Given Fed Chair Kevin Warsh’s appointment of a new Fed task force, we want to offer some important thoughts about the size of the Fed’s balance sheet. The issues encompass both the size of the Fed’s balance sheet and its composition. Implied is that the task force will look at both assets and liabilities.
I want to thank Bill Nelson for giving me permission to share his recent primer on monetary policy with our readers. Bill is Chief Research Officer and Chief Economist at the Bank Policy Institute and an adjunct professor at Georgetown University. His commentaries are available as a free email service via the Bank Policy Institute. I read his missives on arrival, and I recommend them. Bill provokes serious thought about monetary policy. To be added to his email list, please email him. You may find Bill’s missive on LinkedIn or via the BPI website, https://bpi.com.
In the missive that follows Bill raises profound questions about the Fed’s “floor system” and about what monetary economists call a “Minsky Moment.”
Now, and with permission, here is Bill’s missive published on June 8th.
Forward guidance: Shrinking the Fed’s balance sheet will not reduce inflation
https://www.linkedin.com/pulse/forward-guidance-shrinking-feds-balance-sheet-reduce-inflation-bill-d9bre/
I’m no monetarist, but even if I were, I would have no reason to conclude that shrinking the Fed’s balance sheet will reduce inflation. When the Fed shed’s assets, its liabilities, specifically reserves balances – deposits of banks at a Federal Reserve bank – decline. But reserve balances are not part of the money supply, at least not the one associated with inflation. As defined by Milton Friedman and pretty much every textbook, the money supply consists of currency in circulation and deposits of non-bank businesses and households at banks. Reserves are not in M1, M2, or M3. The “money” in the assertions that inflation is caused by “too much money chasing too few goods” and “inflation is always and everywhere a monetary phenomenon” is the money in public hands, which does not include deposits of banks at the Fed. While reserves are in “base money” or M0, that is not the money supply nor the kind of money associated with inflation.
For instance, Friedman stated: “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” He goes on to say that “[government spending] clearly will be inflationary if it is financed by creating money, that is, by printing currency or creating bank deposits [emphasis added]. Similarly, in his treatise on money and inflation “A Theoretical Framework for Monetary Analysis” he cites Philip Cagan’s definition of money “The money stock is defined as hand-to-hand currency plus commercial bank demand and time deposits held by all economic sectors except the Treasury and the Federal Reserve Banks and commercial banks.”
You may object that even if the money supply does not include reserves, the money supply is connected to reserves through the money multiplier. In the past, banks had to maintain reserve balances equal to a percentage of deposits. Consequently, the theory went, the amount of deposits equals one over the reserve requirement times the amount of reserves. However, there are no longer reserve requirements, and the amount of deposits has long stopped being one over the requirement times the amount of reserves. While the ratio of demand deposits to loans was about 20 before the GFC, it fell to about 0.5 just after the GFC (at a time when there still were reserve requirements), and is 2.3 now. The analysis that gives rise to the money multiplier assumes that banks earn a below-market return on reserve balances so that they have an incentive to hold the minimum amount possible.
It has long been recognized by monetarists and Keynesians alike, that when interest rates are all squeezed down to essentially zero, if the central bank purchases Treasury bills funded with reserve balances beyond a certain point, it has no effect on either output or inflation. In that situation, the economy is in what is called the “liquidity trap.” In the liquidity trap, if the Fed increases reserve balances by purchasing bills from banks, there is no effect because the bank views the two as perfect substitutes. If the Fed purchases the bills from nonbanks, the nonbanks end up with deposits, which are perfect substitutes for the bills, and the banks use the deposits to invest in the newly created reserve balances with again, no effect.
The concept of the liquidity trap was developed at a time when the Fed did not pay interest on reserve balances, so it was seen as applying only when interest rates were all zero. The Fed now pays interest on reserve balances, and it conducts monetary policy by providing banks massively more reserves than they need, driving money market rates down to the interest on reserve balance (IORB) rate, using what is called a “floor system” because money market rates are at the floor created by the IORB rate.
