Fatas and Hunt on Reserves and Quantitative Easing

By Dan Kervick

Lacy Hunt reports on three recent academic studies indicating that the Fed’s unconventional asset purchasing programs have failed. Antonio Fatas is “sympathetic to the argument that Quantitative Easing has had a limited effect on GDP growth”, but takes issue with some parts of Hunt’s analysis, and argues that the way Hunt analyzes the relationship between reserves and the money multiplier “is not consistent with the conclusions reached about the lack of effectiveness of monetary policy actions.” I believe there are problems with both Hunt’s analysis and Fatas’s analysis of that analysis. My best guess is that QE has had negligible macroeconomic effects. But some of the considerations Hunt and Fatas adduce in attempting to evaluate that question are red herrings, and don’t get us closer to an answer.

Hunt claims:

If reserves created by LSAP (Large Scale Asset Purchases) were spreading throughout the economy in the traditional manner, the money multiplier should be more stable. However, if those reserves were essentially funding speculative activity, the money would remain with the large banks and the money multiplier would fall. This is the current condition.

To which Fatas responds:

How can reserves be funding speculative activities if they remain in the balance sheet of the banks? Reserves represent an asset in the balance sheet of commercial banks. They have increased by having commercial banks selling other assets to the central bank. So the amount of “riskier” or “less liquid” assets must have decreased.

But contrary to what both Hunt and Fatas seem to imply, whether or not banks are using reserves for riskier speculative activities cannot be determined by looking at changes in aggregate bank reserve balances.

Most businesses in the modern world do not do business with piles of physical cash. The money they hold, and use for day-to-day business operations, is held on account as a deposit at some bank. People or firms who are selling stocks or commodities obviously have bank accounts. If some speculating bank purchases assets of those kinds from the seller, then a payment will be made by the bank to the seller. In order for the payment to be settled and cleared, a transfer will have been made from the reserve account of the bank purchasing the assets to the reserve account of the seller’s bank. Total bank reserves will be unaffected. (If the seller happens to have a deposit account at the purchasing bank itself, then the bank will just credit more money to the seller’s deposit account, and both the bank’s own reserves and aggregate banking system reserves will be unaffected.)

Aggregate bank reserves do not drop as a result of an increase in economic activity unless people for some reason show an increased desire to withdraw physical cash and hold onto it. Note that when people withdraw cash for ordinary, temporary commercial purposes, the cash rapidly cycles back into banks where it again forms part of banks’ total reserves. I personally withdraw some cash each week so I can use it in my company’s vending machines or to make very small, over-the-counter purchases at local stores. Once I have made those purchases, the mangers of the businesses who have received the cash from me collect it together with other daily cash receipts and deposit all of that cash at their bank. Cash is constantly flowing out of bank vaults and back into bank vaults, but the impact on aggregate reserve levels is negligible.

Hunt seems to recognize part of this process in stating that if banks choose to make speculative asset purchases rather than ordinary loans, then “money would remain with the large banks.” But Hunt also seems to suggests that if banks were doing more ordinary lending instead, the money would not remain with the banks. But bank lending does not result in reserves leaving the banking system. When the bank makes a loan, a borrower is given money on account at the bank. As that borrower then draws on the account to make payments of various kinds, the bank will either be required to settle those payments by (i) participating in transfers of reserve balances from the bank’s own reserve account to reserve accounts of other banks, (ii) debiting and crediting money from and to its own depositors’s accounts without drawing on its reserves, or (ii) dispensing cash reserves to the borrower which, as before, are quickly recycled back into the banking system’s total reserves. Bank lending does not result in bank reserves going out of the banking system.

Hunt’s analysis also relies on claims about the so-called “money multiplier”.  This troublesome and much-misused term can be defined in different ways. Sometimes the term just refers to the ex post ratio of commercial bank deposit balances to total reserves, i.e. the ratio of commercial bank money to central bank money. Call this the empirical money multiplier. Others use the term to refer to the reciprocal of a central bank’s formal reserve requirement. Call this the policy money multiplier. Many analysts err greatly in assuming that there is some stable connection between the empirical money multiplier and the positive money multiplier, so that deliberate central bank changes in central bank money will generate predictable changes in the quantity of commercial bank money. This assumption never had much to be said for it, and has been decisively crushed by the events post 2008.

