A common concern among critics of recent Federal Reserve policy is “the Fed” does not have an adequate exit strategy to shrink its balance sheet. Since the financial crisis of 2007 and 2008, the value of its assets has risen nearly fivefold, from less than $900 billion to nearly $4.5 trillion.
This ongoing quantitative easing appears to create a looming monetary overhang that could unleash very high inflation once the economy reaches full recovery.
Measurements of the most liquid parts of the overall money supply—physical cash, checking accounts, and other easily liquidated assets—show banks’ overall reserve accounts exceed 100 percent. As interest rates begin to rise, some fear banks might give more loans to create more assets, in turn causing the broader measures of the money stock to “explode.”
Tools of the Trade
The Fed has created or expanded its tools, allow it to help prevent any sudden expansion of the broader monetary measures.
During the crisis, the Treasury created a special deposit account at the Fed, in which it lodged more than half a trillion dollars “borrowed” from the public. However, this borrowing was not for financing government expenditures.
Instead, the Treasury simply lent the money to the Fed, which in turn lent the money to acquire assets that appeared on its balance sheet, without an impact on Fed-created money. The Treasury simply withdrew this money from circulation, while the Fed injected it back into the economy.
The Fed has also engaged in direct borrowing, through what are called reverse repurchase agreements, or “reverse repos.” In a reverse repo, the Fed uses its securities as collateral for short-term loans.
However, the most important way the Fed borrows is an indirect transaction, paying interest to banks on their reserves.
Bernanke received authorization to do this with the Troubled Asset Relief Program of 2008. Effectively, the Fed created money through quantitative easing, and then borrowed it back from the banks by paying them interest.
On April 30, 2010, the Fed announced the creation of the Term Deposit Facility (TDF). This is a mechanism through which banks can convert their reserve deposits at the Fed into deposits of fixed maturity at higher interest rates set by auction… making them just like Fed-provided certificates of deposit for banks.
By using these four tools, the Fed doesn’t actually have to sell off a single asset if interest rates start to rise. If interest rates climb, the Fed can simply raise interest rates on reserves and other forms of borrowing. By draining reserves or locking them up in the banks, the Fed will perpetuate its enormous impact on the allocation of savings, while preventing any significant change in the money supply.
Quantitative easing has converted the Fed into a financial central planner, in which the Fed, rather than the market, determines the allocation of large amounts of credit.
Jeffery Rogers Hummel, Ph.D. ([email protected]) is a professor of economics at San Jose State University.
“The Federal Reserve’s Exit Strategy: Looming Inflation or Controllable Overhang,” Jeffery Rogers Hummel, Mercatus Center, September 2014: http://heartland.org/policy-documents/federal-reserves-exit-strategy-looming-inflation-or-controllable-overhang