In a floor system, the economy is, in effect, always in the liquidity trap. Indeed, the supposed benefit of operating in a floor system is that with money market rates equal to the IORB rate, variations in the supply of or demand for reserves won’t move money market rates precisely because banks are indifferent between reserves and similar assets such as reverse repos – the definition of the trap. The difference, of course, is that the Fed is not unable to stimulate the economy in the current situation. While it cannot do so by increasing the quantity of reserve balances, it can do so by lowering the IORB rate and therefore lowering money market rates.
Conversely, the Fed cannot slow the economy or reduce inflation by shrinking its balance sheet and draining reserves. It can, however, reduce inflation by raising the IORB rate and therefore raising money market rates.
There is an important caveat. If the Fed reduces its balance sheet to the point where it is no longer oversupplying reserve balances, that too will raise money market rates. But in that case, it would no longer be conducting policy using a floor system and would no longer be in the liquidity trap. Doing so is making a choice (a wise choice) about how to implement policy, not about the stance of policy.
As an aside, if they Fed’s objective is to reduce its interest expense, it must do so by reducing the quantity of reserve balances, changing how it implements policy. It cannot do so by simply ceasing to pay interest on reserves. If it were to cut the IORB rate to zero, market interest rates would fall to zero, overstimulating the economy, boosting inflation. That said, in general, reserve balances are not financially costly for the Fed (although the nonfinancial costs of the Fed’s current implementation approach are large, see here). Interest-bearing reserve balances are used to invest in interest-earning assets, and the expense and earnings essentially cancel out. See “Forward guidance: Misconceptions about reserve balances.”
The canonical Fed rationale for why QE stimulates the economy is not because it creates reserve balances, but because, by purchasing longer-term securities, it shifts interest rate risks from the public to the Fed, reducing term premiums. It is because the Fed is swapping two dissimilar instruments – reserves for Treasury bonds or agency MBS – that the purchases have an effect. That effect works through the interest rate channel, not through too-much-money-chasing-too-few-goods.
As I discussed in a recent email, QT could slow the economy if the Treasury replaced the Fed’s reserve balances with longer-term instruments, but it has no effect on the economy if Treasury replaces the reserves with bills. That’s essentially the liquidity trap again.
That is not to say that there are not significant benefits to the Fed shrinking the balance sheet, there are (see roughly half the things I have written, most recently here). But reducing inflation is not one of them.
Bill
Kotok Closing Note
I thank Bill Nelson again for permission to share this with our readers. I believe he is right on the mark. The appropriate size of the Fed’s balance sheet is a controversy. We can find many opinions about its being too large or too small. But seldom do we see an opinion that it is “just right.” As I see it, the optimal size of the Fed’s balance is unknown in real time and can be evaluated only after the fact and with solid historical data.
There is much to consider. We live in an age of instant payments, which implies infinite velocity of money. So how much balance sheet is needed for payments? No one knows.
We support over $2 trillion of currency in circulation, and two thirds of it circulates outside the United States. That currency is a liability on the balance sheet. The most popular bill is the $100 piece of paper. The gold certificates on the Fed’s balance sheet are still valued at $42 an ounce.
The US Treasury account varies in size from as high as $700 or $800 billion to as low as $50–$100 billion when the Congress goes through its periodic and idiotic political game of chicken with the debt ceiling. Note that the debt ceiling debate is a purely political fiction and has cost the US government billions ever since the first Newt Gingrich threat of default in 2011. As support for what I am asserting here, check the price of a 10-year credit default swap (CDS) on the US Treasury’s debt, and you will see that it is 50 basis points or so today. Prior to Newt Gingrich, that number was 6 or 7 or 8 bps.
Kevin Warsh understands these mechanics. Scott Bessent does, too. It is now time for the current presidential regime to get its house in order, respect the threat from the expanding federal deficit, and deal with monetary policy in an apolitical and independent way.
Bill Nelson is 100% right. The threat is not from the size of the Fed’s balance sheet. That is a subterfuge used by politicians. As I see it, what’s required is a policy implementation change at the Fed. Spoiler alert: The Fed needs to focus on the “real” interest rate and keep that rate a positive number that is higher than the inflation rate. And the hardest part is, for those of us who are in a position to make this happen, we must change the miscreant politicians we elect to our government.
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