(Bloomberg Opinion) -- This is the first of two columns examining the extraordinary actions the Federal Reserve has taken to support the economy during the coronavirus pandemic, and the consequences for the central bank’s financial condition and balance sheet.
The Federal Reserve’s balance sheet is exploding, growing by about $3 trillion since mid-March and now totaling more than $7 trillion. It could conceivably exceed $10 trillion by yearend, as the central bank buys corporate bonds, municipal securities and makes loans to medium-sized businesses while purchasing $80 billion of Treasuries and $40 billion of agency mortgage-backed securities (MBS) each month. This would be more than double the peak that the Fed's balance sheet reached after the 2008-09 financial crisis.
So what should we make of this rapid growth? Do the Fed’s asset purchases represent monetization of the federal debt? Will runaway inflation be the inevitable consequence?
Before answering these questions, we need to explore how the Fed’s purchases change not just its balance sheet, but also the balance sheets of banks, households and business. When the Fed buys a financial asset from a private holder, the proceeds received by the seller typically flow back into the banking system. Even if the seller reinvests the proceeds into some financial asset rather than depositing it at a bank, the cash eventually ends up either as an increase in currency outstanding or an increase in bank deposits. Because most people don’t want to hold large amounts of cash, almost all of the money eventually finds its way back into the banking system. Banks end up with a deposit held at the Fed; these liabilities of the Fed and assets of banks are bank reserves.
So when all the smoke clears, the private sector will hold fewer Treasuries and MBSs and more bank deposits while the Fed holds more Treasuries and MBSs.
So what are the implications of this? The first is that the amount of reserves and bank deposits will have increased sharply, which is what's happened during the past few months with a doubling in the amount of bank reserves. These reserves will keep growing as the Fed expands its balance sheet. Bank balance sheets, all else equal, will be considerably larger. If any particular bank tries to shrink its balance sheet by turning away a household or business deposit, those funds will simply flow somewhere else within the banking system.
The second implication is that the private sector will now hold more cash and deposits than before. There is nothing the private sector can do about this collectively. If I, for example, try to exchange my cash for other financial assets, the seller now has the cash. It doesn’t disappear, it just gets reallocated.
The third implication is that the private sector may react to the increase in cash and deposit holdings forced on it by the Fed by seeking other, riskier higher yielding assets. In fact, this is a major motivation of quantitative easing. By reducing the supply of safe assets and increasing the amount of deposits that the private sector must hold, the Fed generates a demand by the private sector for more risky assets. The result is a rise in financial-asset valuations and an easing of financial conditions. The Fed’s asset purchases change the mix of assets available to be held by private investors and this influences asset valuations.
So what of the concern that the rapid growth of bank reserves will prove inflationary? This concern is misplaced. The Fed can adjust the interest rate it pays on bank reserves, controlling the cost of credit and influencing whether the reserves are lent out. If there were ever a surge in bank loan demand, the Fed could restrain it by raising the interest rate it paid on banks’ excess reserves. This would give banks an incentive to keep the reserves on deposit with the Fed. If the Fed didn’t have the authority to pay interest on bank reserves -- as was the case before October 2008 -- then the Fed wouldn't be able to control loan demand in this manner.
The ability to pay interest on reserves allows the Fed to have a balance sheet as large as it desires, without necessarily leading to an uncontrolled expansion of bank credit. Only when the bank reserves are lent out does the expansionary credit multiplier process start to work. The Fed controls this process because it controls short-term interest rates.
So what’s the bottom line of the Fed’s rapid balance sheet expansion? The Fed is changing the composition of the assets that the private sector can hold, with implications for the prices of financial assets. But the rapid reserve growth won't lead to runaway inflation as long as the Fed is willing to raise interest rates as needed to keep credit demand in check.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Bill Dudley is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.
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