Do excess bank reserves really lead to inflation?
All the hoopla over bank reserves has led me to do some analysis on the matter and I have come to the conclusion that inflation may come at us, and come at us hard, but excess reserves will not be the culprit. Since about 95% of our money supply is in the form of credit, we must understand how credit is created before a valid conclusion can be drawn about whether an increase in bank reserves leads to inflation.
In school we are taught to believe that base money comes first and is multiplied out as credit money at a decreasing rate throughout the banking system. However, in 1979 an economic journal , the opposite was discovered1. Banks extend credit first and then afterwards seek out reserves. As said succinctly by an economist, Bail Moore,"In the real world, banks extend credit, creating deposits in the process, and look for reserves later"2. We live in a credit money dominated society (To the tune of $52 trillion) where banks create the money and the money supply is fluctuates based upon society's ability to service debt.
There are basically two types of restraints on bank lending:
1. Reserve Restraints. By law, banks are required to hold a certain percentage of their transaction deposits in the form of reserves. In practice, a bank only holds enough reserves to cover settlements at the end of each day (i.e. depositor withdrawals) as there are many ways to get around the reserve requirements.
2. Capital Constraints. Having enough equity to support additional lending activities (Think overall leverage ratio for the bank). Reserves are not equity, they are an asset of the bank.
Reserve RestraintAs stated before, although banks are required to hold a certain portion of their assets in the form of reserves, banks only hold enough reserves necessary to process settlements at the end of each day. This is because there are so many loopholes as to which accounts require reserves and at what time that it becomes a minor issue for the bank. However, there is always the very real need for the bank to hold a certain amount of short-term liquid assets in order to pay out depositor withdrawals and the like.
This need for liquid assets is met be a special, highly liquid market of bank reserves. Only banks are allowed to hold these instruments and the Federal Reserve is the sole supplier. The need for a bank to settle cash claims each day is met by this reserve market. Banks rely on trading amongst themselves to satisfy short term needs. A real problem can arise if banks aren't willing to trade reserves with each other as was the case in 2008 when distrust ran high amongst banks and they were only willing to lend at high interest rates and to a few participants. In situations such as these the banks really are constrained to lend because they fear they will not be able to meet depositor withdrawal demands and therefore might cease lending activities until the problem is resolved. In periods of extreme stress such as this, the Fed can step in and flood the market with reserves in order to allow banks to meet their cash needs. The influx of reserves can free up the overnight market, which in turn frees up lending.
Other than these types of periods, banks are never really reserve restrained as the Fed will always provide the amount of reserves that are demanded by the banking system. The reason for this is because the Fed's primary monetary policy tool is to set the FFR and it cannot do this if there is turmoil in the overnight market. This turmoil could result if there are insufficient reserves for settlement purposes as was mentioned previously. The reason for this is because the demand for bank reserves is inelastic as is shown in the diagram below:
This inelastic demand curve means that the bank absolutely requires that that a certain amount of reserves be available and if there is an insufficient supply then the overnight rate would spike up tremendously as bank's clamored for reserves. Therefore the Fed first makes sure that all supply equals demand first, and then they target the fed funds rate, which allows them to achieve their target without the extreme volatility of supply shocks. The Fed targets the FFR because it directly influences the prime rate and other rates that are widely used as consumer credit benchmarks.
Are Reserves somehow special and unique?
The only thing really 'unique and special' about Reserves are the fact that the fed is the sole supplier and thus determines the market rate of interest, only banks can use reserves, and the fact that reserves are also often used as the market of last resort for short term financing needs. But that is where the uniqueness ends. Remember that reserves are considered to be a part of the bank's assets, not equity, and are therefore not able to make a bank solvent, if impaired. Reserves are actually very similar in nature to T-Bills, as they are both short term, highly liquid, and basically risk-free. Amounts in excess of the reserves are just another liquid asset of the bank. It is important to note that the fed still does impose a 10% reserve requirement on banks but there are so many loopholes, such as overnight sweeps of checking accounts, and no reserve requirement on corporate accounts, that the requirement is a mirage and reserve requirements do not really impose any sort of restraint on the bank. This is evident when you look at the total debt of the economy versus the base money supply ($52 trillion in debt versus $800 billion in reserves, far less than the 10% reserve requirement)
The excess reserves in the banking system do not mean anything more than the Bank's choosing to hold more of their liquid assets in the form of bank reserves, instead of say, T-Bills. The increase of a banks liquid assets (reserves) does not make a bank any more capable of increasing lending than a construction of a new freeway would somehow increase the number of cars on the road. Just as the new freeway allows for more cars to be on the road, it is pointless if it is: (a) not needed and (b) there aren't any more drivers taking to the road. This is how we should think of excess reserves. They are not needed as the demand for settlements is already taken care of (inelastic demand curve) and there aren't an increasing number of qualified borrowers or increased asset values to lend against. This is strikingly evident when you look at the case of Japan in the last decade. The BOJ expanded reserves at an incredible rate but lending actually decreased during this time period.
2. Basil Moore 1983, "Unpacking the post Keynesian black box: bank lending and the money supply", Journal of Post Keynesian Economics 1983, Vol. 4 pp. 537-556; here Moore was quoting a Federal Reserve economist from a 1969 conference in which the endogeneity of the money supply was being debated.
