Last week, I began a two-part primer on the role the central bank, specifically the Federal Reserve, to help people understand what is meant by the Fed’s balance sheet shrinking, the nation’s money supply and how this relates to interest rates. The discussion continues today.
A central bank like the Fed manages the amount of money in an economy, and thus the ease or difficulty of borrowing, by controlling the quantity of bank reserves — the money deposited in banks but not lent out. It can change reserves by varying the legally-stipulated percentage of deposits that must be kept in reserves, by making loans directly to banks or buy purchasing bonds in open financial markets.
Importantly, when it increases reserves it does so by creating new money out of thin air, but when it decreases reserves that money just disappears. The money does not enrich some secret cabal or the U.S. Treasury or commercial banks or anyone. It just disappears.
The Fed must be judicious in the process. Create too many new reserves, and thus increase the money supply too excessively, and money loses its value; the general price level rises and there is inflation. Increase reserves too slowly and the money supply will stagnate. There will be a recession and often deflation, which can be even harsher on an economy than inflation.
There are two different but important indicators. One is the “monetary base.” This is the currency in circulation plus all bank reserves, those required to meet legal minimums plus any over that level.
Then there is the “money supply” which is currency plus bank deposits. In econ courses we learn about different specific measures of money supply, called M1, M2 and so on, which differ in exactly which types of bank accounts are included. But the important thing for the issue at hand is that bank reserves, the variable that the Fed directly controls, are part of the monetary base. That in turn is a subset of the money supply. Currency is in both measures but reserves are a fraction of the total money supply. It is the money supply that has greatest impact on the general price level. And it is the money supply and its effects on interest rates that are apparent to the average business or household.
Unfortunately, the money supply is not a fixed multiple of the monetary base. Over the last half century it is usually six to ten times as large, but that is not fixed. If banks are eager to lend every possible dollar, the ratio gets larger. If they are hesitant to lend, and keep excess reserves or simply buy bonds themselves, the ratio shrinks.
That leads us to a complication that only recent econ students have learned: The Fed now pays interest to banks on the reserves that these banks have in accounts at the Fed.
Historically, banks hated having to keep reserves. Each dollar in reserve is a dollar accepted from a depositor and on which interest may have to be paid, but that is tied up and that cannot be lent out at interest to earn any revenue. The fraction of deposits not held in reserve has to earn enough to cover the costs of all deposits. The higher the “required reserve ratio” the less income the bank has, at least as long as the reserves earn nothing.
That was the case from the 1913 creation of the Fed until 2008. Banks’ reserves at the Fed earned no interest. But the law changed in 2006, allowing interest to be paid on reserve accounts starting in 2011. When the financial debacle unfolded in 2008, the start date was moved up.
For a century, banks had three choices when a deposit came in. They could loan out most of the money, lend it to the U.S. Treasury by buying a bond or simply hold onto it as excess reserves. The same three options held true after 2008, but the relative cost-return calculation had changed. Now a bank could lend to customers, lend to the government or lend to the Federal Reserve. The first option held risk, the second two were essentially risk free. All earned interest.
From the point of view of the Fed, there now was an additional tool to manage the money supply. By raising or lowering the rate of interest it paid the banks for their reserves, it could vary how willingly banks made business and household loans.
For complicated reasons, when banks lend out money, it expands the money supply while a bank buying a bond or holding reserves does not. So the more banks lend, the greater the money supply is relative to the monetary base that the Fed actually controls. The greater this multiple, the more impact a Fed action will have on the money supply and interest rates.
From 1975 to 2005, the average ratio of M2, the “broad” measure of the money supply, to the monetary base was 10.4. In July 2007, just before the financial debacle unfolded, the ratio was 8.6 times. By March, 2008, when Bear Stearns folded, it was 8.9. But by October, when panic set in after the failure of Lehman Brothers, it was 7.1. By mid-2009, it was down to 4.9 and by 2014 it was below 3. It is now about 3.5.
So, in reaction to the financial crisis, our central bank pumped unprecedented quantities of reserves into the economy. The monetary base went from about $850 billion in July 2007 to $4 trillion in July, 2014, when the “quantitative easing” effort was near its peak. The quantity of currency had changed less but reserves increased five-fold from Fed action.
The Fed bought U.S. Treasury bonds as usual, but it also took the extraordinary step of buying many mortgage-backed bonds that were at the heart of the crisis.
It is important to note that the Fed did not pay face value for these securities. It buys in the “open market” along with myriad other buyers. It got most of the mortgage bonds at a steep discount from their face value. So it was not a bailout of any particular mortgage bond holder. But the Fed was such a large buyer that it did increase the value of these bonds as a whole class compared to what would have been the case if the Fed had stood on the sidelines.
The upshot was that in July 2007, the Fed’s holdings of U.S. Treasuries were $790 billion and they are now $2.5 trillion. Mortgage-backed-bonds went from zero to $1.8 trillion today. These are the assets on the Fed balance sheet that we hear about in the news recently that need to return to more normal levels. This is what needs to “shrink” the balance sheet.
The Fed liabilities offsetting these assets are the reserves that banks have with the Fed. If the Fed sells off its bonds or simply lets them mature, the money received will disappear. It will be “destroyed.” The bonds won’t be on the asset side and an equal amount of reserves won’t be on the liability side.
So why should anyone care? The issue is that as the Fed reduces its bond holdings and hence bank reserves, the money supply will be smaller than it would be in the absence of Fed “shrinking.” And, all other things equal, interest rates will be higher. So the question of how fast the Fed should “shrink its balance sheet” really is just another facet of the issue of how fast and far it raises interest rates.
The money supply did not increase nearly as much as bank reserves did. While bank reserves are about five times as big as before the crisis, the money supply is only 2.8 times as large. Interest rates remain very low by historical standards and consumer-level inflation remains below 2 percent, the Fed target.
However, the Dow Jones industrial average just passed 22,000 and stocks in general remain at record highs. I think that obviously is a result of Fed-created money sloshing around the economy. The Fed, and economists in general, are still dancing around the question of what happens when money growth goes into asset prices instead of consumer prices of goods.
The Fed can gradually sell off its bonds but keep interest rates from rising too fast by lowering the interest it pays banks for reserves. That would motivate more lending to businesses and consumers. So shrinking the balance sheet does not imply a spike in interest rates or drying up of credit. But it is a dicey process.
Stepping well back, it all manifests the fact that economists and both political parties largely have avoided the full implications of the financial debacle. We stood at the edge of an abyss in the fall of 2008. The Fed, which bears some of the blame for getting us to that edge, snatched us back from falling into a repeat of 1933. But in the process, financial power in the economy became even more concentrated and systemic risk remains alive and well. But those are other topics.