NY Fed’s Dudley tees off on reserve-driven inflation view

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Dudley almost has it.

NY Fed’s Dudley tees off on reserve-driven inflation view

As Dudley notes, the fears of higher inflation expressed in that survey are likely being influenced by the Fed’s balance sheet expansion, which has of necessity increased excess reserves.

The argument that large amounts of excess reserves will fuel credit expansion and eventually inflation goes back to Karl Brunner’s formulation of the money multiplier hypothesis. According to this schema, holding excess reserves – which historically earned zero interest – would entail lost returns relative to holding earning assets. To avoid this cost, banks would seek to lend out excess reserves, thereby increasing credit, economic activity, and price pressures. As Dudley notes, this logic breaks down when reserves become earning assets, as they have since last fall when the Fed began paying interest on reserves.

He is wrong on that part. It does not matter if they are earning assets or not. In no case does reserve availability have anything to do with lending. It is about price, not quantity.

This counter-argument doesn’t excuse the Fed from responsibility for controlling inflation. The Fed still needs to set interest on excess reserves (IOER) rate consistent with a cost of capital that will promote price stability and sustainable growth. As Dudley points out, the IOER rate is effectively the same as the funds rate.

Just my theory, but seems to me they have this part backwards. The way I read it, it is lower interest rates that promote price stability.

In addition to the foregoing argument, Dudley also makes a novel and clever point


about the argument that excess reserves on bank balance sheets are ‘dry tinder:’ “Based on how monetary policy has been conducted for several decades, banks have always had the ability to expand credit whenever they like. They don’t need a pile of ‘dry tinder’ in the form of excess reserves to do so. That is because the Federal Reserves has committed itself to supply sufficient reserves to keep the fed funds rate at its target. If banks want to expand credit and that drives up the demand for reserves, the Fed automatically meets that demand in its conduct of monetary policy. In terms of the ability to expand credit rapidly, it makes no difference whether the banks have lots of excess reserves or not.”

Got that part right, except the Fed has no choice but to allow that to happen.

While the meat of Dudley’s talk centered on conceptual issues regarding bank reserves, he also made some remarks on the economy and policy. On the economy, Dudley sees recovery driven by three forces – fiscal stimulus, an inventory swing, and a rebound in housing and auto sales – but remaining subdued by historical standards for four reasons – a waning of support to personal incomes, ongoing adjustment to lower household wealth, weak structures investment, and a response to monetary policy easing that should be more constrained than in the past. Because the recovery is expected to be subdued, Dudley remarked that concern about when the Fed exits its very accommodative policy stance is “very premature.”

Here he still implies there are grounds for concern when in fact it is a non event.

Just as Dudley gave little indication that policy would be tightened anytime soon, he also reinforced the perception that an expansion of asset purchases is highly unlikely. He did so by noting that there are three costs to purchasing assets: a misperception of the intent of asset purchases that could increase inflation expectations,

He is still in the inflation expectations camp.

a reduction in bank leverage ratios from higher reserve balances which could slow credit growth,

Yes, as I have previously stated, quantitative easing is best understood as a bank tax.
Glad to see that aspect here.

and added interest rate risk on the Fed balance sheet.

Like I said above, he’s almost got it.


This entry was posted in CBs, Government Spending, Inflation, Interest Rates and tagged . Bookmark the permalink.

12 Responses to NY Fed’s Dudley tees off on reserve-driven inflation view

  1. warren mosler says:


    is there a remaining open issuer here?


    JKH Reply:

    no – just clarifying my earlier, and done now.


  2. Dissenting Comments Encouraged says:

    Several financial giants that received federal bailout money in the last year paid out bonuses to employees in 2008 that greatly exceeded the amount of profit generated by the banks, according to a study on executive compensation released by New York State Attorney General Andrew Cuomo Thursday.

    Despite claims by bank executives that bonuses are tied to the company’s performance, the report states that “there is no clear rhyme or reason to how the banks compensate or reward their employees.”

