Don’t Fear the Rise in the Fed’s Reserve Balances

By Scott Fullwiler

Many in the financial press have noted the rise since September 2008 in the Fed’s reserve balances from about $20 billion to more than $800 billion today. A number of well-known economists have expressed concern that this will be inflationary.

However, fears that these are inflationary are misplaced, even inapplicable, as they apply only to a monetary system operating under a gold standard, currency board, or similar arrangement, not the flexible exchange rate system of the U. S.

Under a gold standard, for instance, banks must be careful when creating loans that they have sufficient gold or central bank reserves to meet depositor outflows or legal reserve requirements. This is the fractional banking, money multiplier system standard in the economics textbooks. If there is an inflow of gold, then bank deposit creation can increase and prices can rise. The same can occur if the central bank raises the quantity of reserves circulating relative to its own gold reserves.

But that’s not the case under modern monetary systems with flexible exchange rates.

In the U. S., when a bank makes a loan, this loan creates a deposit for the borrower. If the bank then ends up with a reserve requirement that it cannot meet by borrowing from other banks, it receives an overdraft at the Fed automatically (at the Fed’s stated penalty rate), which the bank then clears by borrowing from other banks or by posting collateral for an overnight loan from the Fed. Similarly, if the borrower withdraws the deposit to make a purchase and the bank does not have sufficient reserve balances to cover the withdrawal, the Fed provides an overdraft automatically, which again the bank then clears either by borrowing from other banks or by posting collateral for an overnight loan from the Fed.

The point of all this is that the bank clearly does not have to be holding prior reserve balances before it creates a loan. In fact, the bank’s ability to create a new loan and along with it a new deposit has NOTHING to do with how many or how few reserve balances it is holding.

In other words, there is no loan officer at any bank that checks with the bank’s liquidity officer to see if the bank has reserves before it makes a loan.

What constrains a bank in the creation of new loans and deposits, then? First, there is the fact that there must be a willing borrower . . . one whom the bank deems to be creditworthy. Second, the loan must be perceived as profitable . . . in this case, the bank’s ability to raise deposits does matter, since it probably expects the borrower to withdraw the deposit it will create, and finding new deposits is much cheaper for the bank than borrowing from other banks or from the Fed. Third, the loan must be on the regulator’s approved list of assets, and if the loan results in an expansion of the bank’s balance sheet, the bank must be aware of the impact on its capital requirements and other financial ratios with which the regulator is concerned.

But, how many reserve balances the bank is holding does NOT affect its operational ability to make the loan.

Most fears expressed by economists, policymakers, and the financial press regarding the rise in reserve balances since September presume—like the inapplicable money multiplier model—this will necessarily lead to excessive creation of loans and deposits by banks and thus rising inflation.

But this cannot possibly be true. Banks have the same ability to create loans with $800 billion in reserve balances that they had with $20 billion. The difference now is mostly that they do not see as many creditworthy borrowers coming through their doors, given the deep recession, which has led them to create fewer loans.

Admonishments of banks by members of Congress for “not lending out the TARP funds” make the same mistake. Banks don’t lend out TARP funds or any other funds. They create loans and deposits out of thin air, then use reserve balances to settle payments or meet reserve requirements.

For further evidence, consider two recent extreme cases:

In Canada, reserve balances have been effectively zero for over a decade now, and bank lending continues as it does anywhere else. Canada’s inflation also has been similar to that of the U. S.

In Japan, under the so-called quantitative easing regime of 2001-2005, reserve balances reached around 15% of GDP, and the monetary base (reserve balances plus currency in circulation . . . often termed “high powered money”) reached 23% of GDP. But Japan has, if anything, experienced deflation during and since this period, which is not surprising, since—again—the rising quantity of reserve balances did not enhance Japanese banks’ abilities to create loans.

In the U. S., by comparison, reserve balances have reached about 6% of GDP, with the monetary base rising from about 6% to about 12% of GDP since September 2008. Those fearing rising Fed reserve balances apparently haven’t noticed that an increase in reserve balances about three times the size in terms of GDP already happened in Japan, with none of the effects that have been predicted for the U. S.

In short, don’t fear the rise in the Fed’s reserve balances. It is not inflationary because the money multiplier view, found in the textbooks, doesn’t apply to the flexible exchange rate monetary system of the U. S. The U. S. may indeed experience rising inflation in the future (or it may not), but it won’t have anything to do with the quantity of reserve balances banks are holding.

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