Current excess reserves could create a massive increase in the money supply if banks significantly increase their lending or investing.Monetary policy - United States ; Money supply ; Financial crises

Daniel L. Thornton

English

Research Papers in Economics

Economic SYNOPSES
short essays and reports on the economic issues of the day
2010 ■ Number 34
A
t its November meeting the Federal Open Market
Committee (FOMC) decided to engage in a second
round of quantitative easing called QE2 (i.e., quan-
titative easing in the form of large-scale purchases of U.S.
Treasury securities) by purchasing an additional $600 bil-
lion in longer-term government securities by the end of the
second quarter of 2011. In a recent Economic Synopses essay,
I reviewed the transmission mechanism of monetary policy
to evaluate the potential effectiveness of QE2.1 That analysis
suggested several reasons why QE2 might have little or no
effect on output, employment, and inflation or inflation
expectations. This essay analyzes several potential dangers
associated with the FOMC’s previous quantitative easing
actions that will be exacerbated by the decision to expand
its portfolio further.2
The first potential danger is that quantitative easing
increases the likelihood that long-run inflation could
increase well above the FOMC’s implicit inflation objective
of about 2 percent. As a result of the Committee’s previous
quantitative easing measures, banks currently hold about
$1 trillion in excess reserves. As I have noted elsewhere,
the supply of money (M1) can be increased massively with
a relatively small reduction in excess reserves because the
effective reserve requirement is at a historically low level.3
Hence, the current level of excess reserves could create a
massive increase in the money supply should banks signifi-
cantly increase their lending or investing. QE2 only increases
this potential. Few analysts doubt that such a massive
increase in the money supply would be inflationary.
Currently, banks are content to hold massive amounts
of excess reserves. There are a number of possible reasons
for this, including (i) weak loan demand associated with
regulatory and cost uncertainty and a somewhat anemic
recovery; (ii) capital ratios below their desired or required
levels; and (iii) unprofitable lending due to interest rates at
or below the cost of capital, thereby encouraging banks to
hold excess reserves rather than make loans.4 The impedi-
ments to bank lending will surely dissipate as the economy
recovers. Should banks begin to significantly expand their
lending and investing, the FOMC would have to take
extreme actions to avoid a marked acceleration in money
growth. The FOMC has two options. They can reduce
the supply of excess reserves by selling large quantities of
securities (either through outright sales or by continuously
rolling over temporary sales using reverse repurchase agree-
ments [repos]). Alternatively, the FOMC could increase
the interest rate it pays banks to hold excess reserves to a
level competitive with the risk-adjusted rate banks could
earn by making loans and investments—thereby preventing
the money supply from increasing.5
If the Fed can remove the reserves when the time comes
or neutralize their effect on the money supply by paying
banks interest to hold them, why do they constitute such
a serious inflation risk? I believe there are at least four
reasons. The first is that, historically, there has been a lag
between accelerations in money growth and subsequent
inflation. Consequently, inflationary pressures associated
with excessive money growth could build before the FOMC
either sells securities and/or increases the interest rate it
pays on excess reserves sufficiently to significantly curtail
money growth.
A second reason is the considerable disagreement among
economists and policymakers about whether and to what
extent money growth per se is inflationary. In the macro-
economic model commonly used in analyses of monetary
policy, inflation is determined by inflation expectations and
the gap between actual and “potential” output. The output
gap is currently estimated to be very large and negative,
so proponents of this model are unlikely to be concerned
about rapid growth of the money supply until inflation
begins to increase. Even then, the rise in inflation can ini-
tially be attributed to special factors (e.g., an increase in
The Downside of Quantitative Easing
Daniel L. Thornton, Vice President and Economic Adviser
Current excess reserves could 
create a massive increase in the 
money supply if banks significantly
