How Can The Fed Avoid Hyper-Inflation?

Includes: BAC, JPM
by: Modeled Behavior
By Karl Smith

Believe it or not I am trying to keep myself off the blog, but sometimes when I am taking care of my son and he falls a sleep for a bit, I am like – oh great time for a blog post – and here I go.

So, I have seen more than a few people worry about money coming off of the Fed’s balance sheet and creating hyperinflation in the United States. More often than not this is phrased as “Well right now banks are hording cash but as soon as they stop the Fed is going to be in trouble”

I want to respond to that but it's difficult to find the exact framing.

On the one hand the issue of an exit strategy and effectively transitioning to a new monetary model is not trivial and should be taken lightly. Fed officials are rightfully wringing their hands over the execution of such maneuvers.

On the other hand its not the kind blatant monkey business that I think some people are envisioning. It is overwhelmingly likely that the Fed is going to be successful at making this work.

So briefly let's think about why someone might suspect hyper-inflation or at least a very high level of inflation is coming and why the Fed is overwhelmingly likely to prevent it.

By law banks are required to hold reserves to back up their deposits. In the United States a bank must have $10 in cash on hand or at the Federal Reserve, for every $100 in deposits.

Now, typically banks don’t want to hold more in reserves than they have to. This is because cash just sitting in a vault or on deposit with the federal reserve (traditionally) earns no interest. The entire point of being a bank is to earn interest and so if you have excess reserves you are really sleeping on the job.

Now the first place you are likely to look to for lending opportunities is in your local area. You want to loan money to borrowers at an interest rate that will prove profitable. However, what if you don’t see too many good lending opportunities, maybe your local economy is depressed or maybe your borrowers are in really risky situations that have you nervous about their ability to pay you back.

What you can do is loan the money to some other bank. There are other banks out there that might be in areas with a strong economy or who specialize in lending to the type of customers who are good credit risks or in a promising industry. You loan the money to that bank and then that bank loans the money to its customers.

The market where banks loan each other money is of course the Federal Funds market.

Now as it turns out what usually happens is that small local banks loan money to big Money Center banks. As you may have noticed the big money center banks – Bank of America (NYSE:BAC), JP Morgan (NYSE:JPM), etc – can always find ways to lend out money. They have very smart people who spend all day thinking of new ways to make profitable loans.

So if First Bank of Main Street ((FBMS) doesn’t see good local opportunities, it loans money to Bank of America.

Now, since we’ve already built up this structure it is worth spending a few sentences on how the financial panic affected all of this.

We have First Bank of Main Street lending money to Bank of America . BAC is a big bank full of smart people who can always find ways to make money. But, wait a second! It looks as if BAC may have made some mistakes. It wound up making a whole bunch of bad loans that might not get paid back.

What should FBMS do? Well it doesn’t have super analysts on staff who can figure all of this out and even if it did the big boys on Wall Street got it wrong so who is to know what’s right. Well, in this case FBMS should stop lending to BAC and protect its customers.

But, now OMG! BAC is watching all of its reserves wash away. It needs to have a 10-1 ratio. Every dollar that FBMS pulls back means that BAC has to reduce its loan portfolio by $10. BAC is going to have to really start shutting down its loans.

But, many large corporations depend on BAC. That’s where they get money to meet payroll or pay vendors or other immediate needs. What are they to do? Are they going to be able to meet payroll this week?

Full scale panic ensues.

Now the Fed steps in and says, hey BAC, we’ll loan you the money you need to cover your reserve ratio. You won’t have worry about borrowing from FBMS.

So the Fed injects all of these reserves into the banking system.

Now normally that would simply cause the Fed Funds rate to simply collapse to zero and indeed the Fed pushed the Fed Funds rate pretty close to zero. But, the Fed Funds rate is also a useful tool for monitoring what’s going on in the banking system.

So the Fed said it will pay interest on reserves. That way if anything crazy happens you can just keep your reserves and earn interest, you don’t have to run the risk of loaning them out to banks with shady books.

So where are we now? BAC got the reserves it needed to keep its lending going. FBMS got back all the reserves it had loaned to BAC and so now FBMS has excess reserves sitting on the books.

Shouldn’t FBMS loan out those excess reserves?

There is really no reason to. Before the crisis started FBMS would have rather loaned excess reserves to BAC than to customers in the local area. Now, after the new policy FBMS would rather just earn interest from the Fed than loan out reserves to folks in the local area. As far as FBMS is concerned nothing has really changed.

Well what if loan demand picks up in the local area? Won’t FBMS loan out its reserves? It will start to but then the Fed can simply raise the interest it pays on reserves. This means that FBMS could either make loans to customers or just hold the extra reserves.

This is the exact same trade off that FBMS would have faced if the Fed had raised the Federal Funds rate. It could have loaned out money to customers or it could have loaned the money to BAC.

In effect the interest of reserve policy lets the Fed stand in for BAC. This is important because BAC needs some time to get its act together. But as far as FBMS is concerned there is really no difference between the two scenarios. All that matters is the interest it is earning on its excess reserves. It’s the same whether those reserves go to BAC or are held by the Fed.

So, even though FBMS officially has more excess reserves on its books, its desire to lend is no different than under normal conditions. Thus, any increase in inflation that could be choked off by raising the Federal Funds rate can be choked off by raising the interest rate on reserves.

The Fed has complete power to slow the expansion of lending and hence the emergence of hyper-inflation, as it did before, and it doesn’t have to remove its reserve injections to make it happen.