Fed Valentines

I love this new meme. And it is just in time for Valentine's day.

Financing Christmas

From all of us at TPS: Happy Holidays!

The Fed's Balance Sheet: Size and Composition

Here's an illustration of the Fed's balance sheet from the Cleveland Fed.

A lot of talk has focused on the expansion of the Fed's balance sheet since Sept 2008. The big question: why no inflation? Bob Higgs writes:

Ordinarily, one would have expected this development to produce hyperinflation of the general price level. However, the price level has increased quite moderately, and for a while many analysts warned that deflation was the greater risk. [...] Not only has hyperinflation failed to appear; even garden-variety inflation of prices in general has been extremely low by the standard of recent decades.
[...]
The most obvious answer, of course, is that the banks are simply sitting on the reserves, rather than lending them to customers. And why are they doing so? The usual answer is that since late 2008, the Fed has paid the banks a rate of interest on their reserves at the Fed. This interest rate has recently been in the range 0-0.25 percent. Although this is not nothing, it verges very closely on nothing. And if one notes that the purchasing power of money has fallen at least a bit, it is clear that the banks are realizing a negative real rate of return on their holdings of excess reserves at the Fed.
[...]
Moreover, they are doing so notwithstanding that they appear to have the option of lending at 3.25 percent to their best corporate customers and at higher rates to their less creditworthy customers.

So we haven't seen much inflation yet. But if (when?) banks start lending out reserves, we should see it pick up. Right?

Good question. The standard view is that the Fed can simply sell its assets to keep the money supply from expanding when the money multiplyer picks up. But the Fed's balance sheet ain't what it used to be. It is not only larger, but also differs in terms of composition. Note that traditional security holdings have actually fallen since Dec 2007. The net increase stems from loans to financial institutions in 2008 and 2009 (much of which has already been repaid) and then large scale asset purchase programs associated w/ Freddie and Fannie starting around Jan 2009. The Fed can certainly sell these assets. But at what price? Will they be able to suck up enough money when the time comes? We will soon find out.

Addendum: Check out this Barron's article by Walker Todd and Bill Ford.

Blockquoting X

X = Ben Bernanke.

The reason the Federal Reserve was founded a century ago was to try to address the problems arising from financial panics, which did, by the way, occur in an unregulated environment in the 19th century.

Discuss.

Sumner on Recessions and Policies to Combat Them

Scott Sumner at TMI hits the nail on the head:

We need to stop thinking about deep slumps as a sort of random “problem” that needs to be “fixed.”  They need to be prevented; if they aren’t, they probably won’t be fixed.

ATSRTWT

Why Do We Have a Central Bank?

O'Driscoll poses this very important question in a recent WSJ article. Here's the take away:

The Federal Reserve System was created by an act of Congress only in 1913. It then presided over a great wartime inflation followed by a major depression in 1920-21. The 1920s were an era of prosperity, due as much to Treasury Secretary Andrew Mellon's wise fiscal policies as anything the Fed did. The Fed's performance in the Great Depression was disastrous, a judgment shared by its current chairman, Ben Bernanke.

The Canadian banking system weathered the Great Depression without a central bank. Instead of the thousands of small, undiversified banks that the United States had, Canada had a small number of banks (with many branches across the country) that were able withstand localized downturns. Even in the Great Depression, banking failures in the U.S. were concentrated in specific regions. Canada's central bank, the Bank of Canada, was created in 1935 in part because of pressure from the rest of the world. Canada had survived without it quite well.

In short, central banking has been neither necessary nor sufficient for the development of a modern economy and financial system. A number of reform proposals for the Fed are being crafted, but there is no agreement on why the institution exists.

ATSRTWT.

Mopping Up Excess Reserves

As you probably know, the Fed has expanded base money by roughly 140% over the last couple years. Under normal circumstances, we would expect a rapid increase in the money supply to follow (recall that M = B m, where M is the money supply, B is base money, and m is the money multiplier). However, banks are holding higher reserves (that's in the denominator of m, hence the multiplier is decreasing). So the unprecedented increase in B is being largely offset by the decrease in m. As a result, M1 and M2 have grown slowly.

Bob McTeer asks whether the Fed should "mop up" the excess reserves held by banks:

The idea that the excess reserves held on banks’ balance sheets should be “mopped up” to prevent them being used in inflationary ways later is a very dangerous idea. They are there voluntarily because bankers feel they are needed. To remove them would cause further bank retrenchment, as it did in the 1930s when the Fed decided to “mop up” the excess reserves of that time.

As the economy and confidence improves, banks will begin using their excess reserves more aggressively. At that point, the Fed will have to be very careful not to stifle that desirable activity on the one hand or let it get out of hand and become inflationary on the other hand. Since they have lots of good, two-handed economists, I think they can pull it off.

Should the rapid increase in B over the past few years be mopped up? Absolutely. But when? Ahhh. That is the tricky part. Ideally, we would want B to fall as m returns to normal levels--that is, when banks start lending out their reserves. If the Fed reduces B too quickly or too soon, the money supply will shrink (deflation). If it reduces B too slowly or too late, the money supply will grow (inflation). This, unfortunately, is the knife's edge that central bankers must traverse if they are to maintain monetary equilibrium.

HT: Harry David

Central Bank Reform

I just got back from the annual Public Choice meeting (held in beautiful Monterey, CA). While there, I had the pleasure of discussing Sven-Olov Daunfeldt's paper on central bank reform. Here's the abstract:

This paper is a first empirical attempt to investigate why politicians around the world have chosen to give up power to independent central banks, thereby reducing their ability to fine-tune the economy. A new data-set covering 132 countries, of which 89 countries had implemented such reforms, was collected. Politicians in non-OECD countries were more likely to delegate power to independent central banks if their country has been characterized by a high variability in historical inflation and if they faced a high probability of being replaced. No such effects were found for OECD-countries.

You can find the full version here.