Martin Feldstein has long since (make that loongg!) been warning of inflationary doomsday scenarios. Perhaps not to the tune of Meltzer but significantly nonetheless. Meltzer, as Krugman loves to recall has repeatedly stated his opinions such as:
"Besides, no country facing enormous budget deficits, rapid growth in the money supply and the prospect of a sustained currency devaluation as we are has ever experienced deflation. These factors are harbingers of inflation. When will it come? Surely not right away..."
Of course, you could nitpick right away. The US budget deficit as compared to an EZ budget deficit, the rapid growth of money supply is not relatively not very rapid at all. And currency devaluation? Currency devaluation??
"Besides, no country facing enormous budget deficits, rapid growth in the money supply and the prospect of a sustained currency devaluation as we are has ever experienced deflation. These factors are harbingers of inflation. When will it come? Surely not right away..."
Of course, you could nitpick right away. The US budget deficit as compared to an EZ budget deficit, the rapid growth of money supply is not relatively not very rapid at all. And currency devaluation? Currency devaluation??
But Feldstein backs the excess reserves argument once again over in a piece at Project Syndicate. While the warnings are less dire, they're still present. And it brought to mind the Keister/McAndrews paper back in 2009 on excess reserves.
Now to be sure, you can't argue with the logic on the surface. If the money multiplier had a temporary demise and the Fed is paying interest on the excess reserves (the IOER has long since been 0.25%), then those parked reserves might see the day of light soon. After all, rapid monetary growth is the best harbinger of inflation!
This is what's happened over the past 10 years as far as inflation and the monetary base and M2 are concerned. All have been indexed to the start for a clearer comparison:
And this is what the money growth actually looks like on a monthly and year on year basis:
Lastly, the level of excess reserves is, in fact, unprecedented:
So when Feldstein states, "When businesses and households eventually increase their demand for loans, commercial banks that have adequate capital can meet that demand with new lending without running into the limits that might otherwise result from inadequate reserves. The resulting growth of spending by businesses and households might be welcome at first, but it could soon become a source of unwanted inflation," does he have a point?
What about the Fed? Feldstein has little faith - "The Fed could, in principle, limit inflationary lending by raising the interest rate on excess reserves or by using open-market operations to increase the short-term federal funds interest rate. But the Fed may hesitate to act, or may act with insufficient force, owing to its dual mandate to focus on employment as well as price stability."
You see, you can't forget a few things. For starters, the fractional reserve banking system operates on the premise of a money multiplier. So the idea of excess reserves contradicts the existence of a multiplier. It works like this:
increase in bank reserves -> increase in broad money (lending/deposits) -> expansion of deposits raises reserve requirements.
Clearly this has not occurred. And this is where the IOER (interest on excess reserves) checks in. Any bank holding excess reserves should seek to lend at a positive rate and this lending, in turn should decrease the short-term rate.
From Keiseter/McAndrews, this:
"leads to a small increase in reserve requirements, as described in the previous section. Because the increase in required reserves is small, however, the supply of excess reserves remains large. The process then repeats itself...until one of two things happens. It could continue until there are no more excess reserves,...In this case, the money multiplier is fully operational. However, the process will stop before this happens if the short-term interest rate reaches zero. When the market interest rate is zero, banks no longer face an opportunity cost of holding reserves and, hence, no longer have an incentive to lend out their excess reserves. At this point, the multiplier process halts."
But the Fed does pay interest on these excess reserves, so the multiplier process stops far sooner. Instead of continuing till the market interest rate is 0, it continues till this rate reaches the rate paid by the central bank on reserves. So if the central bank pays interest on excess reserves at its target interest rate, the multiplier ceases to exist.
As for the looming inflationary risks lurking deep within, they hold in a traditional framework - where the Fed influences interest rates by changing the quantity of reserves. But if it's paying interest?
With no interest being paid, as demand for loans pick up etc. etc., the central bank must remove the excess reserves to arrest or check this multiplicative process. Only by removing these reserves can the CB check banks' willingness to lend and cause a rise in short-term rates.