But let’s focus entirely on the empirical money multiplier, which is clearly the quantity to which Hunt is referring. Is Hunt correct in claiming that if banks start using reserves to engage in more speculative asset purchases, then the empirical money multiplier will fall?  That’s possible.  But the empirical money multiplier can also fall as a straightforward consequence of QE without any changes in bank speculation or lending behavior. If, starting with some fixed and unchanging quantity of aggregate reserves, banks increase the ratio of loans to other assets in their portfolios, the empirical money multiplier will grow; and if they instead decrease the ratio of loans to other assets, the empirical money multiplier will fall. But reserve balances are actually fluid, especially given the Fed’s asset-purchasing programs, and so the fact that there has been a fall in the empirical money multiplier cannot be used to conclude banks either are or are not increasing speculative activity or decreasing lending.

Suppose a bank owns $1 billion dollars in reserves and $9 billion in other assets, including $2 billion in treasury securities. It’s total assets are thus $10 billion. Suppose it has $8 billion in deposit liabilities, so that the ratio of deposits to reserves is 8/1. Now suppose the bank sells $1 billion in treasuries to the Fed.  As a result, the bank’s total assets will still be $10 billion, but its reserves will now be $2 billion. Suppose the bank’s rate of lending and loan collections remains unchanged, so that deposits do not change and remain at $8 billion. Then even if the bank makes no other changes in its portfolio whatsoever, its deposit-to-reserve ratio will have been slashed in half to 4/1. Lending has continued unchanged; and the bank has not increased its speculative investments. It has just swapped one kind of low-risk asset for another. But since the assets for which it swapped the treasuries – dollars on account at the Fed – comprise a part of its reserve balance, the deposit-to-reserve ratio is affected drastically. So clearly, attempts to draw conclusions about bank behavior from changes in either reserve balances or the empirical money multiplier are fraught with peril.

Hunt also claims:

(Banks) can allocate resources to their proprietary trading desks to engage in leveraged financial or commodity market speculation. By their very nature, these activities are potentially far more profitable but also much riskier. Therefore, when money is allocated to the riskier alternative in the face of limited bank capital, less money is available for traditional lending. This deprives the economy of the funds needed for economic growth, even though the banks may be able to temporarily improve their earnings by aggressive risk taking.

To which Fatas responds:

Yes, banks can trade their Reserves for either bank loans to the private sector or by purchases of risky assets (stocks). But in both cases the amount of reserves has to go down. One can make the argument that the injection of liquidity is triggering one type of lending more than another but this is inconsistent with the view that the problem with QE is that banks are simply sitting on reserves without doing anything with them.

Fatas makes a good point here: if banks are using reserves to buy other assets, then that is quite a different matter than “sitting on them”. But he is quite wrong, as we have already seen, in asserting that if banks were using reserves to purchase risky assets, the quantity of bank reserves would be going down. And he also seems to accept Hunt’s assertion that if banks are using reserves to speculate in stocks and suchlike assets, then that activity is putting financial constraints on their ability to generate loans. Again, bank reserves do not go out of the banking system when banks make loans, and aggregate reserves do not represent a relatively fixed quantity of loanable or available funds. Bank liquidity managers will generally respond to any need that added lending creates for additional reserves by acquiring those additional reserves, either by borrowing them from other banks or selling treasuries to the Fed. And the Fed will generally accommodate any need for additional reserves by the banking system as a whole by supplying them in a way that maintains the Fed’s target policy interest rate. Right now the cost of acquiring reserves is exceedingly low – approaching 0%.

But in the present circumstances the cost of adding reserves for the banking system as a whole is a moot point, since banks are already carrying abundant excess reserves. So allocating some of those reserves to the purchase of risky assets, if that is indeed what banks are doing, leaves plenty of reserves left to cover any increased volume of interbank payments and depositor cash transactions that would be sparked by expanded lending, with no need for additional liquidity.

