Some may have noticed a few weeks ago when the European Central Bank – the counterpart to the Federal Reserve in the Eurozone – conducted a one-day operation that resulted in $622 billion in 1-year loans to the European banking system. At the time, I and others wondered where the fanfare was, as a similar operation by the Fed would surely have resulted in an outcry about the inflationary impact of such a large “liquidity” injection. But a piece by Simon Nixon in the Wall Street Journal explains why there was so little fanfare. As Nixon put it:
“True, the ECB isn’t increasing the quantity of money in circulation in the same way as the Federal Reserve and Bank of England, which are buying assets outright. But providing unlimited liquidity to banks is designed to achieve a similar goal. Since the crisis began, the ECB has expanded its balance sheet as aggressively as the Fed or the BOE.”
So, as Nixon correctly points out, the ECB has been expanding its balance sheet much like the Fed, but apparently this is less worrisome than the Fed’s actions, since the ECB is “only” lending, not purchasing assets as the Fed is doing. But let’s take a quick look at the Fed’s balance sheet. As of July 2, 2009, the Fed reported the following assets on its balance sheet:
- Term Auction Credit: $283 billion
- Commercial Paper Lending Facility: $115 billion
- Central Bank Liquidity Swaps: $115 billion
- “Other” Loans (includes the Primary Dealer Credit Facility): $119 billion
Together, these assets amount to $632 billion. And what do they all have in common? They are all LOANS. Note also that they comprise the bulk of the $726 billion in reserve balances held by banks the Fed reports on its liability side. So, it seems rather strange to give a blanket characterization of the Fed’s operations as asset purchases.
In fairness, it’s true that in the past few months the Fed has changed its strategy to purchasing Treasuries and ABS-related assets (the TALF), but overall the Fed’s balance sheet has shrunk, by over $600 billion (to around $2 trillion), while reserve balances have fallen from a peak of above $800 billion. Yet we still see the financial press and many economists continue to tell us that inflation is “just around the corner” since the Fed is “printing more and more money.”
More puzzling is that these lending programs were the overwhelming majority of the increase in the Fed’s balance sheet beginning last fall from around $800 billion in assets to a peak of over $2.6 trillion.
So, it again seems more than a little strange that when the Fed made a lot of loans back then, it generated concerns about inflation (witness Bernanke’s speeches earlier in the year trying to calm fears about the size of the Fed’s balance sheet), but when the ECB does it, there is no such outcry. John Taylor, for instance, was practically screaming bloody murder to anyone who would listen (see, here and here).
At their peak, the above Fed lending programs looked like this:
- Term Auction Credit: $493 billion on March 12, 2009
- Commercial Paper Lending Facility: $350 billion on January 22, 2009
- Central Bank Liquidity Swaps: $600 billion-plus in December 2008 (precise figures not listed until 2009)
- “Other” Loans: $438 billion on October 16, 2008
So, yet again, why do commentators consider it safe for the ECB to expand its balance sheet via lending, but they become alarmist when the Fed does it? Nixon explains that one of the main reasons why he and others (like Taylor) are so worried about the Fed’s purchases of assets is the Fed, unlike the ECB, lacks a clear “exit strategy.”
“The advantage of the ECB’s approach: It doesn’t require an elaborate exit strategy. As the three-month, six-month and one-year liquidities mature, the ECB’s balance sheet will automatically shrink. In contrast, the Fed and BOE are struggling to explain how they will mop up the excess liquidity they have provided, causing uncertainty and fueling fears of inflation.”
Apparently he and others don’t realize that the same is true for the Fed. John Taylor certainly didn’t cede that point when the Fed was extending all that credit. But all the above listed loan programs represent short-term lending, so the Fed’s balance sheet and (ceteris paribus) the quantity of reserve balances circulating will automatically shrink when the loans are paid back, just as with the ECB’s loans.
In fact, this has already happened. As one can see by simply comparing the peak numbers to the current ones for these lending programs, the Fed has already been “exiting” from these programs, while the financial press apparently hasn’t noticed.
But to address Nixon’s main point . . . are the Fed’s current asset purchases any more difficult to “exit from” than loans would be? To answer this, one must consider in a bit more depth the Fed’s operations. To start, obviously, the Fed’s holdings of Treasuries could be liquidated whenever desired. The TALF-related assets are admittedly a bit trickier, so I won’t address these directly. Instead, let’s look at the main issue being raised here, namely, the rise in reserve balances.
That is, it is the rise in reserve balances (from about $20 billion in August 2008 to over $800 billion within short order, and $622 billion now) that bothers the Fed’s critics the most, as I know of no economic theory that argues a rise in the central bank’s assets alone creates inflation.
But are reserve balances more difficult to drain if the central bank’s assets are mostly assets it has purchased instead of credit it has extended? Certainly not. The Fed already does this by selling Treasuries, engaging in reverse repos, and so forth. It could similarly issue its own bonds, as San Francisco Fed President Janet Yellen said, the Fed is considering (provided Congress approves), effectively turning overnight reserve balances into time deposits. Several other central banks already do this.
Of course, the underlying issue here is the incorrect belief that the rise in reserve balances will be inflationary as banks now have more “high-powered money” with which to create loans. As Nixon says, the ECB “hopes this funding will both encourage banks to redeploy the cash in other assets, driving down yields, and to resume lending.”
But this is incorrect, as I explained at length in a previous post.
To recap that post: Banks DO NOT use reserve balances to create loans. They create loans and deposits simultaneously out of thin air. They use reserve balances to settle payments or meet reserve requirements ONLY. If a bank is short reserve balances for either of these purposes, the Fed provides an overdraft AUTOMATICALLY at a stated penalty rate, which the bank then clears via the money markets or the cheapest alternative. Whether banks in the aggregate hold $1 or $1 trillion in reserve balances, there operational ability to create loans is the same . . . infinite! (Though the creation of even 1 loan requires a willing, credit-worthy borrow in the first place, of course.) Thus, the ECB is not providing reserve balances that banks can “lend or use” to purchase assets, but instead setting a cap on the cost of bank liabilities at different maturities when they do make loans or purchase assets (which, Nixon correctly points out, the Fed ought to do a lot more of).
That is how loan creation works in a modern monetary system. The belief that banks need reserve balances in order to lend is only applicable in a gold standard-type of monetary system.
What does this all mean? First, until recently, the operations of the ECB and the Fed weren’t all that different in the sense that both were using various standing facilities to provide credit, but for some reason only the Fed’s actions appear to have raised inflation fears. And second, talk of a need for an exit strategy is simply baseless. Neither the current rise in the Fed’s total assets nor the increase in reserve balances is inflationary. Banks don’t use reserve balances to create loans, so whether there are more or fewer of them is irrelevant. Indeed, an appropriate “exit strategy” might actually be for the Fed to continue to pay interest on reserve balances at its target rate—thereby enabling it to raise its target if it so desires at some point—and simply leave whatever reserve balances there are circulating, as I proposed a few years ago.