The following is a response from Peter Stella, former chief of monetary and foreign exchange operations at the IMF on the subject of reserve requirements and whether or not they pose an inflationary or credit expansion threat.
The note was penned as a response to an article by Jeremy Siegel, the Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania, in the FT calling for the Fed to raise reserve requirements.
In short, Stella feels Siegel is a little bit confused.
Excess bank reserves are no more likely to cause credit expansion than full tanks of petrol cause driving.
Similarly, requiring drivers to always maintain a petrol tank at least half full is neither an efficient nor effective way to curtail miles driven. Any sound microeconomic textbook will explain why, in general, using the price system (taxes or tariffs) is superior to quantitative rationing (quotas or coupons). That is why central banks in developed countries have virtually always used interest rate policies to indirectly influence macroeconomic variables whether their targets were credit, inflation, or broad monetary aggregates. The only significant experiment with using reserve requirements as a tool was undertaken by the Federal Reserve in 1936-37 and was associated with the most sudden and severe recession in US history.
Jeremy Siegel, in a March 27 Financial Times Markets Insight article advocating raising reserve requirements, refers to “All textbooks on money and banking…” as evidence that reserve requirements are one of the “three principal policy options” open to central banks. While it is true that most (though not all) money and banking texts rely on the money multiplier as a key pedagogical device to explain how commercial banks create money and then go on to extend this framework to “explain” how monetary policy works, those that do are simply wrong.
An individual bank extends credit based on a myriad of factors, but not one of them is whether the bank holds enough deposits at the central bank. This is because central banks do not ration reserves, they provide them on demand to banks at the monetary policy rate. When aiming to restrict credit growth, central banks raise their policy rate. This impulse is then transmitted through the yield curve with an immediate impact on the price and quantity of loans extended. Similarly, apart from brief periods such as the weeks following Hurricane Sandy, no driver in the US contemplates the probability that their local filling station will have gasoline on hand when they come by to fill up. The decision on when, whether and where to drive certainly depends on the price of gasoline but, in the absence of quantity rationing, never on its fundamental availability.
One to file in our expert monetary commentary confusion box.
Worth reiterating Anat Admati’s point again as well, which of course is that reserves do not equal capital.
Related links:
The base money confusion - FT Alphaville
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