David Price sent me an interesting article that he wrote for the Richmond Fed. This caught my eye:
If banks believe that they can earn more by reducing their excess reserves, and if they appear likely to use their excess reserves to expand their activities faster than the economy is growing, the Fed can avoid the torrent of money simply by raising the interest rate that it pays on reserves. That is why high excess reserves do not necessarily set the stage for high inflation.
But is there a risk of the Fed getting the timing wrong? If it doesn’t act quickly enough to raise IOR, or if it doesn’t raise the rate enough, an unwanted rise in inflation or inflationary expectations could be the result.
For some economists, the likelihood of such a sequence of events is remote. “The FOMC [Federal Open Market Committee] meets every six weeks,” says Stephen Williamson of Washington University in St. Louis. “You’re not going to have a huge inflation instantaneously. They can head it off if they’re willing to tighten at the appropriate time.”
Ennis and Wolman of the Richmond Fed suggest, however, that high excess reserves create a greater timing challenge for the Fed than it normally faces. “Absent the excess reserves, banks would have to raise funds to make new loans,” Wolman says. “People argue about whether the large quantity of reserves materially changes the sensitivity of the economy to the Fed messing up.”
The issue is that with high excess reserves on tap, banks can increase lending quickly — “without having to sell assets, raise deposits, or issue securities,” Ennis and Wolman wrote. Thus, they suggested, high excess reserves mean that an expansion can take place more quickly, perhaps before the Fed is ready to act on signals that it is happening.
Williamson’s right, it’s not a problem. And the mistake Ennis and Wolman make is an interesting one. Individual banks are not constrained in making loans in the short run, as they can always borrow needed reserves in the fed funds market. If they do so that will put upward pressure on interest rates, and the Fed will supply the needed reserves to maintain their fed funds target.
In the long run banks are constrained, as the Fed will adjust the monetary base to prevent economic overheating. The endogenous money folks, who are right about the period between Fed meetings, overlook this longer run problem with their theory. Six weeks is not a long enough period to have major macroeconomic consequences. But in the very short run the banks are not constrained by a lack of reserves, if the Fed is targeting the short term interest rate. The base is endogenous during that period.
I was also struck by Price’s description of the onset of IOR during the fall of 2008. Before quoting from the paper, let me explain my mindset. Suppose you found the following account of someone’s day:
I got up and had eggs for breakfast. Got in the car and went to the grocery store to buy some milk. While driving down Elm street I pulled out a AK47 and shot 3 children on a playground. Then I went to the dry cleaners, to pick up my shirts. I pointed out that the shirts were still a bit wrinkled, and one had a stain that had not been removed. Then I got an oil change at Valvoline . . .
Most people would go “Whaaat!?!?!” when they read about the shooting. That was roughly my reaction when I read Price’s matter of fact description of the Fed’s decision to pay interest on reserves, made in early October, 2008:
In the Financial Services Regulatory Relief Act of 2006, Congress authorized the Fed to begin paying IOR on Oct. 1, 2011. In May of 2008, however, in the midst of the financial crisis, the Fed asked Congress to move up the effective date. During the crisis, the Fed had been carrying out emergency lending to financial institutions on a large scale. The Fed neutralized this process in monetary terms by “sterilizing” the money that it was creating; that is, as it created money, it sold the same amount of Treasury bonds from its holdings to absorb an equal amount of money. (Technically, the New York Fed, acting on behalf of the Federal Reserve System, would sell the bonds and the reserve account of the trading counterparty would be debited, causing those reserves to, in effect, disappear.) The Fed was selling off its supply of Treasury securities quickly, however, and it was foreseeable that it would run out of sufficient Treasuries with which to sterilize its lending.
“The Fed had sold so many securities that most of those left in its portfolio were encumbered in one way or another,” says Alexander Wolman, a Richmond Fed economist who co-authored a 2012 working paper on excess reserves with colleague Huberto Ennis. “Given that the Fed wanted to continue expanding its credit programs without lowering market interest rates, the answer was to start paying interest on reserves.”
Yes, given they wanted to continue expanding credit without lowering interest rates (which were at 2% at the time.) But we are talking about October 2008! To me that like saying; “Given I had decided to eliminate those three little children, the solution was to pull out my AK47.”
Is it any surprise the stock market crashed in early October? I mean if you are having to go to Congress for emergency powers because the economy is going down the toilet, I’m not sure “below target interest rates” is the number one thing the Fed should have been worrying about.