What Is Inflation, and What Is Its Real Rate?

There’s no one-click way to figure out what that graph means by “cash” (it’s certainly more than just their holdings of printed dollar bills), but I believe I found the explanation on the Federal Reserve’s website:

“Includes vault cash, cash items in process of collection, balances due from depository institutions, and balances due from Federal Reserve Banks” (footnote 21 in https://www.federalreserve.gov/releases/h8/current/)

I think that last means it includes deposits at the Fed, which since 2008 pay interest. That would be part of the explanation: banks now earn interest on that “cash”, so keep more of it than before.

If that earning of interest strikes you as a pure political giveaway to banks, well, that’s basically the official rationale, too. They were kind of feeling sorry for banks in 2008, and it was argued that it was unfair for banks not to be able to earn money on their required reserves. (If we were to follow that sort of logic generally, other industries too would have the government pick up the tab for all the regulatory burdens it imposes: the FDA would be paying for drug companies’ safety studies, for instance.)

3 Likes

Traditionally, banks were required to deposit a fraction of their “net transactions accounts” with the Federal Reserve under the “Reserve Requirements” regulation. The Federal Reserve explains this in a “Policy Tools” document last updated on 2022-01-04.

Prior to the change effective March 26, 2020, reserve requirement ratios on net transactions accounts differed based on the amount of net transactions accounts at the depository institution. A certain amount of net transaction accounts, known as the “reserve requirement exemption amount,” was subject to a reserve requirement ratio of zero percent. Net transaction account balances above the reserve requirement exemption amount and up to a specified amount, known as the “low reserve tranche,” were subject to a reserve requirement ratio of 3 percent. Net transaction account balances above the low reserve tranche were subject to a reserve requirement ratio of 10 percent. The reserve requirement exemption amount and the low reserve tranche are indexed each year pursuant to formulas specified in the Federal Reserve Act (see table of low reserve tranche amounts and exemption amounts since 1982).

And what was that change on 2020-03-26? Well…

As announced on March 15, 2020, the Board reduced reserve requirement ratios to zero percent effective March 26, 2020. This action eliminated reserve requirements for all depository institutions.

Explaining, in the linked document:

For many years, reserve requirements played a central role in the implementation of monetary policy by creating a stable demand for reserves. In January 2019, the FOMC announced its intention to implement monetary policy in an ample reserves regime. Reserve requirements do not play a significant role in this operating framework.

In light of the shift to an ample reserves regime, the Board has reduced reserve requirement ratios to zero percent effective on March 26, the beginning of the next reserve maintenance period. This action eliminates reserve requirements for thousands of depository institutions and will help to support lending to households and businesses.

So, the Federal Reserve administers a fractional reserve banking system. And since early 2020, the fraction is…zero.

5 Likes

I wonder who they think they can stick the MBS they purchased recently when home prices had skyrocketed? Well they say they are all good because the no, no, no loans were not given this time around. These are solid folk on the other side.

However, I lived through the boom, bust in Austin Texas in the late 80s. When peoples house drop 30 percent. They walk. It isn’t a matter of ability to pay. It is a matter of why would they pay for something that lost all that value. Credit rating be damned.

Today is credit rating a thing? I know people that defaulted on home loans and a few years later qualify for a home loan.

I wouldn’t touch a MBS at this point after watching my home value skyrocketed the last two years.

Central planners were not thinking about thinking about raising interest rates. I guess that means they were also not thinking about thinking about the impact of rising interest rates on their portfolio of loans.

4 Likes

The Fed doesn’t have to worry about people defaulting on the MBS they bought. Fannie and Freddie are the entities that have to worry: they guaranteed the damn things. Not that this is a real worry: the government will bail them out again if it comes to that.

Of course, keeping this sort of nonsense up long enough leads to national bankruptcy, and everybody has to worry about that. I believe the last time the dominant power of its day went bankrupt was the French Revolution. Not a pretty scene.

7 Likes

One thing about reserve requirements which took me a while to grok was that they’ve largely been replaced by capital requirements. The difference is that with reserve requirements, for every hundred dollars someone deposits with you, you have to set aside (say) fifteen dollars of it as a reserve and not lend it out. With capital requirements, for every hundred dollars you loan out, you have to set aside (say) eight dollars of your own money (not customer money) as a reserve.