    Cuomo’s investigation “suggests a disconnect between compensation and bank performance that resulted in a ‘heads I win, tails you lose’ bonus system.”

    According to the report:

    • Goldman Sachs, which earned $2.3 billion last year and received $10 billion in TARP funding, paid out $4.8 billion in bonuses in 2008 – more than double their net income.

    • Morgan Stanley, which earned $1.7 billion last year and received $10 billion in bailout funds, handed out $4.475 billion in bonuses, nearly three times their net income.

    • JPMorgan Chase, which earned $5.6 billion in 2008 and received $25 billion from the government, paid out $8.69 billion in bonus money.

    • Citigroup and Merrill Lynch lost a combined $54 billion last year. They received a total of $55 billion in bailouts and paid out $9 billion in combined bonuses. ($5.33 billion for Citigroup; $3.6 billion for Merrill Lynch, which was subsequently acquired by Bank of America.)



  3. Dissenting Comments Encouraged says:

    “If banks want to expand credit”

    The illegal alien loan officer in Miami wanted to expand credit to his illegal alien drug lord cousins. They bought houses and cars and lots of drugs and my girlfriend left me to be with the wealthy high luxury ballers. When I went to the police to complain he was getting big payoffs from those bad loans, when I went to the FBI, they were getting even bigger payoffs from those bad loans – see how the evil spreads? Were is uncorruptable law man? Melvin Purvis G man!

    30 years of honest hard work to achieve something in life getting wiped away from some illegals who cheated. I don’t like your banking system, and how people can infiltrate it from the inside and corrupt it and hurt me and every other honest j6p, william black was right.

    “Agreed any bank can do anything for any reason until the regulators catch up with them.”

    The regulators never catch up with them. R U NUTZ Warren? The regulators and the evil bankers are in the strip club snorting cocaine together laughing at all the suckers the rest of you are. The best way to rob a bank is to own one. Even if the regulators were honest, there are too few to police the system, therefore the system must be redesigned. It is like that recent movie american gangster, the cop that busted the drug lord, went to work as his defense lawyer later on. Howard Hughes, the top CIA investigator assigned by the US government to hinder him later went to work for him. Hank Paulson, toting his bazooka around to save goldman sachs while the rest of us trembled in fear. Whatever you say about price v quantity of reserves takes a back seat to the real world of HUMAN BEINGS that are corruptable, emotional, evil. As long as you have a banking system design that can be corrupted by nefarious humans, it will always fail the rest of us borg.


  4. warren mosler says:

    Agreed on your first point, pricing, as that’s my main point- it’s about price and not quantity.

    Agreed any bank can do anything for any reason until the regulators catch up with them. Regulation sets risk parameters, and banks can legally go no further. Not that some don’t, and not that some do and don’t get caught.

    And the larger problematic credit expansions into questionable realms of risk that I recall were done by the S and L’s in the 80’s and all involved in the sub prime fraud just a few years back, and there weren’t any excess reserves at those times. And then there was Japan with 30 trillion yen of excess reserves for an extended period of time with 0 interest rates, not much loan demand, and no apparent stretching of credit.

    So yes, it’s possible, but not a risk I’d specifically associate with excess reserves.


    JKH Reply:

    That makes sense.

    I agree excess reserves are neither necessary (normal argument) nor sufficient (e.g. Japan) to provoke credit and money expansion, healthy or unhealthy.

    But it’s possible they may act as a catalyst under certain conditions (including extraordinary excess levels, and better than Japan recovery conditions).


    JKH Reply:

    Another way I think about compensated excess reserves is that it’s like forcing the banking system to hold t-bills without forcing individual banks to hold t-bills. Once the system gets revved up back to some kind of normal credit and money process, it seems like something’s got to give in terms of desired asset mixes, competitive processes, etc. Some sort of game theory element must come into it when individual banks are not constrained but they know the system is constrained (in terms of asset mix).


