Paying Banks to Not Make Loans

Vault with Safe-deposit Boxes InsideSince the fall 2008 financial meltdown the Federal Reserve has engaged in open-market purchases of the highest order.  Open market purchases refer to the buying of government bonds to keep bond prices high and interest rates low. 

At the present time the Fed’s program involves the monthly purchase of $85 billion of government and government-agency bonds.  This monthly amount, when multiplied by 12, gives an annual figure of just over $1 trillion, which is roughly the size of the federal government’s current budget deficit.  The implication is that the Fed is ultimately financing the budget deficit by creating new money, which is referred to as “monetization of the debt.”  And we have frequently argued that the end result of all this monetization is bound to be inflation.

But why is inflation not soaring right now?  With such a rapidly expanding monetary base, why are prices not also sky-rocketing?  The issue of inflation, and its measurement, is something we will take up this month in a series of blogs.  However, to begin our analysis, we note that there is a difference between the money supply and the monetary base (see Capital as Money for a thorough explanation).  The monetary base includes commercial bank reserves, and it has grown at a much more rapid rate than the money supply.  And it is the money supply that ultimately impacts on consumer spending and prices. 

Why isn’t the money supply soaring in the face of all the Fed’s aggressive bond purchases?  The answer is in part due to another Fed policy, enacted in October 2008, of paying interest to banks for holding excess reserves. 

Take a minute to digest what you just read:  Starting in the darkest days of the financial crisis, the Fed enacted a new policy of rewarding banks with interest payments for NOT making loans!  The Fed’s paying of commercial banks to hold excess reserves, while at the same time buying bonds at a feverish pace appear to be contradictory policies.  Bond purchases by the Fed are designed to increase the monetary base, which normally expands the money supply.  Paying banks to hold excess reserves discourages lending and works to decrease the money supply.   Why the contradictory policies? We are not exactly sure why the Fed would head down these two conflicting roads.  Perhaps it is because the Fed wants to finance reckless government spending through massive bond purchases, while at the same time keeping a bit of a lid on the growth in the money supply.  If and when banks do start making more loans there is ample fuel in the form of a gargantuan monetary base to cause a dramatic surge in the money supply and in consumer prices. 

The Fed suggests that increased inflationary pressure, when it manifests itself, will be readily subdued by increasing the interest rate the Fed pays on reserves.  When prices start to rise, the Fed will promptly increase the rate paid to banks from 0.25 percent to some higher number, stopping inflation dead in its tracks.  Time will tell.

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