Increase in the Fed’s balance sheet – let’s be objective

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This post is a guest contribution by Paul Kasriel* of The Northern Trust Company.

In recent weeks two prominent economic commentators – Arthur Laffer and Alan Greenspan – have warned about the inflationary potential emanating from the unprecedented increase in the Fed’s balance sheet. Yes, as shown in Chart 1, reserves created by the Fed have increased by a staggering $858 billion in the 12 months ended May. But excess reserves on the books of depository institutions have increased by almost as much, $842 billion (see Chart 2). So, in the 12 months ended May, 98% of the increase in reserves created by the Fed has simply ended up as idle reserves on the books of depository institutions.

northern-trust-30-june-2009

Yes, the bulk of the reserves the Fed has created are sitting idly on the books of depository institutions for now, but what if these institutions begin to lend them out in the future? Will this not result in an explosion of bank credit and the money supply, the raw ingredients of accelerating inflation – some might say the very definition of accelerating inflation? Why, yes, if the Fed were stand idly by.

If, however, the Fed wished to “neutralize” these excess reserves, it has the means to do so. The Fed now pays interest on reserves. If it observed an undesired “activation” of these hundreds of billions of dollars of excess reserves, it could hike the interest rate paid on excess reserves. Why would depository institutions lend more at the same loan rate when the risk-free rate they could earn from the Fed on excess reserves had risen?

They would not. So, the increase in the rate paid by the Fed on excess reserves would induce depository institutions to hike the interest rates charged on loans. All else the same, the quantity of credit demanded by the public would decrease and, therefore, bank credit and the money supply would not increase.

But what about the federal government? Its demand for credit is not sensitive to the level of interest rates. Yes, but the Fed could continue to raise the rate it pays on reserves until the quantity of credit demanded by the private sector falls sufficiently to offset the increased demand for credit by the federal government. But might this imply a substantial increase in interest rates? Yes, it might, depending on the sensitivity of private-sector credit demand and the amount of borrowing by the federal government.

Would not this “crowding out” of private sector borrowing by federal government borrowing be a negative for future productivity and economic growth? Yes. But that’s a different issue. The point I am attempting to make in this commentary is that the increase in the Fed’s balance sheet in the past year is not currently inflationary and need not lead to higher future inflation. Whether the Fed has the will or the skill to prevent the current increase in its balance sheet from manifesting itself in future higher inflation also is a different issue.

Source: Paul Kasriel, Northern Trust – Daily Global Commentary, June 29, 2009.

*Paul Kasriel is Senior Vice President and Director of Economic Research at The Northern Trust Company. The accuracy of the Economic Research Department’s forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005. The accuracy of Paul’s 2008 economic forecast was ranked in the top five of The Wall Street Journal survey panel of economists. In January 2009, The Wall Street Journal and Forbes cited Paul as one of the few who identified early on the formation of the housing bubble and foresaw the economic and financial market havoc that would ensue after the bubble inevitably burst.

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2 comments to Increase in the Fed’s balance sheet – let’s be objective

  • Would not this “crowding out” of private sector borrowing by federal government borrowing be a negative for future productivity and economic growth? Yes. But that’s a different issue.

    “I am the Fed. I am here to help you.”

    Has our government been mostly correct in handling the country’s financial or social engineering? Is the current treatment from our government of the financial disaster falls under the portion where it may not be correct acceptable to us?

    Why is our government deviate from capitalism? Do the majority people of our country no longer believing in this form of structure for our country?

    Or has the people been spoon fed by the government for so long we can no longer think for ourselves anymore?

  • Ian Nunn

    The issue of the excess reserves, I think, is one of the most importance to get right. Unfortunately, the banks seem to be opaque to analysis.

    The alternatives I see are:

    1. The banks are afraid to lend. This is the mantra of the Street. Credit spreads such as the TED spread, which seem to be the measure of this fear, have been dropping significantly. Excess reserves are actually increasing. So I don’t see this is the case.

    2. The banks would rather earn 0.15% (Gary North) on a risk free investment than lend to riskier clients. This has recently appeared in several discussions as above. The issue here is to note that these are banks. Their business is to accurately assess risk (admittedly they may be a little gun shy, but the smell of blood – I mean money …) and make loans based on this. Why the Masters of the Universe would suddenly settle for 0.15% when there are fortunes to be made in debt markets where the risk will now be more reasonably assessed, is beyond me.

    3. Which leads to the next point. Is there a market for debt? This is a recession. Business reduce capital spending and consumers reduce spending. Other than sovereign institutions, maybe there is no market.

    4. The other point that I think bears serious consideration and is maybe hinted at in the odd source is the banks technically may not have “excess” reserves. They may need every penny of this money to retain their capital ratios if they still maintain large off-balance sheet exposure to future credit liabilities relating to real estate, both private and commercial. I have seen no assurance that the derivatives problem has been cleaned up – at least not from any source I would believe.

    Take your pick.

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