The Fed’s Exit Strategy and Excess Reserves

by: Bob McTeer

As I pointed out in my last post on inflation, the expansion of Fed balance sheet assets has been largely offset on the liability side of its balance sheet by excess reserves held by banks. Those reserves are assets to the banks and liabilities to the Fed. They are “excess” reserves because they exceed the amount of reserves Fed regulations require to back the banks’ deposit liabilities.

Some pundits treat those excess reserves as a ticking time bomb set to go off any minute (used aggressively by banks to increase loans and investments, thus creating much more deposit money), unless the Fed “mops them up.” Those who acknowledge that those excess reserves have not sparked inflation yet still expect them to trigger and feed inflation any minute now.

I keep pointing out, to no apparent effect, that those reserves are being held voluntarily by banks. Since the banks aren’t being required or incentivized (much) to hold them, bankers must not regard them as “excess” in a sense meaningful to them. If bankers regard those reserves as serving a useful purpose amidst all the uncertainty and legacy problems facing the banking system, they would logically react adversely if the Fed “mopped them up” through open market operations or by increasing reserve requirements, as the Fed is being urged to do in many quarters. Given banker fears and uncertainty, particularly over the adequacy of their capital, bankers would likely regard the loss of those reserves as a significant tightening of monetary policy rather than a mere technical adjustment.

Amazingly, this exact same problem appeared during the Great Depression. Banks were holding reserves above and beyond the legal requirement (excess reserves) when the Fed used its new powers to raise reserve requirements to “mop up” those excess reserves, thus causing a sharp bank retrenchment. The Fed had regarded those excess reserves as loosening its influence over bank behavior, and, since the reserves were “excess,” the Fed did not anticipate the bankers’ reaction. Clearly, the bankers reeling from the shocks of the depression, including many bank failures, did not regard those reserves as excess. We have the same situation today.

I don’t know exactly how the Fed’s exit strategy will play out, but the implication that it has to play the 2008-2009 movie backwards and contract its balance sheet to pre-crisis levels seems far off the mark. What is important is what happens to money and credit flows as the Fed allows special lending programs to expire and begins to replace other purchased assets on its balance sheet, mainly mortgage backed securities, with traditional Treasury bills. The important thing is doing what has to be done without sharp increases or decreases in the money supply or its growth rate. Hopefully, that outcome would also prevent unnecessarily large changes in short-term interest rates, but that is not clear. In any case, a massive net sale of securities, that would be necessary to shrink total Fed assets to pre-crisis levels, would sharply contract the money supply and likely produce panic in the banking and financial system. Fortunately that isn’t necessary.

There is no cost to taxpayers to leave the enlarged balance sheet approximately as it is and focus policy on future needs. Actually, the enlarged balance sheet has been a boon to taxpayers since it has increased Fed profits that are turned over to the Treasury’s general fund. Shrinking the balance sheet would reduce those supplements to tax revenues in the future. People on financial TV continue to treat net Fed lending as a cost to taxpayers. The opposite is true.

Disclosure: No positions

About this article:

Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here