increase their lending or investing.oil prices that could be viewed as temporary) and not a
persistent rise in inflation above the FOMC’s inflation objec-
tive. This possibility further increases the likelihood that
the FOMC may be slow to respond.
A third reason for concern is that employment growth
is uncharacteristically slow during this recovery. At 15
months past the recession’s end, employment is only slightly
above its post-recession trough. Consequently, employment
likely will remain below its pre-recession peak much longer
than it did after either of the two previous recessions.6 If
employment remains significantly below its pre-recession
peak and the unemployment rate stays historically high,
the FOMC may be particularly reluctant to move quickly
if money growth were to accelerate sharply or, perhaps,
even if inflation were to rise somewhat above its implicit
inflation objective. 
A fourth reason is related to the third. Specifically, the
FOMC may be concerned about the adverse effects on the
financial market from selling large amounts of government
securities quickly. This concern will make the FOMC less
likely to engage in large-scale asset sales and is likely to be
intensified if employment growth is slow and the unemploy-
ment rate high.
Of course, the FOMC could attempt to impound the
excess reserves by paying market interest rates to banks
for holding them. However, this could be very expensive
and significantly reduce the Fed’s earnings. Indeed, because
the banks would be making loans that are not default-risk-
free while the Fed would be earning interest on default-risk-
free government debt, it is possible that the Fed would have
to pay a higher rate to entice banks to hold reserves than
it would earn on its holdings of government securities.
More  over, paying banks a large amount of interest to hold
reserves might be viewed as providing banks with an unwar-
ranted and undeserved subsidy.
Given that additional quantitative easing may have
only modest effects on economic growth, employment, or
inflation and the potential to significantly exacerbate the
FOMC’s problems when the time comes to restore its bal-
ance sheet to a more normal configuration, it is easy to
understand the considerable disagreement about the desir-
ability of such a policy. At least one policymaker, Kansas
City Fed president Thomas Hoenig, believes the potential
benefits are likely to be smaller than the potential costs.7 ■
1 Thornton, Daniel L. “Would QE2 Have a Significant Effect on Economic Growth,
Employment, or Inflation?” Federal Reserve Bank of St. Louis Economic Synopses,
No. 29, October 13, 2010;
http://research.stlouisfed.org/publications/es/10/ES1029.pdf.
2 For two other potential problems not discussed here, see Plosser, Charles I.
“Economic Outlook.” Presented to the Greater Vineland Chamber of Commerce,
Vineland, NJ, September 29, 2010; www.philadelphiafed.org/publications/
speeches/plosser/2010/09-29-10_vineland-chamber-of-commerce.cfm.
3 Thornton, Daniel L. “Negating the Inflation Potential of the Fed’s Lending
Programs.” Federal Reserve Bank of St. Louis Economic Synopses, No. 30, July 1,
2009; http://research.stlouisfed.org/publications/es/09/ES0930.pdf. For example,
the effective reserve requirement is approximately 5 percent. Consequently, a
reduction in excess reserves of $100 billion could increase M1 by as much as $2
trillion; however, the increase would occur if the public significantly increased
its holding of currency. 
4 See Wheelock, David C. “The Monetary Base and Bank Lending: You Can
Lead a Horse to Water…” Federal Reserve Bank of St. Louis Monetary Trends,
September 2010;
http://research.stlouisfed.org/publications/mt/20100901/cover.pdf.
5 The Fed has also considered paying banks to hold reserves in the form of “term
deposits,” which is, in effect, very similar to paying interest on excess reserves.
6 Employment did not return to its pre-recession peaks for 23 and 39 months,
respectively, after the 1990-91 and 2001 recessions.
7 Hoenig, Thomas M. “The Federal Reserve’s Mandate: Long Run.” Presented at
the National Association of Business Economists Annual Meeting, Denver,
Colorado, October 12, 2010; 
www.kansascityfed.org/speechbio/hoenigpdf/nabe-hoenig-10-12-10.pdf.
Economic SYNOPSES Federal Reserve Bank of St. Louis      2
research.stlouisfed.org
Posted on November 10, 2010
Views expressed do not necessarily reflect official positions of the Federal Reserve System.

The downside of quantitative easing

http://research.stlouisfed.org/publications/es/10/ES1034.pdf

The downside of quantitative easing

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