(The Economics Correspondent had planned a series of articles on monetary theory and central banking at a later time but the Federal Reserve’s unprecedented actions in response to the coronavirus outbreak warrant moving some of the content forward)
Most of us have recently seen the sensational headlines:
“Fed launches $700 billion asset purchase program”
“Fed balance sheet exceeds $5 trillion for first time”
“Fed’s asset holdings swell by nearly $1 trillion in two weeks”
“Fed lowers key policy rate to near zero”
But what exactly do they mean?
In this installment we’ll discuss the mechanics of Fed asset purchases with an introductory primer on money and banking. How the Fed believes its policies will support both the U.S. and international economies will come in the next column.
I. THE MONEY SUPPLY
Of the Federal Reserve’s five primary functions—monopoly issuer of cash and currency, Federal Reserve member bank regulator, lender of last resort, interbank clearinghouse system, and administrator of monetary policy—the last is its most influential on the economy. As America’s monetary policy authority, the Fed attempts to steer—with some exceptions—the U.S. money supply and interest rates in the direction it feels best achieves its Congressional dual mandate of price stability and full employment.
But contrary to popular belief the Fed does not have complete and unequivocal control over the money supply. A great deal of the quantity of money is dictated by the private commercial banking system and the public at large.
The Fed’s direct issuance of money is limited to supplying reserves for the commercial banking system. Reserves include both cash, which the public is familiar with as the Federal Reserve notes in their wallets and purses, and to a larger extent commercial bank reserves which are simple ledger entries on the Fed’s books establishing how many reserves each member bank holds on balance at the Fed itself.
You can think of the Fed as a giant bank where the private banks deposit their reserves. And in the modern age, just as your checkbook balance is simply ones and zeros on a bank computer, private bank reserve balances are ones and zeros on the Fed’s computers.
The only extent to which the general public holds reserves directly is by holding currency. The public has no reserve balance on account with the Fed, only member banks do. Thus the bulk of systemwide reserves are held by the private commercial banks themselves.
Incidentally the sum of all systemwide reserves (currency plus bank reserves) is also known as the monetary base.
If the banks are in a lending mood and the public in a borrowing mood, banks loan out a fraction of their reserves to customers and retain a fraction on hand as a reserve cushion. Prior to the coronavirus crisis the minimum reserve balance the Fed required banks to hold (the "reserve ratio") was slightly below 10%.
To be more precise, the required reserve ratio on bank reserve balances under $16.9 million was 0%, between $16.9 million and $127.5 million it was 3%, and for any reserve balances over $127.5 million it was 10% (source: Federal Reserve). However, money center banks like J.P. Morgan and Bank of America hold tens of billions or even over $100 billion (Morgan) in reserves so obviously the reserve ratio for their reserve holdings will be virtually 10%.
II. FRACTIONAL RESERVES AND DEMAND DEPOSITS
To illustrate how reserve ratios impact the broader money supply, we’ll employ the classic textbook example learned by all students in undergraduate money and banking theory class. For those interested in monetary theory, this section is worth reading carefully and remembering.
Consider a customer of Bank A who deposits $1,000 in cash. Bank A now has $1,000 in reserves, most of which it redeems at the Fed for a credit to its reserve account, and credits their customer with $1,000 in their demand deposit (ie. checking) account. Then Bank A lends 90% of the reserves out ($900) to a borrowing customer who spends the money via written check to a supplier.
The supplier takes this Bank A-issued $900 check to Bank B who credits his demand deposit account with $900. Through the Fed’s check clearinghouse system $900 in reserves is transferred from Bank A to Bank B, all via their Fed computerized accounts.
However Bank A’s customer still has a $1,000 demand deposit balance and no idea that $900 in reserves have transferred to Bank B. And Bank B’s customer still has a $900 demand deposit balance.
So there are $1,900 in demand deposit balances available to be spent in the economy, yet the total quantity of reserves in the system is still just $1,000 ($100 remains at Bank A and $900 goes to Bank B).
