The Fed’s Balance Sheet and Excess Bank Reserves

People keep talking and writing about the explosion of the money supply and the coming inflationary tsunami. Let me point out once again that the M1 and M2 measures of the money supply spiked but have since come back down. There is no explosion of the money supply.

I

The monetary base (currency outstanding plus bank reserves) has exploded, and its graph is indeed startling-startling that is until you realize that excess bank reserves on deposit at the Fed is the reason. We learned to pay attention to the monetary base because it provided the raw material (reserves) from which the banking system can create new money by lending and investing. Because of the money expansion multiplier, the monetary base has been referred to historically as “high powered money.”

In today’s ongoing financial crisis, however, the base is not being used as the basis for monetary expansion. The accumulation of excess reserves behind the explosion of the monetary base is the result of the weak state of many banks and the fear of bankers that they won’t have enough liquidity to meet deposit withdrawals. In other words, the reserves that are excess in a regulatory or legal sense, aren’t excess at all in the minds of the bankers. They represent the prudent hoarding of bank cash in uncertain times. Measures to reduce “excess” reserves could, therefore, have disastrous results as banks liquidate assets to restore their liquidity.

This movie has been shown before. It played a significant role in the 1930s when the Fed acted to “mop up” excess reserves in the banking system by raising reserve requirements in 1936 and again in early 1937. Then, as now, the reserves were excess only in a regulatory or legal sense. Under the circumstances bankers did not regard them as excess, and their reaction to the increase in reserve requirements helped prolong and deepen the Great Depression. We should not make the same mistake now.

I find it amazing that I have not heard a single talking head on financial television or read a single article in the financial press about this instructive experience in the 1930s that has such important lessons for today. I suppose it’s largely a result of the youth of the pundits these days and their reliance on memory.

What follows is my review of the 1930s episode along with a refresher on money and banking.

II

One might think of the Fed influencing the economy by influencing the reserve base of the banking system to generate more or less lending and money creation. If bank reserves become more plentiful, through Fed loans to banks or open market security purchases, the banks will make more loans or purchase more investments and, in doing so, cause the money supply to expand.

Largely because of gold inflows resulting from the devaluation of the dollar in 1934, banks accumulated large amounts of reserve deposits at the Fed. By 1936 banks had accumulated much more reserve deposits at the Fed than were “required.” In other words, they had excess reserves, or substantially more than were required. The Fed came to think of those excess reserves as a buffer or cushion that loosened its rein on the banks. Its policy actions might not elicit the response intended for the banking system. If the Fed added or removed reserves from the banking system, the banks could let losses be absorbed by their excess reserves and might just let additions add to the excess already there.

In an effort to tighten the link between its actions and the banks’ reactions, the Fed in 1936 and again in early 1937 raised reserve requirements to mop up the excess reserves. Its intent was to tighten the reins, not to tighten monetary policy. It wasn’t tightening policy, it thought, because the reserves absorbed were already in excess. It wouldn’t force banks to cut back on lending.

But cut back they did. On Monday morning, it was revealed that those bank reserves were excess only in a legal or regulatory sense. The banks didn’t regard them as excess given the uncertain and turbulent times. In effect, the banks own reserve requirement were higher than the Fed’s reserve requirement. The banks thought of all their reserves as precautionary balances needed for emergencies; so the increase in reserve requirements had the unintended consequence of a substantial tightening of monetary policy which either made the depression worse or helped cause a double dip recession, whichever you prefer.*

We hear many references today to the “excess liquidity” represented by the large amount of excess reserves on the Fed’s balance sheet. Before we recommend doing something about that in the interest of preventing future inflation, we should consider the lesson of the 1930s. Those excess reserves may not be considered excess by their owners, even less so since they do now earn a nominal interest rate. It would be very easy to repeat the Fed’s mistake in 1936 and 1937.

*An excellent account of the excess reserve experiment during the depression may be found in Richard H. Timberlake, Money, Banking, and Central Banking. In the first edition, it begins on page 201. Professor Timberlake was my teacher in these matters back in the olden days.

Comments (9)

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  1. Mark says:

    Mr Bob,

    I’d be interest to hear your opinion on how significant the impact of paying interest on excess reserves could have in the scenario that the Fed begins to try to tighten or constrain lending. Will paying interest on excess reserves likely be used by the Fed in this manner, and if so, will it be a powerful tool? Or is the jury still out on this?

    (Also…Tough to find a whole lot of work done on this, so if you have any links or suggestions for readings on the topic of paying interest on reserves, that would be great too…)

    Thanks.

  2. [...] The Fed’s Balance Sheet and Excess Bank Reserves [...]

