Fed Musings /2

The only way to have a chance at implementing the inflation mandate is to have complete control over either one side or both the demand and supply side of currency. Although the Fed as agent of the department of treasury and in theory is the issuer of currency in the US and therefore should have a supply side monopoly on currency creation, there is a fly in the currency creation ointment. As per MMTs horizontal and vertical currency concept the Fed does not appear have material control, or chooses not to materially control the fractional reserve lending system, let alone the shadow banking system. Government can try to regulate the minimum reserve requirements (although they can be, and are circumvented through a number of pathways) but the government (yet) cannot impose maximum reserve ratios (force banks to lend a certain minimum amount visa viz their reserves). Whether commercial banks use a fractional reserve of 10% of 12% has a very significant impact on the actual number of currency units floating around in the economy and the Fed has no direct control over it although it can has a number of tools which in the short term can increase or decrease the amount of money in the system.

All this puts commercial banks in the de facto position of issuers of the currency. When you go to a bank for a loan the money which the bank puts into your account does not exist until the bank creates it out of thin air and “lent” it you. In other words, that commercial bank created more currency units without a corresponding increase in goods and services to maintain the currency’s value. As long as you don’t use the newly deposited money now sitting in your checking account to buy goods/services you won’t be creating inflation but that is unlikely because one generally does not take an interest bearing loan without the a probability of spending the money of greater than zero. In the meanwhile the banking system charges the borrower interest on money on which in effect it only pays interest on 10% of the balance and the other 90%, which the banking system wished into existence, it pays net zero.  As a numerical example, if you go to the bank and borrow 1000 at 4% the bank does not pay a depositor say 2% on 1000. Because of the magic of fractional reserve banking the banking system pays a depositor 2% on 100 and charges the lender 4% on 1000. The missing 900 was in effect pulled out of thin air at zero cost to the bank. To be clear, one has to look at this on a system basis, not an individual bank basis. Just looking at the interest, for the 1000 loan it receives 40 in interest and pays 2 to the depositor.

Net Interest Margin, or NIM in short then is a deceiving measure because it doesn’t equalize for dollar amounts but for percentages.

As a suggestion then in fractional reserve banking then one theoretically should be able to borrow and lend at the same rate as the fractional 90% at zero cost provides the profit margin.

 

As an aside, inflation is similar to obesity in that a large pantry does not make you fat, but consuming its contents faster than one uses the energy content does. Money is similar that way; as long it is not used to buy goods/services there won’t be upwards pressure on prices. And that is why the Federal Reserve pays interest on reserves; as long as the money is parked at the Fed not too much money is chasing goods/services, thereby containing the quantity of money available to buy goods/services. It is likely though that at some point those reserves will no longer be parked at the Fed at which point roughly 10 times that amount will be available, although not necessarily used, for investment/consumption.

 

Zero inflation in a complex economy is difficult to achieve because there are so many different moving parts both on with respect to the demand for goods and services as well as the combined currency supply of the Fed and commercial banks. As the quantity of goods and services changes continually the money supply in an ideal world would change in the same amount at the same time. That is highly unlikely to happen. Take a look at BEAs GDP series – the Q/Q gyrations are significant and it would be impossible to match the quantity of money in real time.

Human activity is by nature deflationary. Whatever we humans do, we will try to do it better/faster the next time we do it. And generally we succeed. The change from one try to the next may not be necessarily significant but even a 1% improvement adds up quickly.