There seem to be some misconceptions about the monetary consequences of actions that the Federal Reserve has taken to address liquidity needs.
One hears a fair bit of chatter these days along the lines of
The Federal Reserve (and other banking institutions around the world) have poured a couple hundred billion dollars into the system in an attempt to ensure that there is enough “liquidity” for banks to make loans
and references to
the Fed printing money and increasing the money supply on a high scale as if it was dropping money from an helicopter, thus the nickname of Fed Chairman Ben “Helicopter” Bernanke.
I hope in this post to get beyond these sound bites, beginning if I may with some details of the process whereby money is created in the United States. Where did the cash in your wallet come from? Presumably you got it from your bank or ATM. And the reason that the bank was willing to give you that cash was that you already had deposits in an account with the bank, which were in effect credits to obtain cash when you wanted it.
And where did your bank get that cash? If it is a member of the Federal Reserve, your bank got it from a Federal Reserve Bank. And the reason that the Federal Reserve was willing to give your bank the cash was that your bank had deposits in an account with the Fed, that give it credits to obtain cash when it wants it. These credits are known as Federal Reserve deposits, which I’ll simply refer to here as “reserves” for short.
And where did those reserves come from? The standard mechanism is that the Fed purchased Treasury bills from independent securities dealers, paying for them by creating new reserves in the dealers’ banks. The Fed now is the owner of the Treasury bills, and those banks now have new reserves, which they could use to obtain new dollar bills, if they desired.
To follow what’s happened over the last 6 weeks, it’s necessary to add a few details to this basic story. For day-to-day fine-tuning of interest rates and the money supply, the Fed usually does not use outright purchases of Treasury securities, but is more likely instead to rely on repurchase agreements, or repos. A repo is a short-term loan, often overnight or for just a few days, made by the Fed through a private securities dealer, which the Fed again provides by creating new reserves at the dealer’s bank. As collateral for the loan, the Fed temporarily takes possession of high-quality securities. A few days later, the securities are returned to the original owner and the reserves come back to the Fed. Although its effects are strictly temporary, on any given day the Fed’s outstanding repos have created reserves and thus potential dollars in circulation.
|Total dollars created||818,498|
|Less: Reverse repos||-31,647|
|Discount window loans||251|
|Total dollars held||818,498|
|Currency in circulation||813,051|
The table at the right summarizes the Fed’s balance sheet (from Fed release H.4.1) for the week ended August 8, just before the summer fireworks in international capital markets. At that time, the Fed held $791 billion in Treasury securities and $19 billion in repos. The Fed can also take the reverse side of a repo, temporarily borrowing from private lenders and thereby absorbing reserves from the banking system. To calculate the total number of potential dollars in circulation at any point, we’d have to subtract this number from the Fed’s Treasury and repo holdings.
In addition, a bank that wants reserves can borrow directly at the Fed’s discount window, where the bank temporarily surrenders high-quality assets in order to obtain more reserves. On August 8, such borrowings were quite tiny.
There are some more details of the Fed’s balance sheet and classification of reserves that played little role in recent developments, so I’ve lumped these together in an “other factors” category in the table above. When you add together the Fed’s Treasury holdings, repos, discount loans, and other factors, and subtract off the reverse repos, you get the total number of potential dollars created, which came to $818 billion on August 8. Of that sum, only a tiny fraction ($5 billion) was held as reserve balances, and all of the rest had ended up as money in circulation. If you took the view that another $1 billion in Treasury securities purchased by the Fed will eventually mean another $1 billion in currency in circulation, that would be an excellent summary of the long-run reality.
Beginning August 9, the Fed aggressively used repos to add new reserves. Much of this was done with overnight repos, meaning that in order to keep the reserves in the next day, the Fed would need to conduct a new repo. The hundred billion dollar figure that some people use comes from adding together each day’s repo operations, which is a completely nonsensical calculation. At the height of these operations (the week of August 9-15), Fed repos created an average of $18 billion in new daily reserves compared with the previous week. It is also inaccurate to refer to such repo operations as any kind of bailout, since the Fed was physically holding securities whose value equaled that of the reserves temporarily injected.
And what exactly happened to that $18 billion while it was in the banking system? The answer is– absolutely nothing. Banks simply held these funds as excess reserves, with nobody withdrawing a single dollar bill. This tremendous increase in banks’ desires to hold reserves beyond the amount that they were required was one of the remarkable aspects of this situation and the primary reason that the Fed needed to conduct such repo operations in the first place.
Aug 8 to Aug 15
Aug 8 to Sep 19
|Total dollars created||818,498||836,308||815,476||17,810||-3,022|
|Less: Reverse repos||-31,647||-31,357||-35,735||290||-4,088|
|Discount window loans||251||271||2,421||20||2,170|
|Total dollars held||818,498||836,308||815,476||17,810||-3,022|
|Currency in circulation||813,051||812,403||809,915||-648||-3,136|
And what’s been happening since August 15? As the table above indicates, the Fed continues to do a lot of repos, giving those pundits who want to add each day’s operations together some marvelous big numbers to play with. Although no longer at the same level of mid-August, the Fed’s repo holdings are still about $12 billion higher than they were the week of August 8. However, since then the Fed has also allowed some of its Treasuries to mature without rolling over. When the Treasury paid the Fed for these maturing Tbills, that ended up absorbing reserves in an amount that almost entirely offsets the added repos.
And how about discount window borrowing, which as of last week was still supplying a few billion in reserves in the system? This was more than offset by a $4 billion increase in reverse repos and some other factors, which drained considerably more in reserves than discount borrowing has added. The combined result of all these effects is that reserve balances are now right back where they were on August 8, and currency in circulation is in fact $3 billion lower than it was. The Fed has done its job, and the kvetchers have done theirs.
This is not to insist that concerns about higher inflation are unfounded. But, if one wanted to motivate such concerns from a monetarist perspective, one could not point to money that has been printed so far. Instead, the story would have to be that, in order to achieve the path for the fed funds rate that the Fed is now likely to set for the following year, the Fed will eventually need to add more reserves that do end up as more cash in circulation. In this scenario, markets have been reacting to an anticipation of future money creation and not to something that has already happened.
Now, I realize that this explanation may not be as entertaining as the whole Helicopter Ben meme. But on the other hand, it may be a whole lot more accurate.