Submitted by Lune.
As the Fed embarks on quantitative easing, a large number of economists have voiced concerns about the resulting inflation that we may face once the economy starts to recover.
The traditional tool for fighting inflation is contracting the money supply, usually by decreasing the reserves available, thus constraining the total amount of money that may be lent by the fractional banking system. Sceptics worry that since those reserves are now backed by illiquid — and frequently impaired — assets, the Fed will have a hard time shrinking the reserves outstanding.
In an article on voxeu.org, Robert Hall and Susan Woodward argue that the Fed now possesses another tool that would allow it to effectively reduce credit without decreasing reserves. In Oct, 2008, the Fed, in a break from long-standing policy, began paying interest on reserves held by banks. Hall and Woodward argue that the differential between the interest paid on reserves and the federal funds rate now forms another variable which the Fed can use to control the money supply independent of any manipulation of the amount of reserves outstanding:
When the Fed pays interest on reserves at a rate well below market rates – in particular, well below the Fed funds rate governing borrowing and lending among banks – banks economize on reserves. If the margin between the Fed funds rate and the reserve rate is large, say several percentage points, banks will hold only required reserves. In this case, standard old-fashioned monetary theory applies, taught to generations of freshman principles students as the “multiple expansion of deposits.”
Suppose we start with deposits of $100 billion and reserves of $10 billion, so banks hold no reserves in excess of requirements. Then the Fed creates another $1 billion of reserves. Banks will expand their activities to try to avoid holding excess reserves, which are undesirable because they pay interest far below market rates. The economy expands as a result, depositors hold more in their checking accounts – $110 billion to be precise – and banks no longer hold excess reserves. The economic expansion is a combination of more real activity and higher prices. An expansion of reserves raises the rate of inflation over some period, generally thought to run from about a year after the expansion to around four years.
This conventional analysis always applied when the Fed paid zero interest on reserves and market rates were in the range of 5% or more. Banks used sharp-pencil policies to avoid holding excess reserves. Manipulation of the quantity of reserves gave the Fed powerful and direct and direct control over economic activity and inflation.
Today’s situation: No risk of excess inflation
When reserve interest rates and the Fed funds interest rate are close to each other, the situation is quite different. Banks are happy to hold excess reserves which pay just as much as could be earned on other safe investments. Expansion of reserves results mainly in expansion of excess reserves and has little effect on bank lending. Rather than stimulating economic activity and raising the volume of bank deposits, an expansion of reserves just adds to banks’ holdings of reserves. The Fed loses its control over economic activity. In particular, expansion of reserves is not inflationary when the reserve rate and Fed funds rate are the same. There is no risk of excess inflation in today’s economy.
In other words, if the interest paid on reserves is significantly less than the federal funds rate, then banks are quick to use the additional reserves as a basis to lend, while if the interest paid is close to the federal funds rate, then the banks will simply continue to accumulate reserves without increasing lending.
This may by one additional factor why banks have been sitting on all their extra cash given to them by the Fed rather than to start using it to lend (although other factors also exist, such as the fact that most of their balance sheets are still quite impaired, and that there are very few credit-worthy borrowers left in the current economy, most of whom are paying down their debt rather than looking to increase it, etc.)
If Hall and Woodward’s analysis is correct, then even if the Fed is unable to withdraw reserves fast enough, they might still be able to avert inflation by equalizing interest on reserves and the federal funds rate, thus disincentivizing banks from extending credit.
The basic point emerging from the analysis of the role of the reserve interest rate is simple: The margin between the Fed funds rate and the reserve rate is a potent new tool for stabilizing the economy. When the Fed wants to expand, it should raise the margin. In today’s economy, this would call for a negative reserve rate, that is, a charge to banks for holding reserves. When the time comes to move to a tighter policy, the Fed should lower the margin. At that time, the Fed would raise the reserve rate for two reason: first to reduce the margin and second to follow increases in market interest rates that will occur in a recovery.
So the question John Taylor posed – how can the Fed control inflation in coming years when it is committed to have a large volume of reserves outstanding to finance its purchases of illiquid assets? – has a simple and effective answer: The Fed should raise the rate its pays on reserves as needed to control economic activity and inflation. It is unnecessary for the Fed to cut its reserves to low levels once the economy approaches normal conditions. Rather, it only needs to raise the reserve interest rate to a point sufficiently close to market rates to make banks willing to hold excess reserves.
Regardless of future actions, Hall and Woodward point out that the Fed’s current actions are running counter to their stated goals:
Raising the reserve interest rate is a contractionary measure. A higher interest rate on reserves makes banks more likely to hold reserves rather than increasing lending. The Fed’s decision to raise the reserve rate from zero to 75 basis points just as the economy entered a sharp contraction in activity is utterly inexplicable. Fortunately, the Fed lowered the reserve rate subsequently, but the continuation of a positive reserve rate in today’s economy is equally inexplicable. [Emphasis in the original]
Some economists have proposed that the Fed charge banks for holding reserves, an expansionary policy worth considering. With the Fed funds rate at around 15 basis points, it would take a charge to restore the differential that drives banks to lend rather than hold reserves. Were the Fed to charge for reserves, they would become the hot potatoes that they were in the past, when the reserve rate was zero and the Fed funds rate 4 or 5%. Banks would expand lending to try not to hold the hot potatoes and the economy would expand. There is no basis for the claim that the Fed has lost its ability to steer the economy. (However, the Fed would have to go to Congress to get this power, as it did to get the power to pay positive interest on reserves.)
While Hall and Woodward’s analysis about bank behavior in the face of variation in the reserve rate / fed funds rate differential is insightful, the end-result is something well studied, namely the manipulation of reserve ratios to meet macro-economic goals. In essence, lowering the reserve rate / fed funds rate differential leads to de facto higher reserve ratios, leading to a contractionary policy similar to de jure higher reserve ratios such as a central bank explicitly raising minimum reserve requirements (for example, China’s central bank frequently changes minimum reserve requirements to meet macro-economic goals). Thus, this is not necessarily a new tool so much as a new impementation of an old tool.
One other criticism is that Hall and Woodward pay no attention to the political pressures that would lead the Fed to improperly use this tool. Everyone knows the goal of the Fed is to take away the punch bowl just when the party’s getting started, but recent history has shown the Fed unwilling to be such a party pooper. Regardless of the tools available, the Fed must have the independence to take politically unpopular decisions. Today’s Fed, behaving more like an off-balance sheet special purpose vehicle of the U.S. Treasury, is hardly that independent actor.
Indeed, the Fed’s current actions are telling. Hall and Woodward label the Fed’s current reserve rate as inexplicable since it directly contradicts the goal of getting banks to start lending. Yet it’s highly explicable: despite the macroeconomic damage being done by paying interest on reserves when the federal funds rate is so low, the Fed is loath to give up this method of funnelling yet more public money onto bank balance sheets. And you can be sure that any Fed moves towards charging banks for their reserves will be met with howls of protest (along with armies of lobbyists).
So in the end, while the reserve rate constitutes yet another tool in the Fed’s arsenal of macro-economic levers, we are back to the original problem, dating at least to Greenspan’s tenure, of how to get the Fed to use the tools it already has.