Bank B eventually lends 90% of its $900 reserve balance out, transferring $810 to Bank C, and this process can theoretically repeat itself indefinitely until systemwide there are $10,000 in total demand deposit obligations backed by the same $1,000 in reserves—both spread out across several banks.
Hence, the original $1,000 in reserves becomes $10,000 in checkbook balances, balances that the public chooses every day to accept for payment.
This process, known as fractional reserve banking, illustrates how the Fed has only partial control over the money supply as the lending/borrowing behavior of the public dictates demand deposit balances.
The Fed also doesn’t have much control over cash in circulation. It doesn’t stop bank customers from pulling cash out from the ATM and thus depriving the banking system of reserves (the U.S. is not Greece—yet). However cash has traditionally been a smaller portion of the entire system’s reserves than reserves held by commercial banks.
So the Fed can control overall reserves issued to the banks. However the Fed can’t directly control the higher and larger aggregate of demand deposits which expands or contracts based on the willingness of banks to lend or customers to borrow.
Incidentally, the sum of all currency in circulation plus all demand deposit balances (and a few small components like travelers checks) is known in the United States as the M1 money stock. Higher lending instruments which are redeemable into M1 balances—such as savings deposits, time deposits, and money market shares—plus M1 itself comprise the next larger aggregate of M2.
So to review, the money supply consists primarily (but not wholly) of:
-Currency: Banknotes and coins used by the public
-Reserves: Currency and to a larger extent private bank reserve balances at the Fed
-The Monetary Base: Currency plus bank reserves at the Fed. Effectively another name for total reserves.
-Demand Deposits (aka checkbook balances): Private bank obligations to pay out currency to the public on demand, usually some multiple of reserves.
Incidentally if this whole process of producing reserves and multiplying them into more demand deposits sounds bizarre, it’s the simple product of monetary evolution.
For centuries the public stored their gold and silver coins at private banks which issued either currency or demand deposit credits as claims on those gold and silver reserves, and private banks loaned a fraction of those gold and silver reserves out by creating more currency or demand deposit liabilities.
The modern day banking system was founded on this historic system with the exception that gold and silver are no longer legal bank reserves. Reserves are now "fiat" (computerized ones and zeroes and unbacked pieces of paper currency).
III. HOW THE FED STEERS (NOT CONTROLS) THE MONEY SUPPLY: RESERVES
At a simplified level, the Fed’s two primary tools for adjusting the money supply are:
-Adjusting the quantity of reserves, and
-Influencing the quantity of bank lending
The more reserves in the system—all other things being equal—the larger the money supply.
The more willing banks are to lend and customers to borrow—all other things being equal—the larger the money supply.
The policy tool that the Fed employs to increase system bank reserves is asset purchases and sales which take place during “open market operations” via the Federal Open Market Committee (FOMC).
When the Fed wants to inject more reserves into the banking system, the FOMC votes to buy more securities—traditionally Treasury securities although since 2008 also federal agency-backed mortgage securities. It creates the new reserves out of thin air with a simple keystroke entry on its computers.
Every week the FOMC holds an auction conference call with over twenty of its largest, most favored banks (called primary dealers) conducted usually by an intern. What would the public think if it knew hundreds of billions of dollars in monetary policy was being carried out by a 22-year old college student?
If the Fed wants to remove reserves from the system it sells securities from its portfolio. The buying member banks pay with their reserves which the Fed destroys with a simple keystroke on its computers.
Note: Prior to 1971 the Fed was partially constrained in how many reserves it could create because some fraction of system reserves had to be backed by gold. As of 1971 the Fed has no commodity backing requirement whatsoever and can thus create as many new reserves as it sees fit—what is known as fiat (“let it be done”) monetary policy. The Economics Correspondent will write on the history and function of the gold standard at a future date.
Hence it becomes clearer what headlines like “Fed purchases $500 billion in securities” means: the Fed is trying to inject more reserves into the banking system by buying $500 billion in securities from the portfolios of what are usually its largest, most favored member banks (primary dealers).
