Category Archives: Quantitative easing

Inflation and Coronavirus Monetary Policies

Is there any reason to think that inflation might increase in the near future after the current coronavirus lockdowns and stay-at-home orders end? The Federal Reserve is engaging in extraordinary policies that will substantially increase excess reserves in the banking system. That said, the Fed did similar things during and after the Financial Crisis of 2007-2008 and inflation has been benign since. Are the current policies as likely to have little or no effect on inflation?

There are contrasting views by experts, among them Tim Congdon in an op-ed in the Wall Street Journal and George Selgin on the Alt-M blog. Congdon says that “history suggests the U.S. will soon see an inflation boom.” Selgin says that “[I]f denying any risk of future inflation is unwise, so is exaggerating that risk, or claiming that it’s imminent when it isn’t.” Selgin quotes Olivier Blanchard as saying that the risk of inflation is “very small.”

In fact there is reason to be concerned that Federal Reserve policies will not work out so well this time.

The money stock increased substantially in March and April 2020One way of assessing future inflation is the quantity of money in the United States. Figure 1 shows that the money stock, M2, has increased substantially, even relative to the increase in the Financial Crisis of 2007-2009. Inflation, which loosely speaking results from “too much money chasing too few goods”, can result from more rapid growth of the money stock.

Lockdowns and stay-at-home orders and other disruptions associated with the coronavirus pandemic have reduced employment and output substantially. The size of the decreases remains to be seen but filings for unemployment insurance by roughly 30 million people in the United States certainly suggest a very large decrease in goods and services to be purchased by this larger stock of money. This decrease in goods and services available is likely to be temporary though, so it is the increase in the money stock that is a longer-term concern.

Is recent money growth likely to continue? To the extent that the increase in M2 is associated with stimulus payments and unemployment payments, that source of increases in M2 probably will not continue for more than a few months.

The Federal Reserve, though, is on track to increase its balance sheet and reserves in the banking system substantially by buying financial assets and making loans to private firms. Purchases of financial assets are little different than the Federal Reserve’s policy since the Financial Crisis of 2007-2008. What is there to worry about?

The Federal Reserve has been operating a system in which it pays banks to hold reserves over and above required reserves. The Federal Reserve has used those excess reserves, which are deposits at the Fed, to acquire assets, long-term Treasury securities and mortgage-backed securities. Figure 2 shows that excess reserves increased substantially during the Fed’s policy of quantitative easing (QE) implemented in QE1, QE2 and QE3 visible in the graph.

Current policy proposes to increase reserves and asset holdings substantially more in the near future. The size of that increase is not certain, but the Treasury has provided credit protection and equity investments of $235 billion in the financial vehicles acquiring assets and making loans. Excess reserves increased by 90 percent from March 25, 2020 to April 22, 2020. It would not be particularly surprising if excess reserves reached twice the prior peak of $2.7 trillion. They already exceeded that prior peak by over 10 percent on April 22 and surely will exceed it by 25 to 50 percent ultimately.

The outsize increase in the Fed’s balance sheet during and after the Financial Crisis of 2007-2008 quite obviously had little or no effect on the M2 or on inflation. Are there reasons to think that conditions now are different?

A major concern is that banks may not want to hold the additional reserves in excess of requirements. Why not? About a third of these excess reserves are held by U.S. branches of foreign banks. These reserves satisfy a recently added requirement for banks: the liquidity coverage ratio. Reserves at the European Central Bank (ECB) also satisfy this requirement but the Federal Reserve pays interest for holding reserves at the Fed while the ECB charges interest for holding reserves at the ECB. There is foreign-exchange risk associated with holding dollars instead of euros, but that apparently does not deter foreign banks from holding liquidity at the Fed instead of the ECB. Large U.S. banks also are subject to the liquidity coverage ratio.

Is the demand for excess reserves unlimited? There is a major constraint on banks’ desire to hold excess reserves paying a relatively low interest rate. That constraint is a required leverage ratio imposed by banking regulations. The leverage ratio is a minimum requirement of equity capital in a bank relative to assets. Expansion of assets by acquiring excess reserves eventually runs into the leverage ratio, at which point equity capital would have to be issued to satisfy the required leverage ratio and increase holdings of reserves. Given the cost of capital and the interest rate on excess reserves, any bank doing this would be reducing the value of the bank to shareholders. In short, banks will eventually stop adding excess reserves.

If a bank doesn’t want to hold an increase in its excess reserves, what can it do when its excess reserves increase? Instead of holding the excess reserves, the bank can loan the money out or buy a security after holding reserves equal to a fraction of its increase in customer deposits. Other banks would do the same. Through the traditional multiple expansion of deposits, the money stock would, unlike in recent years, increase because excess reserves are increasing. If the Fed does not reduce excess reserves, an increase in the money stock ensues.

