How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-2009 (continued)
4. Excess reserves again
The unprecedented increase in excess reserves during past year is shown in the figure. They are due to the increase in the Federal Reserve credit. Concerns have been expressed for their inflationary potential when loan demand turns up, but Chairman Bernanke says not to fear. He has an exit strategy.
… at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs. To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities. Indeed, where possible we have tried to set lending rates and margins at levels that are likely to be increasingly unattractive to borrowers as financial conditions normalize…. However, as the unwinding of the Fed's various programs effectively constitutes a tightening of policy, the principal factor determining the timing and pace of that process will be the Committee's assessment of the condition of credit markets and the prospects for the economy….
A significant shrinking of the balance sheet can be accomplished relatively quickly, as a substantial portion of the assets that the Federal Reserve holds--including loans to financial institutions, currency swaps, and purchases of commercial paper--are short-term in nature and can simply be allowed to run off as the various programs and facilities are scaled back or shut down. As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy--namely, by setting a target for the federal funds rate.
Ben Bernanke, Stamp Lecture,
Easier said than done. There is no reason to believe that the Fed will do any less damage than when it “shrunk” excess reserves in 1936-37. The monetary base grew 49% between May 1933 and May 1936, almost entirely due to inflows and the revaluation of gold. M2 rose 42% but half the increase in bank reserves was held as excess, which rose (in millions) from $319 to $2800, compared with the increase in requirements from $1806 to $2838. The rising ratio may be seen in the figure. The FOMC saw the large excess reserves as a threat to monetary stability that needed to be “mopped up.” It adopted the following resolution in October 1935:
It was the unanimous opinion of the Committee that the primary objective of the System at the present time is still to lend its efforts towards the furtherance of recovery…. But the Committee cannot fail to recognize that the rapid growth of bank deposits and bank reserves in the past year and a half is building up a credit base which may be very difficult to control if undue credit expansion should become evident.
The Banking Act of 1935 had given the Fed the power to raise reserve requirements up to twice the levels then existing, and that power was used to its full extent, in three steps, between August 1936 and May 1937. The resulting fall in excess reserves is shown in the figure. Although the Fed claimed that the excess reserves thus eliminated had been superfluous, it was soon revealed that banks thought otherwise. Having come through the great downturn of 1929-33, with massive runs and record failures, banks were cautious. Their cut-back in loans to restore their excess reserves contributed to the severe 1937-38 recession.
The figure indicates that the task is much greater today. As we learned (or should have), “excess” is a legal term that tells us nothing of desires. A policy of shrinking slowly, as Bernanke suggests, may not be an improvement. It may not be possible. If banks want these excess reserves, and they apparently do, they will restrict lending in anticipation of reserve losses. Things can seldom be done “on schedule” in the financial markets, which are characterized by arbitrage across time. We do not know what will happen. The problem is unnecessary and may come back to haunt us.
It is made more complex by the recent decision to pay interest on reserves, another example of the tendency of policymakers to enforce gratuitous changes in the environment that increase the uncertainty of their policies.
Milton Friedman and Anna J. Schwartz. A Monetary History of the United States, 1867-1960. Princeton Univ. Press, 1963, pp. 520-32.
Clay J. Anderson. A Half-Century of Federal Reserve Policymaking, 1914-64. Federal Reserve Bank of Philadelphia, 1965, pp. 77-82.