (Reuters) – The sound money set remains concerned that the Federal Reserve’s emergency actions to corral collapse could ignite hyperinflation.  In particular, they point to the explosion of excess reserves inside the banking system, which they call dry tinder just waiting for the spark of recovery.  Bill Dudley, president of the Federal Reserve Bank of New York, says this isn’t an issue because the Fed now pays interest on excess reserves.  It’s a good argument, but only in the short run.

excess-reserves

To liquefy the banking system, the Fed drastically expanded its balance sheet, which, as you can see in the chart to the right, has led to an explosion of excess reserves at banks.

(Click chart to enlarge in new window)

For decades they never rose above $10 billion. Now they’re above $700 billion. To understand why this level of excess reserves has some worried about hyperinflation, it helps to understand what they are.

The Fed requires banks to keep a certain level of assets in reserve against deposits, either cash in the vault or reserves held at the Fed.  Reserves held over this required amount are referred to as “excess” reserves which banks are free to lend out.

When banks lend money into the economy, the money borrowed typically ends up as a deposit in another bank.  Say I borrow to buy a house; the mortgage I get from the bank is money I give to the seller, who then deposits the cash in his own bank.

Lent money turns into a new deposit, which turns into more lent money, which turns into another deposit, and so on.  As the supply of money multiplies, you get inflation.  If it multiplies too quickly, you get hyperinflation. The multiplication of money that might come from banks lending out over $700 billion of excess reserves is the stuff of inflationary nightmares.

But banks aren’t lending it out.  Why not?  As Dudley points out in his speech, it’s because the Fed is now paying them an interest rate.

Before last October, banks lent out all their excess reserves.  After all, excess cash in the vault earns the bank no profit.  But then Congress gave Ben Bernanke the power to pay interest on excess reserves, which means banks now can earn a return by keeping them on deposit at the Fed. Money that could be lent isn’t, inflation remains a potential threat, not a kinetic one.

But there’s a catch. When the economy recovers banks won’t any longer want to keep their excess reserves on deposit at the Fed, not unless the Fed is willing to pay a much higher interest rate.

Walker Todd of the American Institute of Economic Research argues that “the economy won’t be able to handle the high interest rates the Fed will be forced to charge in order to keep excess reserves immobilized in its vault.”

The Fed argues it has other tools to shrink its balance sheet when the time is right. For one, its emergency lending facilities are priced high enough such that banks will stop drawing on them when the economy recovers. But even after its lending facilities are wound down the Fed acknowledges the level of excess reserves will still be huge. To keep them immobilized will require substantially higher rates.

But raising rates will cause asset prices to plummet. Weak balance sheets will collapse and the financial crisis could return in full force. This is the conundrum the Fed faces.

17 comments

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wouldn’t that be a shame, if to prevent inflation, the Fed was forced to pay a hefty interest rate to their member banks? So banks get risk-free interest for preventing a problem they caused. Beautiful scheme. Or am I missing something?

No Adam, I think you’ve nailed it….

Posted by Rolfe Winkler | Report as abusive

[...] analysts are having a hard time swallowing the pill the Fed is selling as they still claim both inflation and hyperinflation can be curtailed.  Today was a big day in the commodities market where oil was the big loser.  Due to the banter [...]

This argument only applies to the hyperinflationists that do not understand what causes hyperinflation. The true hyper-inflation that begins to show its head (when the 28 year uptrend in the long bond breaks) is monetary in nature. It does not require any pickup in the business cycle at all but simply a breakdown in confidence in the $. Hyperinflation is a currency event. Forget the business cycle.

Posted by walkdontrun | Report as abusive

I agree with walkdonotrun;
Hyperinflation is a matter of trust.
There is 2 trillion dollars outside the US which is more dangerous than the money in the feds vaults, and all the world is in deep dollar. They dont trust the dollar anymore and they want to get rid of it but they cannot do it now, what they do is shorten the terms of US treasuries when they mature, it will take time( few years) and every year interest will rise because fed will sell more treasuries and each time the terms will be shorter, its like a ticking time bomb.
In order to stop this we must increase tax and other incomes to pay back the debth but this will push us into another recession.
this is the vicious cycle that we will see in the coming years

Posted by JohnS | Report as abusive

To the last two commenters, I agree. While the Fed is busy worried about the business cycle, the administration and Congress just might destroy confidence in the dollar.

The point of this column was primarily to explain why the explosion in reserves, which is of course a monetary event, hasn’t had any inflationary impact.

Posted by Rolfe Winkler | Report as abusive

The Fed pays almost nothing on funds on deposit. You make it sounds like banks would rather keep money on deposit and make fat bank than lend it out, but that’s not even a choice. Funds on deposit with the Fed are funds losing money for the bank. Funds out on loan are funds making money for the bank, and while there’s the potential for the rim shot quip of “not mkaing money these days,” we’re talking about fresh loans. If a bank can’t make a fresh loan that makes money for a couple years at least, they need to serious redesign their credit underwriting or just close up shop.

Further, while I have my own concerns about inflation, let’s either tap the breaks on hyper inflation or define the parameters of what is “hyper”. In my mind “hyper” is Weimar Germany, Hungary, or Zimbabwe like inflation… not even that bad, but definitely up there. This situation requires a non productive economy as part of the equation, which is not the case today. I believe if you look into any example of runaway inflation you will find a wretched economic foundation, and for all that the media whines and nashes teeth, I’m still not convinced this recession is even worse that the late 70′s/early 80′s, never mind the worst calamity to befall the enlightenment of humandkind since the Great Depression / the death of St. Franklin D freakin’ Roosevelt (may he bless us and show us the way through this time of trial just as he single handedly reforged the economy in the 30′s).