It’s important to note that banks don’t get these reserves for free. They are not a handout or even necessarily a bailout. They have to exchange something of equal value to obtain those reserves, usually U.S. Treasury securities that they hold in their own portfolios (by the way this guarantees a huge market of lenders to the federal government which has been part of the grand design going all the way back to the Civil War, but we’ll save that for another time). So the Fed is converting assets into liquid reserves which it hopes will be converted into either cash or higher checkbook balances via private lending.
In monetary economics jargon, the central bank “monetizes assets.”
IV. HOW THE FED STEERS (NOT CONTROLS) THE MONEY SUPPLY: INTEREST RATES
Since the higher M1 aggregate of demand deposits is a function of bank lending, the willingness of banks and borrowers to come together has an impact on the overall money supply too. If both banks and borrowers are frightened during a financial crisis (or even a global pandemic) banks may not want to part with their reserves and borrowers may not want to take on more debt. Hence the Fed can create as many reserves as it wants but the overall money supply won’t budge.
Although extreme economic duress is required for this phenomenon to occur, lending has fallen off sharply during past contractions largely neutralizing central bank expansionary policy. During the Great Depression British economist John Maynard Keynes referred to reserve creation being offset by reduced lending as “pushing on a string.”
Thus the Fed also attempts to manipulate interest rates in order to influence private lending/borrowing behavior.
The Fed’s traditional policy tool up until the 2008 crisis, was the so-called “Fed Funds rate,” or the rate at which member banks lend their reserves to one another.
Before 2008 some banks were loaned up to the hilt with no reserves to spare. However other banks may have had excess reserves beyond their 10% requirement but no clear, immediate lending prospects for those reserves. When the more highly leveraged bank wanted to lend more it was happy to pay the surplus bank interest for short-term access to their funds.
The more reserves the Fed creates, the more abundant (greater supply) they will be and thus the price of those reserves (Fed Funds rate) will fall. Officially the Fed calls the Fed Funds market a “free market,” but the reality is it manipulates the market via open market operations.
Fed Funds loans are also very short term leading to the perception that lending in the Fed Funds market is very safe. However in 2008 the perception of safety deteriorated and banks stopped lending to one another which became a major concern for policymakers.
Once the Fed Funds rate falls far enough, the more leveraged bank will be more willing to borrow in the Fed Funds market. The lending bank may not be as attracted to the lower rate, but given that reserves are plentiful now thanks to the Fed, it won’t have many better options that are as safe and will likely still lend into the Fed Funds market.
And obviously the lower the interest rate in the Fed Funds market, the lower the retail interest rate will fall. More borrowers will then step forward for a loan. Just consider how many more people buy homes at 4% interest rather than 8%, or refinance their homes, or buy cars at lower interest rates.
Hence the Fed uses open market operations to create more reserves and to drive down interest rates so that those reserves multiply into larger M1 demand deposit balances (the larger monetary aggregate) due to more lending and borrowing activity.
Since the 2008 financial crisis, the Fed has switched to a new policy tool called Interest on Excess Reserves (IOER) to influence the quantity of private lending. In short, banks are now loaded up with trillions of dollars in reserves, the result of the QE1, QE2, and QE3 (and now coronavirus unlimited QE) giant asset purchase programs.
If the banks decided to lend all those reserves out aggressively, America would experience a devastating price inflation.
However the Fed pays the banks risk-free interest on their excess reserves (IOER) which motivates banks to sequester those reserves instead of lending them out. By lowering or raising the IOER rate, the Fed can also influence the level of bank lending.
Finally, as the Fed buys more and more securities, the asset side of its balance sheet grows. But so does the liabilities side—in the form of the reserves it issues to member banks. Should banks or the public wish to convert those reserve balances into currency, the Fed is obligated to make good on issuing the cash, even if the money is simply printed on unbacked paper.
Hence the more assets the Fed monetizes, the larger its balance sheet grows. Which is why the public sees business page headlines like “Fed expands balance sheet,” “Fed plans to unwind its balance sheet,” and recently “Fed’s balance sheet reaches $5 trillion for the first time in history.”
In the next installment we’ll apply this banking vocabulary to explain why the Fed chooses to aggressively expand its balance sheet during times of economic distress, including the current coronavirus crisis.
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