The whole idea that one can measure whether either lending or speculating is increasing or decreasing simply by looking at fluctuations in bank reserve accounts, or changes in the empirical money multiplier, is deeply flawed. My suggestion for economists is that they give up on the pointless task of analyzing bank behavior through the study of reserves and ratios involving reserves. If you want to see whether banks are increasing or decreasing their lending, study the statistics on bank lending; if you want to see whether they are increasing or decreasing their risky asset purchases, study bank balance sheets and measure changes in those asset classes. If you want to study whether changes in these activities are tied to Fed asset purchasing programs, study whether there is a robust temporal correlation between changes in bank behavior and changes in Fed asset purchases.

Cross-posted from Rugged Egalitarianism

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23 responses to “Fatas and Hunt on Reserves and Quantitative Easing

  1. Excellent article. One thing that you could have said more forcefully is that both authors seem to make the implicit assumption that banks are reserve-constrained, that the manipulation of reserves by the Fed through QE has any effect at all on the ability or desire of banks to make loans.

  2. ” if banks are using reserves to buy other assets, then that is quite a different matter than “sitting on them”.”

    I wasn’t aware that it was operationally possible for a bank to use reserves for anything other than trading with the Fed., i.e. holding them instead of treasuries.

    • Bank reserves are just deposits in accounts at the Fed. Banks use them whenever they buy almost anything (at least if the firm or person they are paying doesn’t have a deposit account at their own bank).

      • I’m not sure I’ll ever understand this point. I envisioned the reserve accounts being completely separate than the rest of the banks activities (equities, mortgage, underwriting departments for example) and being part of a closed system with the Fed and the other interbank market participants.

        There’s a FT article I read talking about this, it says : “whether commercial banks let the reserves they have acquired through QE sit “idle” or lend them out in the interbank market 10,000 times in one day among themselves, the aggregate reserves at the central bank at the end of that day will be the same.”


        Or from Randall Wrays blog: “So anyone who thinks that pumping banks full of reserves while driving interest rates toward zero is a way to encourage lending simply does not understand banking. (This also means, of course, that whether banks have $100 billion or $100 trillion of reserves has no implications for prospective inflation.)”

        I get why it wouldn’t spur lending since the banks are flooded with reserves already and don’t really need them to lend in the first place, but the part in parenthesis still implies the money could not enter the real economy. Otherwise, why haven’t banks bought up every business in the Dow 30 if they can do whatever they want with reserves?

        • “Otherwise, why haven’t banks bought up every business in the Dow 30 if they can do whatever they want with reserves?”

          Don’t confuse the aggregate with individual banks. If Citi bought up a bunch of shares of IBM, the reserves would go from Citi’s reserve account at the Fed to other banks’ reserve accounts at the Fed. Total reserves wouldn’t shrink, or “enter the economy”. If JPM and all the rest did the same thing, reserves would flow back into Citi’s reserve account, because some of the sellers would have deposits at Citi.

          I’m very sure of that. I’m not a banker or banking expert. What follows is what I think I’ve learned in the course of learning MMT.

          When the Fed buys Treasuries and other assets, the money they spend goes into deposit accounts at banks, raising bank deposits and reserves, but doesn’t affect the capital of the banks, either individually or in the aggregate. Their assets (cash, reserves) and liabilities (deposits) go up by the same amount. They are in no better financial position than before, and have no additional capital to deploy to more assets than what they already own. If some banks were the sellers of securities to the Fed, that was because those banks wanted to change the mix of assets they owned, not because of any change in reserves. In fact, they wouldn’t know it was the Fed that bought their securities, they just sold them on the open market without knowing or caring who the buyer was.

          So, banks can’t “do whatever they want” with excess reserves. They have requirements about what they can do with their capital, and how much capital they must maintain. I think an increase in deposits would even raise the capital requirement, causing less flexibility for them, not more.

          • There are also capital requirements and other banking regulations to bear in mind – stocks have a 100% risk weight. And only investment banks are permitted to buy stocks in the first place.

            Banks don’t manufacture their own reserve assets from scratch. Total market value of public companies is something like 19 trillion I believe. Banks couldn’t afford to buy all that even if they wanted to.