    Warren Mosler Reply:

    what happens is that as loan demand picks up banks can switch assets from t bills to loans and therefore not need to increase capital as much as if they just added the new loans.

    if the banking system as a whole tries to do this it can move t bill yields a bit higher to the point they are attractive to the sector that’s the next highest bidder, probably only a few basis points back.


    JKH Reply:

    Agree, but I probably wasn’t clear on my comparison.

    I intended to compare excess reserves to t-bills, only in the sense they now have a broadly similar interest rate and credit characteristic as t-bills. They’re still reserves issued by the central bank, distinct from t-bills issued by treasury. My comparison was as if there were two categories of bills – c-bills issued by the central bank to “replace” current reserves but acting in the same role as reserves, and t-bills issue by Treasury, not serving as reserves, as is currently the case.

    As you describe, when selling t-bills to non-banks in conjunction with expanding credit, there’s both an individual bank and a system advantage in the capital effect. Selling t-bills reduces the incremental capital requirement (i.e. due to the nominal balance sheet capital ratio discipline), compared to adding loans without selling. The marginal capital cost of holding excess bills (however marginal), is moved out of the system to non-bank holders. The t-bills are gone from the system balance sheet.

    By comparison, there’s no similar system substitution effect when individual banks attempt to “sell” their excess reserve positions by acquiring other assets. The capital advantage from selling actual t-bills isn’t there, at least at the system level, because the excess reserves can’t be sold out of the system the same way actual t-bills can. The t-bills are still on the system balance sheet.

    Nevertheless, individual banks may perceive a marginal capital benefit in selling excess reserves, particularly as economic conditions improve. Individual banks may attempt to move their reserves and associated nominal capital costs to other banks, up to a point. That’s part of my argument as to why extraordinary levels of excess reserves could influence lending volumes marginally. But it’s a zero sum game for the system.

    JKH Reply:

    Above 4th paragraph should read:

    The excess reserves are still on the system balance sheet.

  5. JKH says:

    “It does not matter if they are earning assets or not. In no case does reserve availability have anything to do with lending. It is about price, not quantity.”

    Beg to differ, just slightly.

    First, reserve availability has something to do with pricing. $ 800 billion in excess reserves would trap the Fed funds rate at zero forever, unless the Fed paid interest on reserves when it wanted a higher Fed funds rate. Interest on reserves is an extension of the Fed funds rate. So reserve availability at the macro level affects the pricing of the risk free or near risk free rate in that sense, one way or another, depending on whether interest is paid or not.

    Second, it’s easy to see reserve availability has virtually nothing to do with lending in a “normal” environment. That’s reasonably straight forward. It’s not so clear in an $ 800 billion excess environment. In a normal environment, the average expected excess reserve holding for individual banks is pretty close to zero. That can’t be true in an $ 800 billion environment. So, unlike the normal environment, the excess reserve number starts to affect the asset mix of banks. Individual banks may not want to hold risk free assets at that level. So they start to push the push the envelope on pricing risk, which translates to an effect both on the pricing of risk and lending. This may not be ideal risk management, but there are reasons why it could happen. While reserves as assets are risk free, banks are still motivated by profit, including making a spread against the deposits that were created by the reserves. And reserves eat up nominal balance sheet capital ratios, which people still look at.

    The fact that banks don’t need reserves to lend is one thing. But that doesn’t necessarily mean that a system buried in excess reserves, compensated at the near risk free rate, won’t react to that position to some degree through both the pricing of risk and incremental lending. That may not be good risk and capital management, but it’s easy to think it could happen.


    RSG Reply:

    “While reserves as assets are risk free, banks are still motivated by profit, including making a spread against the deposits that were created by the reserves. And reserves eat up nominal balance sheet capital ratios, which people still look at.”

    If reserves and deposits are created in equal amounts then nominal capital ratios would not be affected.


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