The Federal Reserve has, over the past few years created $4 trillion dollars. With a T. It’s just whipped it up to purchase bonds and securities to try and juice our economy.
(Side note: If you are curious as to how buying bonds and securities helps our economy here is a rough explanation. Fed buys bonds -- price of bonds rises -- effective interest rate offered by bonds falls (interest payment on a bond doesn’t change, so if bond price rises, it cuts into the interest payment you get, making that interest payment seem smaller and smaller) -- bonds look like less of a good deal to everyone else including banks -- banks go looking elsewhere to invest, hopefully spurring the economy -- also, other interest rates in the economy stay low since they’re based on bond interest rates).
Peter Fisher used to do this when he worked at the New York Fed. He’s now a senior fellow at the Center for Global Business and Government at Dartmouth’s Tuck School of Business and a Senior Director of the Blackrock Investment Institute.
"You sit in an open area that looks like a bond trading desk, you can do it over the phone or the computer, the Fed would call up banks and say we’d like to buy some bonds today."
The Fed then takes the bonds or mortgage backed securities, and pays the bank by putting money into the bank’s reserve account at the Fed, which is like a bank account for banks.
Banks need to have some of that money on reserve as a safety cushion, but the rest is just extra “excess reserves”. In 2006 there was about $13 billion of extra money in there. Now it’s around $2.5 trillion. And here is where some people start to get nervous.
A TIDAL WAVE OF INFLATION?
They look at all that money like water behind a dam. Banks aren’t using it now cause the economy’s still in bad shape, but if they do -- if the dam breaks, the economy will get flooded with cash, we’ll get inflation.
"They do present the potential for significant inflation," argues Steven Horwitz, economics professor at St. Lawrence University. Banks are not lending all that money out right now, but if the economy picks up and they do, the fear is that economic activity and lending could overheat, and prices could rise quickly.
But the predominant thinking among many economists including those at the Fed is that this will not happen.
THROW OUT YOUR OLD TEXTBOOKS
"The textbooks need to be rewritten," says Joseph Gagnon, Senior Fellow at the Peterson Institute for International Economics. Yes, in the old days, the Fed would have to be quite worried about all the money it has created and would have to find ways to suck it out of the economy. (It could sell the bonds it’s bought, for example, and just delete the money -- a financially disruptive proposition given just how many assets the Fed has bought). And it used to be “that if they want to raise interest rates they would have to shrink the balance sheet. But that world is gone.”
In 2008 Congress gave the Fed a power that changed everything, says Gagnon.
"The main thing is that the fed can pay interest on reserves which it couldn’t before."
As in, the Fed can pay banks to sit on their reserve money. The banks aren’t going to lend those excess reserves out -- why would they when the Fed is paying to keep them there.
A NEW TOOL TO INFLUENCE INTEREST RATES IN THE REST OF THE ECONOMY
Not only that, says Gagnon, but those interest rates the Fed pays banks affect the interest rates banks then charge everyone else. The Fed is a no-risk borrower, so whatever interest rate it is willing to pay would (ideally) become the minimum rate anywhere in the economy.
"In this new world, that changes the whole way people think about money and react to it. In the world in which money pays interest, you can have a lot of money hanging out there without causing inflation."
EXPANDING THE FED’S REACH
While paying interest on bank reserves is a dramatic development, it has a limitation. It only affects banks that have bank accounts with the Fed. There are many, many more financial institutions in the U.S. besides banks and they are extremely influential. Paying interest on reserves doesn’t much affect them.
Hence another tool, known as Reverse Repo (not technically new but the Fed has been testing it and will roll it out in future). The Fed will offer to temporarily sell some of its assets to financial institutions besides banks, and repurchase them at a slightly higher price later (in a day, in a month, etc). What’s the point of this? It’s a lot like the Fed paying interest on banks’ deposits, just in a different way and to different entities besides big banks: A financial institution gives the Fed money and then gets it back plus interest some time later.
"The point of Reverse Repo will be to offer same interest rates [that the Fed offers to banks] to everyone else" says Gagnon.
"Only banks have reserves, so Repo is a way the Fed can get outside the banking system and offer to other investors a rate of return. That will help raise interest rates when the time comes."
And again, it’s a way of creating an interest rate floor for the rest of the economy.
"If the fed goes to someone and says invest with me at rate x, nobody will invest elsewhere for below that."
The bottom line is that economists argue these tools will allow the Federal Reserve to control interest rates and temper inflation down the road without having to concern itself with its large balance sheet and the trillions of dollars that it has created.
But the fact remains that this is a new financial world and these tools have yet to prove themselves. Horwitz, for example, is skeptical.
"The strategies that the fed has for limiting those possibilities [for potential inflation] are far from perfect."
He wonders whether paying interest on reserves would compete with Treasury bonds and drive up the cost of government borrowing. Other economists point out this has always been the case, since the Fed has always influenced other interest rates. Horwitz also wonders whether these tools will truly be able to contain banks’ immense reserves.
"If opportunities continue to look good in the economy, no matter what the Fed pays banks they’re going to want to go into that marketplace."
It will only be after the economy is fully recovered, quantitative easing and tapering are long over, that these tools will demonstrate their mettle and the “new financial world” becomes the norm.