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.


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