FMQ Update

If Sheard was correct, the Fed would not have to pay commercial banks the Fed Funds Rate on excess bank reserves. Nor would it have to mobilize reverse repos, a market tool central to the Fed’s liquidity policy. As a matter of fact, depository institutions are free to withdraw all their excess reserves, and redeploy them in money-markets, purchase commercial bonds, lend it to customers, or if they so choose to deploy them any way they like so long as it accords with banking regulations.

Professor Sheard is wrong, and we have no lesser authority than a paper released by the Federal Reserve Bank of Minneapolis, published over two years later than Sheard’s, in other words in the light of actual experience.[iii] To quote from the executive summary:

“Banks in the United States have the potential to increase liquidity suddenly and significantly—from $12 trillion to $36 trillion in currency and easily accessed deposits—and could thereby cause sudden inflation. This is possible because the nation’s fractional banking system allows banks to convert excess reserves held at the Federal Reserve into bank loans at about a 10-to-1 ratio.” 

And it goes on to say:

“What potentially matters about high excess reserves is that they provide a means by which decisions made by banks—not those made by the monetary authority, the Federal Reserve System—could increase inflation-inducing liquidity dramatically and quickly.”

So, the MMT stuff was poppycock. Surely, on the evidence, we should believe a paper sponsored by a division of the Fed. It transpires Professor Sheard has been deeply involved with advising the Japanese, serving on various government committees. His advice in 1995 was that Japan’s woes were due to “timid” monetary policy and stop-start fiscal policy.[iv] It appears Professor Sheard is an arch-inflationist, whose mathematical approach and views accord with the modern monetary theorists.

These errors are important to identify before proceeding to discuss future money supply trends because there is a widespread but incorrect assumption held by inflationists that the Fed actually controls the expansion of bank credit through monetary policy. This is incorrect. The Fed attempts to influence demand for money by interest rate policy, and when it deems appropriate, expands or reduce the overall size of its balance sheet by asset purchases or sales, which is not the same thing as control.

If the commercial banks as a whole seek to reduce their reserve balances, then the Fed must either increase the interest paid on excess reserves, increase the reserve requirements to reduce or even eliminate the excess, step up its reverse repo activity, or liquidate some of its assets. 

It is the last of these, the liquidation of assets forced on the Fed by depository institutions that the MMT theorists failed to see as even possible. And subsequent to their misguided analysis, the banks were reducing their excess reserves on a net basis long before the Fed decided to tighten.

Why banks are not fully mobilizing excess reserves

We can now understand that the American banking system, in theory at least, still has ample room to expand its lending and bond purchases. According to the Fed, required reserves last November were only $126.5bn, and excess reserves were $1,648.8bn[v]  However, bankers naturally wish to make every dollar work instead of leaving them idling at the Fed. Clearly, there are other factors at play.

Now that we have established that the creation of bank credit is not under the Fed’s direct control, we need to find the other reasons why US depository institutions are reluctant to draw down their excess reserves. There might have been an off-the-record agreement between the largest banks and the Fed, which may be concerned that if one big bank starts withdrawing all its excess reserves, the others will follow so as not to lose the market advantage. To that extent, excess reserves may not be lendable assets.

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