            • “And only investment banks are permitted to buy stocks in the first place.”

              Can’t the banks just hand the reserves over to the prop desk, or investment banking division of their bank, as Hunt claims? It seems like, insofar as the banks were filled to the brim with crap MBS after the crash.. they were made a lot more healthier by QE, and could take part in very different activities as they were before.. buy stocks, pay out a dividend to shareholders, executive bonuses? Or is that illegal?

              • I think the bailout, where the Fed bought the toxic assets, was to help the banks appear more solvent. That was before QE and before the zero interest rate policy, if I remember. A lot of small banks were allowed to fail when their mortgages and MBS went south. The TBTF banks were forced to participate, so that nobody would know which ones were solvent and which ones were not. Part of the deal was that they would suspend or greatly reduce their dividends, and maybe some terms regarding executive pay and bonuses.

                I think QE1 was just short-term Treasury purchases, after the Fed Funds rate was already down to 0.25%, creating excess reserves in the banking system, hoping that would spur lending. Didn’t work. Then there was QE2 and the Twist, buying longer-term Treasuries to try to flatten the yield curve, to lower mortgage rates. Not sure which came first. QE1 and QE2 were for limited amounts, QE3 was called QE4ever, meaning until the taper, at $85B a month including both Treasuries and other securities, and that’s where we are now.

                I think the big investment banks have exited the bailout program now, and have resumed dividends and bonuses and trading derivatives like the ones that crashed the system.

                • Pretty good graphic for Fed balance sheet, FYI:


                  Roughly 300 billion or so increase in MBS holdings since the beginning of this year. I guess the question is, if a bank sells a whole bunch of worthless MBS to the Fed under QE, who in turn gives these assets some bogus “mark-to-model” valuation – paying 100 cents on the dollar for MBS that are worth 25 cents for instance – would that be considered “net financial assets” for the economy as a whole?

                  • I think the MBS that the Fed is buying this year under QE are good. It’s not clear to me how much they paid for the toxic assets they bought in the bailouts. Some people claim that the Fed is making a profit on those, which would indicate that they paid 25 cents, not $1. But in that case there would have been no “bailout”.

                    But, to answer the question, yes, if they paid more than fair value, that would be an increase in private sector NFA, although the accounting would not reflect it if the junk were being carried on the books at cost.

          • Thanks for the helpful response. So, banks could “use” reserves to purchase assets from each other, but in the aggregate the reserves would still stay the same. If the banks wanted to buy something, they could have done so with or without QE since it doesn’t change their capital. In the case of treasuries, they are virtually the same asset.. although there doesn’t seem to be much information regarding MBS purchases, how they are valued, etc.

            • “it doesn’t change their capital”

              Sort of. By the accounting definition of capital, that’s true. Banking regulations differentiate between “tiers” of capital. Assets, really, in accounting terms. Depending on risk. So if you need $1 of regulatory capital, $1 of T-bills would suffice, but you might need $2 of mortgage loans, or $X of MBS, or $Y of something else.

              Don’t you love it when they use the same word to mean different things?

          • On the asset side of the aggregate bank we have three things: loans + securities + reserves. The risky assets are loans. The assets that are reserves or can be sold for reserves are the “liquidity cushion” of securities + reserves. So when Fed does QE it injects a huge liquidity cushion equivalent to Treasury bills (interest on excess reserves) which reduces the ratio of loans to deposits in the aggregate bank. The capital requirements are really a requirement to hold a high quality liquidity cushion so my view is that QE definitely helps banks improve their capital position over time. It does this by provding the reserves in the liquidity cushion and the transaction accounts injected by Fed which convert to new paid-in capital on the liability side of the aggregate bank balance sheet.

            By paying interest on reserves at .25%, if short term Treasury bills trade at < .25%, banks have no incentive to purchase short-term Treasury bills at less than the IOR rate. This leaves the short term Treasuries for purchase by nonbanks who need liquid assets to stabilize their balance sheets. The Fed QE program may not stimulate economic growth but it surely can help banks and nonbanks improve their balance sheets.

    • OK, I see a semantic problem now. What does “use reserves” mean?

