Fed Balance Sheet and Inflation
Good piece on Econobrowser –thank you, Yves Smith–on how the Fed is trying to square what is, to many people, an apparent circle. May be tough going for some, but it’s worth it
October 25, 2008
The Federal Reserve’s balance sheet
On Thursday, the Federal Reserve issued its weekly H.4.1 report, which provides details of the Fed’s balance sheet. Once upon a time, this was one of the least interesting of the government’s many releases of data. These days, it’s become one of the most exciting.
The essence of the Fed’s balance sheet used to be quite simple. The Fed’s primary operations would consist of either buying outstanding Treasury securities or issuing loans to banks through its discount window. It paid for these transactions by creating credits in accounts that banks hold with the Federal Reserve, known as reserve deposits. Banks can turn those reserves into green cash any time they desire, so the process is sometimes loosely summarized as saying that the Fed pays for the Treasury bills it buys or loans it extends by “printing money”. Before the excitement began, the Fed’s assets consisted primarily of the Treasury securities it had acquired over time (about $800 billion as of August 2007) plus its discount loans (an insignificant number at that time). Its liabilities consisted primarily of cash held by the public (about $800 billion a year ago) plus the reserve deposits held by banks (which again used to be a very small number).
Bernanke’s overriding goal since then has been to extend a huge volume of short-term loans to financial institutions. If he’d done that in the usual way, just creating new reserve deposits with each new loan, the supply of cash would have ballooned, bringing worries of inflation. The Fed didn’t want to do that, and in fact there was no shortage of funds available for overnight interbank lending. The fed funds rate, an average overnight lending rate between banks, is already quite low, and further reductions seem unlikely to accomplish much. But longer term interbank lending rates remain quite high relative to the overnight rate.
Bernanke’s first approach to this challenge was to “sterilize” the new loans from the Fed…