Posted by Andrew | Report as abusive

Andrew….I think that’s the issue. The banks can’t make money lending because asset prices are still falling, so it’s better to take a risk-free return on deposits at the Fed.

And because writedowns haven’t stopped, liquid reserves are still more valuable, no? Banks are willing to sacrifice higher returns on the altar of greater liquidity.

But that’s why “recovery” poses a risk. Once it IS profitable to take risk lending these funds, banks will do so quickly. And that’s one way we could get lots of inflation in a relatively short period. To stop it the Fed will have to pay big interest rates to keep the reserves from being lent.

But it can’t do that without plunging the economy back into the crapper.

Is hyperinflation in store? There’s actually a great conference going on on the subject this Friday at the American Institute of Economic Research. I’m told some IMF/World Bank economists familiar with Argentina/Brazil will explain why that’s possible. I have my doubts but think the discussion will be fascinating.

Posted by Rolfe Winkler | Report as abusive

By the way, if you doubt the severity of this global recession, take a look at Eichengreen’s and O’Rourke’s work over at VoxEU.

Posted by Rolfe Winkler | Report as abusive

Well, I think there’s also confusion between “the banks don’t want to lend” and “the borrowers don’t want to borrow.”

The banks would love to lend. There are still plenty of quality credit worthy companies around to lend to, they’re just more interested in paying down debt than taking more.

Posted by Andrew | Report as abusive

how could hyperinflation take hold on the back of such high unemployment (U6 pushing 17% now)? doesnt this also curtail demand for credit regardless if banks are willing to take the risk once again? unless we’re talking about transitioning into a transfer-payment based society, instead of a productivity-based one (and thats a possibility imo)

Posted by dw | Report as abusive

Raise reserve requirements up to a level that will restrain lending until bad loans are reduced to a “normal” level (2 to 3 years) then slowly relax reserve requirements.

Posted by Revolt Now | Report as abusive

Andrew – if you cannot see a wretched economic foundation here your vision is impaired – grossly.

dw – Hyperinflation is a currency event. Forget the business cycle.

Posted by walkdontrun | Report as abusive

Walkdontrun – seriously? Step back from the ledge. I’m not saying that everything is peachy, but even in its stressed form, we still have a productive economy that produces goods and services that fill a demand world wide. That produce is the result of knowledge: knowledge of management, of engineering, of process managment, of manufacturing, both in the abstact book-learnin’ sense and the tangible skilled labor force sense. The produce grows from a highly developed infrastructure, again both tangible and abstract.

Even if every company in America went bankrupt, we would still have a productive economy. There would be a blip. for sure. But factories, banks, offices would all reopen and begin producing the goods and services that underpin our abused fiat money.

It’s possible to destroy our economy to get Weimar/hungary/zimbabwe like inflation, but it would take physical destruction of infrastructure and/or apocalyptic decimation of the workforce.

Posted by Andrew | Report as abusive

Andrew makes a good point. I’m amazed by the lack of economic panic, despite the soaring unemployment rate. BTW, John Williams over at Shadow Gov’t Stats figures it’s actually in the 20% range. Of course where I live, in NYC, we haven’t had as much economic upheaval as, say, Michigan, Florida or Vegas. Still, we seem to be managing better than I thought we would. For now, anyway.

Posted by Rolfe Winkler | Report as abusive

[...] Winkler writes :   The sound money set remains concerned that the Federal Reserve’s emergency actions to corral [...]

Dear Readers,

When the FED took over troubled assets on its balance sheet it produced central bank money on the right side, but this newly created money is subtotaly sequestered / pledged, that’s the clue. Now the FED pays interests to the Banks as part of its Seignorage as long as it receives payments out of the toxic waste it holds on the left side.
So – what I guess nobody is understanding – the monetary base was expanding, but the banks can’t use the fresh money for credit creation, the money is inert.

Kind regards,

FESTAN

Posted by FESTAN | Report as abusive

[...] July 31, 2009 by John from Reuters: [...]

Andrew – I am far from the ledge. Comfortably in a deck chair a long way from 20% uneployment. I agree creative destruction and the incredible ability of the US to reinvent itself will eventually ensure a return to a new normal. However you still have commercial realestate, option arms and unfunded pensions without even going into the $50 odd trillion of future promises and plummeting tax receipts. If this is not the recipe for vast amounts of money printing and more than a little concern from your Chinese bankers I cannot think what would worry you.

I disagree that it requires physical destruction of infrastructure and/or apocalyptic decimation of the workforce to ensure hyperinflation. This has never been the requirement historically. Simply watch the lack of faith in the US$ over the next two years. I do not see wheelbarrows of cash for a loaf of bread but the US$ index below 52 and a mad scramble to buy hard assets to exit the US$.

Posted by walkdontrun | Report as abusive

What bothers me about this sort of economic analysis, and as a layman find less than helpful, is the presumptive wisdom of the central banking system, whose tinkering and manipulation of interest rates and the money supply has all but destroyed the free-market. Speaking as a consumer, thanks to commodity profiteering, there is, as far as I can tell, no longer a discernable, predictable, rational, cause-and-effect relationship between supply, demand, and the prices we pay at check-outs and gas pumps. So, so much for the free-market. We were told the bailout was going to be used to save Main Street. Instead, at taxpayer expense, it sits idle, generating interest for the banks. In other words, we were lied to. As suggested in the article, bailout money can’t stay at the Fed forever. Sooner or later it WILL enter the economy, in drops or by the bucket, inflating dollars already in circulation. That much we can predict. I guess what I’m really wondering is, how can you guys be so calm and rational about this — while we’re all being robbed?

Posted by Pennywise | Report as abusive

[...] saw this article on the Reuters Blog, by Rolfe Winkler.  He chronicles quite succinctly the difficulty that the Fed has in trying [...]