September 23, 2014

Over the past 12 months I’ve written extensively at TSI about the myths surrounding US bank reserves and the relationship between bank lending and bank reserves. For example, I’ve explained that bank reserves cannot be loaned into the economy and that in the real world — as opposed to the world described in economics textbooks — banks do NOT expand credit by ‘piggybacking’ on their reserves. As part of these bank-reserve writings I addressed the reasoning behind the Fed’s decision to start paying interest on reserves, reaching the conclusion that the decision had been taken to enable the Fed Funds Rate (FFR) to be hiked in the future without contracting the supplies of reserves and money. Last week there was confirmation from the horse’s mouth that my conclusion was correct, as well as some other interesting information on how an eventual tightening of US monetary policy will proceed.

As implied above, the Fed confirmed last week that when it finally gets around to moving the FFR upward, it will do so primarily by adjusting the interest rate it pays on excess reserve balances. If not for the existence of this relatively new policy tool, the only way that the FFR could be hiked would be via the traditional method involving reductions in the supplies of reserves and money. Moreover, considering the immense quantity of excess reserves now in the banking system, there would need to be a large reduction in the supply of reserves just to achieve a 0.25% increase in the FFR. Trying to shift the FFR upward via the traditional method would therefore quickly ignite a financial crisis.

The other interesting information conveyed by the Fed last week is that the size of its balance sheet will be reduced by ceasing to reinvest repayments of principal on the securities it holds. For example, if the Fed currently owns a bond with 3 years remaining duration, then — assuming that it has embarked on a policy normalisation route — it will not reinvest the proceeds when the bond’s principal is repaid in three years’ time. Instead, the principal repayment will bring about a reduction in the Fed’s balance sheet and a reduction in the money supply.

This means that the Fed plans to reduce the size of its balance sheet — and tighten monetary policy — at a snail’s pace.

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