So yes, reserve requirements are at zero, and in the traditional expansion-of-money formula this results in division by zero, meaning infinite money. But capital requirements are still there, and prevent this.

Another difference is that reserve requirements are simple and mechanical, while capital requirements involve having to keep track of the real value of all the loans you’ve made. They thus require vast compliance staffs, on the banking side trying to figure out how to game the rules to minimize the amount of required capital and on the government side trying to figure out what games are being played on them. Truly the right sort of regulation for our post-modern era.

7 Likes

By the way, I wrote more on this stuff (and put it in better context) in my book review of the best history book ever written:

https://yarchive.net/blog/macaulay/

No easy answers; I refer to it as a trillion dollar unsolved problem.

4 Likes

I am trying to grok it myself. My most recent class on money and banking was a couple years ago when I was an undergraduate student. At the time, the Fed still maintained a reserve requirement. Since the Fed has abolished this requirement, the “money multiplier” that we used in our formulas is no longer a useful concept. We didn’t talk much about capital requirements but it’s apparent they are key to understanding how the modern banking system works. I would be grateful to learn of resources that can explain this.

Edit: In your (excellent) review, you write:

The two requirements cover different risks: reserve requirements cover the risk of a sudden cash drain, while capital requirements cover the risk of loans going bad.

Now that the Fed has abolished the reserve requirement, what insurance do the banks have against sudden cash drain? Earlier I posted about how U.S. commercial banks are holding lots of cash. I suppose that’s something. But rather than being a legal requirement, the banks are holding cash because they are incentivized by interest payments on their deposits at the Fed. Then I wonder if the Fed is paying the banks to keep the cash out of circulation to keep prices down and obscure inflation.

4 Likes

Now that the Fed has abolished the reserve requirement, what insurance do the banks have against sudden cash drain?

With banks being federally insured, there’s no real reason for a run on them. So they only need to keep as much physical cash as is convenient, and if they run out can tell customers “oops, sorry, we’ll have more tomorrow” without any risk of those customers getting scared that the bank might be insolvent. As for the electronic sort of cash, I’m guessing they can get more of that quickly if necessary, though I don’t know the precise details.

I’m not aware of any great overview of capital requirements. But maybe start with https://en.wikipedia.org/wiki/Basel_II.

Oh, and this is the sort of thing that happens when they get it wrong:
https://www.youtube.com/watch?v=Hhy7JUinlu0.
This in particular is referring to capital requirements:

“But the key factor here is, these are essentially just mortgages, so that has allowed us to push the leverage considerably beyond what you might be willing or allowed to do in any other circumstance, thereby pushing the risk profile without raising any red flags.”

5 Likes

Based on the Fed testimony, it sounds like they have a half trillion of losses in their MBS so far. Earlier they made 1 trillion that went to the government and promptly spent. Now the 1/2 trillion plus future losses will go to the government. I would say the taxpayers, but in reality in the deficit system, the taxpayers (being voters) will not pay.

The loss will be absorbed by issuing more bonds that the Fed purchases.

The payment comes when the USD blows up. Then the taxpayers, the non-taxpayers … everyone will pay.

5 Likes

Based on the Fed testimony, it sounds like they have a half trillion of losses in their MBS so far.

I’m guessing those are not defaults but rather mark-to-market losses. In other words, because interest rates rose, the market value of older (low-interest-rate) bonds decreased. (And interest rates rose because of inflation.)

If so, they don’t actually have to do anything about this. The bonds are still there and will still eventually pay off the same number of nominal dollars. It’s just that if they did sell them right now, they’d have a loss.

(Bond values, particularly those of longer-term bonds, are very sensitive to interest rates. Consider a ten-year bond paying 2% versus a ten-year bond paying 4%. Compounded over ten years, 2% becomes 22% while 4% becomes 48%. So interest rates going up 2% makes for an 18% decrease in the value of the bond. (Those numbers assume the bond pays off all at once at the end; for the common case of periodic interest payments the calculation is a bit more complicated and the decrease smaller, but the sensitivity to interest rates is still high.))

5 Likes