Friday, September 26, 2008

Money is plentiful

Bank reserves are the foundation of our monetary system. The Fed controls monetary policy by targeting the rate at which banks lend reserves to each other. They do this by adding or subtracting reserves from the system. In the past week or so, the Fed has added a gigantic amount of reserves to the system, as shown in this chart (the last data point is my estimate based on the recent expansion of the Fed's balance sheet). The amount of reserves they have dumped into the system of late dwarfs the action they took in the Y2K and 9/11 crises. This is a big deal.

Is this inflationary? Potentially, yes. However, since most of the increased reserves can be attributed to a surge in the demand for reserves on the part of banks trying to shore up their liquidity position, the Fed is simply supplying extra money in order to meet extra demand for money, and this is not inflationary. On balance, however, it appears that the Fed has added excess reserves to the system, and that is how inflation can really get going. How do I know this? Since the injection of extra reserves, the Federal funds rate has consistently traded below its target, reflecting an excess of funds in the system. Also, the dollar has weakened, gold has strengthened, and short-term interest rates have collapsed.

It appears the Fed is already trying to reverse its injections of reserves, so there is no reason yet for great alarm. We need to watch this however. Meanwhile, the chart underscores the gravity of the current crisis and the extent to which the Fed is trying to alleviate the pressures in the banking system.

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