More and more one hears the concern that the Fed has embarked on an expansionary policy that will result in high inflation once the economy returns to normal. John Taylor, a leading expert in this area, put the argument as follows, in recent Congressional testimony:
… the enormous increase in reserves is potentially inflationary. Many people ask me if it is inflationary, so I know it is on people’s minds. With the economy in a weak state and commodity and many other prices falling, inflation is not now a problem, but at some time the Federal Reserve will have to remove these reserves or we will have a large increase in inflation…Recall that increases in money growth affect inflation with a long lag. The question is whether the Fed will be able to reduce the reserves in time and whether people will expect the Fed to do so. If reserves get to the level [implicit in recent policy announcements] it will have to sell a huge amount of securities backed by consumer credit, mortgages, student loans, and auto loans. This will be difficult to do politically.
Chairman Bernanke responded to this view in January, but his answer–basically what we view as the correct one–received little attention and did not alleviate the misconception of incipient inflation that has spread widely since then.
A common way to express the concern is that the Fed has created huge amounts of money and that it will not be able to shrink the money supply in time to avert inflation as the economy recovers. This way of expressing the issue is completely confusing, because it equates reserves with money. The Fed now pays interest on reserves, so the connection of reserves to money is not mechanical but requires a modern analysis that includes the role of the interest rate on reserves. Though many central banks now pay interest on reserves, the extension of monetary theory to include that new factor has remained obscure. Only little-known academic studies such as “Controlling the Price Level” and “Optimal Fiduciary Monetary Systems” considered the issue.
Reserves are interest-bearing obligations of the Federal Government, enjoying the same safety and liquidity as Treasury bills. Reserves form the core of the payments system. Anybody can trade reserves dollar-for-dollar for currency by cashing a check, withdrawing from an ATM, or depositing currency in a bank account. Financial obligations stated in dollars can be met definitively by writing a check, which is an instruction to one bank to transfer reserves to another bank.
Banks must hold reserves of 10 percent of the amounts in their depositors’ checking accounts (required reserves), but this requirement is not binding today, as banks are holding vastly more than their required reserves.
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 percent 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.
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.
Equality of the reserve rate and the funds rate comes about in two ways. One is for the funds rate to fall toward the reserve rate. Prior to October 2008, the reserve rate was always zero. Thus, as the funds rate approaches zero, the mechanical connection between reserves and economic activity vanishes. This limitation on the Fed’s ability to stimulate the economy has long been known.
The second way the two rates could become equal is for the reserve rate to rise to the level of the funds rate (or even a bit above, as it has since October). Note that both factors have operated in recent months. When the Fed started to pay interest on reserves in October, it set the rate at 0.75 percent or 75 basis points. The current rate is 25 basis points.
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. 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 percent. 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.)
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.
How should the Fed pick the level of the reserve interest rate? The policy for the reserve rate should be basically the same as the successful policy for the Fed funds rate that delivered exceptional stability to the economy from the mid-1980s until the current crisis. During that period, the Fed set the funds rate adaptively–when the economy seemed headed for overheating and excess inflation, it raised the funds rate to cool the economy off. When the economy stumbled, as in 2001 and in 2008, the Fed cut the funds rate to low levels. The resulting record on inflation was outstanding–the inflation rate remained in a tight band centered on about 2.5 percent. One of the best ways to judge the performance of the Fed is to look at the consensus forecast for inflation over the coming two years. For the past 20 years, the forecast was right on 2 to 3 percent with few exceptions. Today the consensus is for too little inflation–only 1.2 percent in 2009 and 2010 and 1.7 percent in 2011. So inflation forecasts call for expansion. Once the forecast rises to around 2.5 percent for the coming two years, the Fed should raise the reserve interest rate and reduce the volume of reserves (to the extent permitted by the liquidty of its portfolio at that time) as needed to keep the forecast at around 2.5 percent. The Fed can pick a combination of a higher reserve rate and a lower volume of reserves to cool the economy sufficiently to keep inflation on tdarget.
The Fed needs to issue a pronouncement along the following lines to assure the public that there is no need for concern about inflation after the receovery and to reaffirm its historical commitment to stable and low inflation:
The Federal Reserve is fully committed to a policy of stable and low inflation. Though the Fed has not adopted a quantitative target for a specific measure of inflation, its actual performance over the period from 1987 through 2007 is indicative of its goal for the future. The Fed will continue its efforts to expand the economy this year, when inflation appears to be well below its normal range. Its past and planned expansionary policies during the current period of extreme stress will result in a large expansion of reserves. The Fed will use its authority to pay interest on reserves as needed to prevent excessive inflation as the economy recovers.
Even the St. Louis Fed has missed the point that reserve interest policy can take care of an overhang of reserves. An article in its Review that discusses interest on reserves nonetheless concludes.
The key is that the Fed will have to drain reserves when the economy begins to recover if it is to prevent a rapid acceleration of inflation. That necessity drives the current discussion of exit strategies.
The (incorrect) logic suggested by this sentence is that as long as the Fed has a high volume of reserves outstanding, they must be held by the banking system and thus the monetary base must be large and inflationary. It misses the point that banks can be coaxed into just the right demand for excess reserves to ensure the desired inflation rate, by paying the right interest rate on reserves. The exit strategy from the Fed’s holdings of illiquid asssets need not be constrained by concerns about inflation, becuase reserve-rate policy can take care of inflation.
The author responds:
I like your website and this article, though, I think I was misrepresented (but not too badly).
I understood the point made by Woodward and Hall when I wrote the article on recent changes in the monetary base. To quote, “The difficulty of maintaining price stability will depend on the size the balance sheet reaches before the crisis ends, the quality of the assets in the portfolio, and the policy followed to manage the interest rate paid on reserves.” (Italics added, page 57) The article is correct in that I chose to downplay this aspect of policy. For a model of the suggested policy, I recommend “Divorcing Money from Monetary Policy,” by Todd Keister, Antoine Martin and James McAndrews at the New York Fed.
It is not necessarily true that the Fed alone (that is, without further appropriations from Congress) could raise the interest rate on excess reserves high enough to prevent inflation. It is relatively easy to imagine situations in which the interest cost paid on reserves would absorb most or all of the Fed’s income. Such conditions might include an inverted yield curve, reduced income from the GSEs, and/or a rising portfolio of nonperforming assets from bank rescue operations.