Thursday, 18 February 2010

Strange ideas on banking at the Fed.

Thanks to Warren Mosler for drawing attention to a recent speech by Narayana Kocherlakota the new president of the Federal Reserve Bank of Minneapolis.

Kocherlakota’s grasp of banking is not what it might be. He claims that

“Deposit institutions are holding over a trillion dollars of excess reserves (that is, over 15 times what they are required to hold given their deposits). These excess reserves create the potential for high inflation. Suppose that households believe that prices will rise. They would then demand more deposits to use for transactions. Banks can readily accommodate this extra demand, because they are holding so many excess reserves. These extra deposits become extra money chasing the same amount of goods and so generate upward pressure on prices. The households’ inflationary expectations would, in fact, become self-fulfilling."

This is nonsense.

Of course there is such a thing as inflationary expectations. If a significant proportion of businesses, households, union leaders etc think prices will rise, then everyone builds inflation into their calculations, and inflation becomes self fulfilling.

But the transmission mechanism proposed by Kocherlakota does not stand inspection and for the following reasons.

First, why are households suddenly going to decide that large reserves might be inflationary, if this is what Kocherlakota is saying? Second, reserves are high mainly because of quantitative easing. I.e. central banks have printed money and bought securities. Owners of said securities have then dumped their cash in commercial banks.

If “households believe that prices will rise” they would certainly WANT additional deposits in proportion. But banks cannot just GIVE any such additional deposits to households. They cannot just pinch “deposit” from the accounts of those who have dumped the above mentioned cash and donate the money to any old household.

If the exceptionally high level of reserves to which Kocherlskota refers somehow boosted GDP, that WOULD increase the viability of loan applications in the eyes of banks. Such loans would boost household deposits. But why should a high level of reserves boost GDP? Neither the theory nor the evidence supports this idea. As to the theory, banks are capital constrained, not reserved constrained.

As to the evidence, reserves have been at record levels for a YEAR, and banks are still cautious about lending. Has Mr Kocherlakota not noticed this?

The Atlanta Fed.

The Atlanta Fed seems to think in similar terms to Minneapolis Fed. See “Steps 1,2 & 3” here.

Having criticised the above two Feds for thinking that increasing reserves increases bank lending, this is not to say expanding bank reserves has absolutely no influence on lending.

If a collection of cash rich customers suddenly increase a bank’s deposits by significant proportion, that makes investing in the bank’s equity more attractive. This may lead to an increase in bank’s capital, which in turn leads to increased lending. But this is an indirect transmission mechanism.

Moreover, in 2009 and 2010, banks know perfectly well that their reserves have increased because of quantitative easing. Potential investors in bank equity also know this. Both of these groups also know that Q.E. will at some stage be partially or wholly reversed. Thus the current large reserves are not much of a basis for long term investment decisions!

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