  3. Scott Sumner says:

    Bob, I strongly endorse your views. You might be interested in knowing that I have been on something of a crusade against the Fed’s interest on reserves policy since last October. Earlier this year I published a couple of short notes in The Economists’ Voice:

    http://www.bepress.com/cgi/viewcontent.cgi?context=ev&article=1508&date=&mt=MTI0NTUyOTc3MA==&access_ok_form=Continue

    http://www.bepress.com/cgi/viewcontent.cgi?context=ev&article=1543&date=&mt=MTI0NTUyOTM3Mw==&access_ok_form=Continue

    Note that I mentioned the parallel to 1936-37 in the first of these two notes. In February I set up a blog called “TheMoneyIllusion.com” which is devoted to exploring the possibilities of using unconventional monetary stimulus rather than fiscal stimulus. Since 1989, I have published a number of articles advocating a monetary policy target of 5% NGDP growth, preferably after creating a NGDP futures market. My current interest is a proposal for a small interest penalty on excess reserves, so that monetary base injections go to expand required reserves (and hence deposits), or cash in circulation.

    It is a reply to Greg Mankiw, as we had been debating the issue of negative interest rates on money in general, which I don’t think is feasible. It is the most informative of the three links I attached, if you want to just choose one. Any comments would be greatly appreciated.

    Scott

  4. John G says:

    Ok, let’s stop being so naive to what is really going on here. Where do you think the Fed earns profits to pay this interest on reserves?! …mostly from interest on treasuries which is paid by our government, and the government gets the money from YOU through taxing. The Fed has to return all profits after paying operating expenses and dividends to member banks back to the Treasury. Now less of this profit will go back to the Treasury and instead go directly into private banks. Only an idiot would believe the press release from the Fed that this is being done to help set a lower bound on the Fed Funds Rate. In a matter of weeks the spread was quickly increased from 10/75 basis points below the Fed Funds Rate for required and excess reserves respectively to being directly set by the Fed to the same as the Fed Funds Rate of 25 basis points even though the official target is 0-25 basis points. If the current target is 0-25 basis points why would you be worried about a floor!!!! Why would you set it at the upper bound of your target range!!!! HELLO ANYBODY HOME?? HE IS PAYING THIS INTEREST AS RANSOM FOR THE BANKS TO HOLD THE 800 BILLION IN NEW MONEY THE FED CREATED WHEN IT BOUGHT ALL THE TREASURIES AND MORTGAGE SECURITIES AND IS USING YOUR MONEY TO DO IT. This is only going to get more expensive from the over 2 billion a year currently being paid, as interest rates on reserves will only go up with the Fed funds rate to persuade banks not to loan out money and dump it into the market. It’s so obvious Bernanke is a liar. The Fed said they need this new program right now and not in 2011 and the original wording of the bill never intended for interest to be paid on excess reserves, only required reserves, which is why the original estimated cost was only a fraction of what we are paying now. Within days of the Oct. 3 2008 passage of the act allowing interest payments on all reserves the Fed began the massive increase in the money supply to double it to over 1.6 trillion in a few months. This coordinated perfectly with a massive rise in excess reserves to the tune of exactly the 800 billion of newly created money during the same time period. Excess reserves have historically been virtually 0. Now all of a sudden they are 800 BILLION and this is just a cute anomaly!!! The only other time in modern history there has been a notable rise was after 9-11 and this was only about 20 billion, which subsided the next month. Americans now officially pay a banker tax to private banks, and if they don’t they will get hyperinflation. If you have seen all this obvious information and still hold on to dollars you are a moron. This system is coming to an end and this is just a cheap circus trick by the Fed to keep it going a little longer. The spending of government is only increasing to record levels and nobody wants our treasuries anymore. We are about 1 or 2 moves from checkmate. The only way to sop up this money is for the Fed to sell treasuries and securities, I think we all know that ship has sailed. Good luck selling treasuries when the government is conducting record deficit spending, pumping out new treasuries like no tomorrow and China has had enough. Good luck selling junk toxic mortgages. In the meantime make sure you pay your banker tax which will quickly swell to tens of billions of dollars of your taxpayer dollars being funneled directly into private banks as pure profit. Bernanke is a agent of private banking with the private Federal Reserve being the biggest private bank of them all. The private banks and their king, Bernanke, are merely looking out for themselves at your expense. And now Bernanke has set up a situation in which you have no choice but to pay or suffer a hyperinflation holocaust. One man, one private banker, now has a red button to implode our economy any time he wishes, and the only way to keep him from pushing the button is paying the ransom.

  5. John G says:

    The following graph explains it all. There is a complete mirror of our current currency in circulation sitting in the coffers of the Fed as a by-product of all the money it created by buying up securities and given bailouts. The only thing holding back this tidal wave of high-powered money and preventing hyperinflation is your tax dollars in the form of interest payments to private banks.

    http://research.stlouisfed.org/fred2/graph/?chart_type=line&width=1000&height=600&preserve_ratio=true&s1id=EXCRESNS

  6. [...] to "mop up" excess reserves in the banking system. As I've written here recently, the reserves were only "excess" in a legal or regulatory sense. Under the circumstances of the mid-1930s, the bankers didn't regard them as excess and [...]

  7. [...] keep pointing out, to no apparent effect, that those reserves are being held voluntarily by banks. Since the banks aren’t being required or incentivized (much) to hold them, bankers must [...]

  8. [...] mention the clamor for the Fed to withdraw or mop up excess reserves even though bankers feel the need to hold them without significant incentive. Doing that very thing [...]