      “Banks use them whenever they buy almost anything” – meaning that when their check is cashed, the Fed debits their reserve account to clear the check. Like when you buy a car, you “use your checking account” because you pay with a check. Never mind that the funds in your checking account came from selling your boat so you would have enough money in it to pay for the car. One might say you “sold a boat” to buy the car, if talking about the source of the funds, or might say “used a checking account” when talking about the mechanics of a payment.

      “Using reserves” for clearing is the mechanical process. It doesn’t mean that banks spend their reserves to buy other assets. The money they spend comes from their interest income, like the money you spent on the car came from selling the boat, not from your checking account. Having excess reserves doesn’t enable banks to buy more stuff. They have to have income to do that, or spend down their capital (net worth).

      And, as pointed out below, commercial banks can’t buy common stock anyway.

      • joe bongiovanni

        You’re getting it, golfer.
        Start by clearing up that we’re talking about non-cash reserves.
        Otherwise ‘cash’ comes a creeping in.
        Or capital requirements.
        It is not possible for excess reserves to have any effect on the real economy.
        Dan says : “Banks use them whenever they buy almost anything (at least if the firm or person they are paying doesn’t have a deposit account at their own bank).”
        In truth, they must use them whenever there is a transaction , because of CB Rules.
        But they don’t use them as ‘exchange media’ when they buy almost anything, so that is grossly misleading.
        The banks don’t use the ‘reserves’ as exchange media to buy ANYTHING from each other.
        They need another media to make a purchase,(stock, bond or ???, ) but at the end of the day, the accounts at the CB are settled with these reserve balance movements.
        So, Bank A’s reserve balances move to Bank B.
        Nothing happens unless Bank A then needs reserves – doubtful today.

        Seems like just another of the “How Little We Know” postings.
        Although most comments here make it more like one of those, “But, I thought….” postings.

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  5. Is it possible that we, by focusing on bank reserves vs QE, are missing a much more important effect of QE?

    The more important effect I am considering is the ratio of deposits to loans. This ratio represents the strength of the bank and the banking system as a whole.

    We consider one banking rule to be “loans create deposits”. This rule allows all bank deposits to be created by loans. When we reach this one-to-one ratio, borrowers own all the deposits! Admittedly, this a caricature but the illustration serves to point to the dangers of repayment and loaned currency-vs-asset-valuation when this point is reached.

    The one-to-one ratio seems to have been reached in both the 2000 and 2007-8 recessions. The QE program has served to dramatically correct the ratio, greatly improving the total of deposits in banks. At the same time, since the beginning of QE, the total of bank loans shown only slow and erratic growth.

    The question of who benefits from QE is another question. In WWII, the greatly expanded money supply used to finance the war effort was widely spread among the workers and suppliers.

    During WWII, there was a vigorous savings program encouraging people to save and prepare for future spending (when the war was over). Any savings message preparing the economy for the future is lacking in today’s “consume it now” world.

    • joe bongiovanni

      ”The QE program has served to dramatically correct the ratio, greatly improving the total of deposits in banks. At the same time, since the beginning of QE, the total of bank loans shown only slow and erratic growth.””

      Roger, I doubt the QE has expanded the ‘deposit’ balances because that increase would be the result of a loan being made in banker-bookkeeping (loans create deposits) . As you said, these loans show slow, erratic growth, nothing like the regular, humongous QE reserve balance increases which show up on the asset side, almost like it was cash.
      But a far more important point is what will happen with these reserve balances when the shit hits the fan – redux.
      We’ve changed accounting rules before, and we are living under ‘anything goes’ lack of precedent CB mentality.
      Could be just another bank-saver somehow.

  6. If under QE the Fed purchases securities primarily from nonbanks then QE purchases inject both reserves and Fed-generated transaction accounts into the aggregate bank. This policy may not stimulate the economy, but it can prevent the aggregate bank balance sheet from collapsing during a deflation. If it improves the profit to banks, or the ability of banks to convert Fed-injected transaction accounts to capital and other liabilities (debit transacition accounts, credit capital or other bank liabilities) then QE can help both nonbanks and banks clean up their bad balance sheets over some time period. It may not stimulate the economy in the positive sense of economic growth, but it may help prevent economic recesssion.

