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The Irrelevance of Bank Reserves

If you're feeling a bit lost when it comes to all this talk about bank lending not being "reserve constrained," you aren't alone.

Fortunately, the Economist published a good piece explaining it back in 2009.

For the Federal Reserve, as with most central banks, reserves ordinarily serve only one purpose: to help it establish a target interest rate. In ordinary times, some banks have more reserves than they need and lend them to those that have too little. The rate on those interbank loans is called the fed funds rate. If the Fed wants a higher fed funds rate, it drains reserves. If it wants a lower one, it adds reserves. The quantity of reserves, per se, is irrelevant to the Fed. It’s the interest rate that affects spending and it’s spending that drives both the demand for credit and, ultimately, inflation.

These are, of course, extraordinary times. The Fed’s orthodox means of boosting the economy is exhausted because the federal funds rate is at zero. It has increasingly turned to unorthodox means. It has bought Treasuries in an effort to lower long-term interest rates. For a while, it behaved more like a commercial bank than a central bank by making loans to banks, financial institutions, companies, and homeowners (by purchasing mortgages). These actions would only be inflationary if they stimulated demand and elevated the growth of credit; yet overall credit is contracting; the Fed’s actions have only served to stop it from contracting even more quickly.

When a commercial bank makes a loan, it will usually finance it with deposits from customers. The Fed, on the other hand, gets to create its own deposits by simply creating reserves. (This is the equivalent of printing money.) The point is that the Fed is not trying to increase lending by increasing reserves; it is trying to increase lending by lowering long-term rates and directly supplying credit to borrowers who can't get it elsewhere. Higher reserves are the unintended byproduct. Well, unintended or not, couldn't all those excess reserves spur credit growth and inflation? No. Reserves have not been a relevant constraint on bank lending for decades, if ever. Bank lending is constrained by customer demand and by capital. Right now, loan demand is moribund (in spite of a zero federal funds rate) and capital is in short supply. This is partly self-induced; banks have elevated underwriting standards to levels that fewer customers can meet and regulators are hounding them to boost capital ratios, which they can do by lending less. If inflation becomes a problem it will be because the Fed kept interest rates too low for too long in the face of resurgent demand. Personally, I worry more about the opposite—that it prematurely raises rates and demand sputters. Yet in neither case will it have anything to do with whether excess reserves today are $1 trillion or $1.

Go read the whole thing.

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