Such an increase in the money stock due to Fed policy would increase the dollar value of goods and services produced. Printing money does not increase production of goods and services for very long if ever. Increases in prices and inflation ensue.

The recent and prospective increases in excess reserves are different because the creation of excess reserves did not run into the leverage ratio. Without running into the leverage ratio, monetary policy from 2010 to 2020 could let the demand for money determine the quantity of money. With low expected inflation, the growth of money was consistent with that low expected inflation and in fact low inflation followed. If the Fed increases excess reserves and holds fast to those increases, inflation can result if banks no longer find it advantageous to hold those excess reserves.

How big is this risk? It is fair to say that no one knows. As recently as Spring 2019, the Fed was reducing excess reserves and found that banks wanted to hold a much higher level of excess reserves than expected. Similarly, the upper limit to how much excess reserves banks want to hold is uncertain.

Not knowing the relationship between monetary policy and inflation is a risky way to conduct monetary policy. Maybe everything will work out fine; maybe not.

Quantitative easing and inflation

The end of large-scale asset purchases by the Federal Reserve to implement quantitative easing was announced on October 29. While the Federal Reserve will not decrease its extraordinary holdings of securities, it will not increase them either. By coincidence, this came at about the same time I was giving a talk in Cork, Ireland about quantitative easing by the Fed and by the European Central Bank.

There is widespread misunderstanding of how the Fed implements quantitative easing and the implications for the economy. (One particularly careful but ultimately unsuccessful attempt is “Must `Quantitative Easing’ End in Inflation?”.)

Quantitative easing is a policy of large-scale purchases of assets by the Federal Reserve. The Fed has increased reserve balances from about $13 billion before the financial crisis to about $2.7 trillion at the end of October 2014. If that’s not a big increase, nothing is.

Many have been surprised by the fact that quantitative easing on this scale has not been accompanied by substantial inflation. As a general rule, increases in bank’s reserves are accompanied by increases in the quantity of money and followed by higher prices. This seems not to be the case for the United States. Why?

Nominal quantity of money in the United States from 2000 to 2014

Nominal quantity of money in the United States from 2000 to 2014

The nominal quantity of money has not increased at a particularly high rate, let alone an alarming rate. The nearby figure shows the growth of the nominal quantity of money in the United States. The measure used is a standard one, M2, which basically consists of U.S. currency and bank deposits in the United States. The line shows a fairly steady growth of the quantity of money in the United States. Not surprisingly, inflation has not taken off either.

There normally has been a fairly close relationship between purchases of assets by the Fed and M2. What changed?

First, the Federal Reserve now pays interest on reserves held by banks at the Federal Reserve. This need not explain the disconnect between the Fed’s purchases of assets by itself, but it does when combined with a second observation.

Interest rates on excess reserves, federal funds and Treasury bills

Interest rates on excess reserves, federal funds and Treasury bills

The interest rate paid by the Fed on reserves is higher than the interest rates on similar risk-free assets. The second figure shows interest rates paid by the Fed on reserves, on Treasury bills and on Federal funds. Treasury bills are short-term government securities with zero risk of not being repaid. The federal funds rate is the interest rate at which banks borrow and lend reserves at the Fed among themselves. The solid line shows the interest rate on reserves, which has been 25 basis points (1/4 percentage point) for some time. The rate paid by the Fed on reserves is greater than the rates on Treasury bills and federal funds.

There are many things that can said about this, but the fact that the Fed is paying more than the Treasury for short-term funds is sufficient to explain why M2 has not increased. Both interest from the Treasury and from the Fed are risk free; balances at the Fed are better since they pay a higher interest rate. Banks have every incentive to hold excess reserves rather than Treasury bills.

Why does anyone hold Treasury bills given these interest rates? Not everyone is able to earn interest on reserves at the Fed. Among other institutions, money market funds and the government-sponsored-enterprises Fannie Mae and Freddie Mac cannot earn interest on reserves.

Banks are able to borrow funds from those institutions at rates less than the interest on excess reserves and then deposit the funds at the Fed, at which point the banks earn the difference between the 25 basis points (1/4 of a percentage point) on excess reserves and the lower rate at which they borrowed. In effect, the interest on excess reserves and the lower rate on Treasury bills set up an arbitrage for banks in short-term borrowing and lending.

At least so soon after the financial crisis, banks are not likely to want to fund long-term loans by this very short-term funding. (Overnight funding of asset positions is exactly what got investment banks into difficulties in the Financial Crisis of 2008-2009.) The Fed ends up with higher reserves funding its asset purchases with no apparent effect on M2 as a result.

The failure to expand bank loans is even less surprising since about half of the increase in reserves is held by U.S. branches of foreign banks. Most of these banks are not in the business of making car loans or similar loans in the United States and are not likely to go into that business simply because they borrow and lend short-term funds as an arbitrage. Even if they were so inclined, they are not likely to be inclined to fund relatively long-term assets by borrowing very short term, any more than U.S. banks are.