But with interest being paid, the link between the quantity of reserves and willingness to lend breaks. It allows the CB to be independent, (in a way), of the level of reserves.
Which is not to say that the point or the process is moot. It's not. But to suggest, weakly as Feldstein does, that the Fed may act hesitatingly or insufficiently because of its dual mandate is not correct.
At some point, trade-offs between labor market conditions and price levels may emerge. But that's an argument for another occasion.
Now to be sure, you can't argue with the logic on the surface. If the money multiplier had a temporary demise and the Fed is paying interest on the excess reserves (the IOER has long since been 0.25%), then those parked reserves might see the day of light soon. After all, rapid monetary growth is the best harbinger of inflation!
This is what's happened over the past 10 years as far as inflation and the monetary base and M2 are concerned. All have been indexed to the start for a clearer comparison:
And this is what the money growth actually looks like on a monthly and year on year basis:
Lastly, the level of excess reserves is, in fact, unprecedented:
So when Feldstein states, "When businesses and households eventually increase their demand for loans, commercial banks that have adequate capital can meet that demand with new lending without running into the limits that might otherwise result from inadequate reserves. The resulting growth of spending by businesses and households might be welcome at first, but it could soon become a source of unwanted inflation," does he have a point?
What about the Fed? Feldstein has little faith - "The Fed could, in principle, limit inflationary lending by raising the interest rate on excess reserves or by using open-market operations to increase the short-term federal funds interest rate. But the Fed may hesitate to act, or may act with insufficient force, owing to its dual mandate to focus on employment as well as price stability."
You see, you can't forget a few things. For starters, the fractional reserve banking system operates on the premise of a money multiplier. So the idea of excess reserves contradicts the existence of a multiplier. It works like this:
increase in bank reserves -> increase in broad money (lending/deposits) -> expansion of deposits raises reserve requirements.
Clearly this has not occurred. And this is where the IOER (interest on excess reserves) checks in. Any bank holding excess reserves should seek to lend at a positive rate and this lending, in turn should decrease the short-term rate.
From Keiseter/McAndrews, this:
"leads to a small increase in reserve requirements, as described in the previous section. Because the increase in required reserves is small, however, the supply of excess reserves remains large. The process then repeats itself...until one of two things happens. It could continue until there are no more excess reserves,...In this case, the money multiplier is fully operational. However, the process will stop before this happens if the short-term interest rate reaches zero. When the market interest rate is zero, banks no longer face an opportunity cost of holding reserves and, hence, no longer have an incentive to lend out their excess reserves. At this point, the multiplier process halts."
But the Fed does pay interest on these excess reserves, so the multiplier process stops far sooner. Instead of continuing till the market interest rate is 0, it continues till this rate reaches the rate paid by the central bank on reserves. So if the central bank pays interest on excess reserves at its target interest rate, the multiplier ceases to exist.
As for the looming inflationary risks lurking deep within, they hold in a traditional framework - where the Fed influences interest rates by changing the quantity of reserves. But if it's paying interest?
With no interest being paid, as demand for loans pick up etc. etc., the central bank must remove the excess reserves to arrest or check this multiplicative process. Only by removing these reserves can the CB check banks' willingness to lend and cause a rise in short-term rates.
But with interest being paid, the link between the quantity of reserves and willingness to lend breaks. It allows the CB to be independent, (in a way), of the level of reserves.
Which is not to say that the point or the process is moot. It's not. But to suggest, weakly as Feldstein does, that the Fed may act hesitatingly or insufficiently because of its dual mandate is not correct.
At some point, trade-offs between labor market conditions and price levels may emerge. But that's an argument for another occasion.
"the idea of excess reserves contradicts the existence of a multiplier"
ReplyDeleteIBDDs are remunerated. The return exceeds all money market (wholesale funding), or borrow-short to lend-long costs. I.e., the CBs are being paid not to lend by our Federal Gov't.
Drop the compensation & (1) the CBs will then buy "specials" from the NBs (& not sell them to the FRB-NY), & (2) savings will be transferred to the NBs where they are "put to work" (matching voluntary savings with real-investment), i.e., by a non-inflationary transaction.