    • joe bongiovanni

      It’s not a purchase, but a swap.
      The Fed gets electronic ownership of the Tsy’s and the bank gets the CB’s reserve balances.
      The swap does not generate transaction account action.
      There is no income – just a balance sheet swap.
      How it plays out in the coming deflation settlement scenario is yet to be determined – but surely worth watching.
      Wish there was somebody representing The Restofus.

  7. Good post Dan. A couple of questions:

    1) “the bank will either be required to settle those payments by (i) participating in transfers of reserve balances from the bank’s own reserve account to reserve accounts of other banks, (ii) debiting and crediting money from and to its own depositors’s accounts without drawing on its reserves, or (ii[i]) dispensing cash reserves to the borrower which, as before, are quickly recycled back into the banking system’s total reserves.”

    – couldn’t there be a fourth option: couldn’t the bank settled a customer’s payment by transferring deposits from one of its own deposit accounts at another bank to a deposit account of the bank of the payee of the customer?

    2) “If you want to see whether banks are increasing or decreasing their lending, study the statistics on bank lending;”

    – where can one find good statistics on bank lending (including what proportion of bank lending is going into new real production, what proportion is going into existing real assets and financial assets, etc.)?

  8. Mark A. Sadowski

    Lacy Hunt is evidently extremely skilled at taking quotes out of context.

    Lacy Hunt:
    “Dr. Hall also wrote the following about the large increase in reserves to finance quantitative easing: “An expansion of reserves contracts the economy.” In other words, not only have the Fed not improved matters, they have actually made economic conditions worse with their experiments.”

    Robert Hall in context (page 26):


    “With an interest rate on reserves above the market rate, the process operates in the opposite direction: Banks prefer to hold reserves over other assets, risk adjusted. They protect their reserve holdings rather than trying to foist them on other banks. An expansion of reserves contracts the economy. The Fed could halt this drag on the economy by cutting the rate paid on reserves to zero or perhaps 25 basis points.”

    The bottom line is Robert Hall was arguing interest on excess reserves is contractionary, not that QE is contractionary.

    Lacy Hunt:
    “Dr. Shin states, “The trouble is that job creation is done most by new businesses, which tend to be small.” Thus, he found “disturbing implications for the effectiveness of central bank asset purchases” and supported Hall’s conclusions.”

    Hyun Song Shin in context (Page 7):


    “There are some disturbing implications for the effectiveness of central bank asset purchases. If Bob is right, and unemployment is due to high discount rates, pushing down the spreads on corporate bonds or mortgage backed securities will not do much for unemployment as long as bank lending rates are stubbornly high.”

    Shin’s paper was not even a full blown paper. It was a commentary on Hall’s paper, and rather than supporting his conclusions, Shin was speculating on their implications.

    Lacy Hunt:
    “Drs. Krishnamurthy and Vissing-Jorgensen also criticized the Fed for not having a clear policy rule or strategy for asset purchases. They argued that the absence of concrete guidance as to the goal of asset purchases, which has been vaguely defined as aimed toward substantial improvement in the outlook for the labor market, neutralizes their impact and complicates an eventual exit. Further, they wrote, “Without such a framework, investors do not know the conditions under which (asset buys) will occur or be unwound.” For Krishnamurthy and Vissing-Jorgensen, this “undercuts the efficacy of policy targeted at long-term asset values.””

    Arvind Krishnamurthy and Annette Vissing-Jorgensen in context (Page 42):


    “Our paper has three broad lessons for central banks. First, LSAPs targeted at markets affected by financial stress conditions can be beneficial. It is worth noting that this conclusion is likely to hold independent of whether or not the zero-lower-bound is binding. Second, it matters which assets are purchased. Third, it is imperative that central banks outline a framework for the use of LSAPs. Without such a framework, investors do not know the conditions under which LSAPs will occur or will be unwound, which undercuts the efficacy of policy targeted at long-term asset values.”

    Clearly Krishnamurthy and Vissing-Jorgensen’s conclusion reads very different in context.