The Fed has one last ace up its sleeve
Nobody's talking about it though because it's ugly
Note (written in early August, after this piece was published): This piece is highly simplified, and in practise, reserves (given the current situation) do not play a meaningful role in getting inflation down. Effectively, it does not matter if the reserve requirements ratio is 0%, or if it’s 10%. We are way past a time when that mattered. Should you be familiar on this topic and want a more precise look, I recommend reading Joseph’s article on the money multiplier myth here. After all, he is the “Fed guy”.
Note: Do consider reading Brandon’s piece here. It’s well worth the five minutes, and in fact inspired the piece you’re reading now.
9.1%. The highest inflation in 41 years.
Whereas disinflation and deflation were the concerns at the beginning of the pandemic, fast-forward two years, the turns have tabled. Inflation is out of hand.
In response, the Fed has activated two of its tools in managing inflation. First: Interest Rate Hikes. Second: Quantitative Tightening. And yet there is a third tool that nobody’s paying attention to. A third ace up the Fed’s sleeve.
And this is the reserve requirements ratio.
The section below will be for people unfamiliar with the idea of the reserve requirements ratio. If you’re aware, feel free to skip this portion — just scroll down to the picture of an ace.
There are two parts to understanding how the reserve requirements ratio works. First, in terms of how it impacts money creation. And second, in terms of how the Fed goes about adjusting the ratio in practice.
First, on how reserve requirements impact money creation:
When you borrow money from a bank, the bank isn’t simply moving money it already has into your account. Instead, it’s just creating that money (out of thin air) and crediting the money into a new account. Now, you own that account. And you’re now free to use that money.
So money creation isn’t something purely done by the Fed. It’s very much also done by commercial banks.
Where the reserve requirements ratio comes in is in setting a limiter on how much money commercial banks can create. For example, if the reserve requirements ratio is 10%, banks can only loan out a newly created $100,000 if they have $10,000 on hand.
On the mechanics of how the reserve requirements ratio is changed:
You might be inclined to think that the Fed just changes the numerical ratio based on vibe. For example, at the moment, the Fed wants to slow down inflation, right? So perhaps the Fed simply raises the reserve requirements ratio to 20%.
This is WRONG. It’s a little more roundabout.
The Fed used to have thresholds beyond which a specific requirements ratio was applied. For example, in 2019, if a bank held more than $16.3 million, every dollar created thereafter required 3 cents in the vault. In other words, a 3% reserve requirements ratio was applied. Every dollar created beyond $124.2 million in holdings had a 10% reserve requirements ratio applied. So it wasn’t the percentage point that was adjusted. Instead, it was the threshold number.
However, in 2020, that threshold number idea was thrown out of the window. In other words, the reserve requirements ratio was equal to 0% — more on this down below. (It’s worth noting, though, that this doesn’t mean that banks won’t hold any money. And they’ll still only lend if it’s profitable.)
This was a quick and simple explainer. If you want a more thorough one, I highly recommend this classic, here, by Lyn Alden.
We good? OK, let’s get back to the article.
Clearly, at this point in time, the priority of the Fed is to bring down inflation. Many are predicting a 0.75% hike in interest rates. Quantitative tightening is expected to pick up pace. But what about the reserve requirements ratio?
Well, the reserve requirements ratio is currently at 0%. Yes, you heard me right. That means that when the Bank of America loans you $100, it can both create that $100 out of nothing and can keep $0 in vault.
In fact, the reserve requirements ratio has been at zero percent since March 15, 2020. You can find the full press release here and the details, here, at the Fed’s official website.
If this is alarming to you, you’re not alone. We’re seeing the worst inflation in over four decades. You’d think that the Fed would be going hawkish across every channel possible. But instead, a crucial tool a.k.a. reserve requirements ratio is literally at ZERO percent. Even by historical standards, that’s crazy.
However, upon closer examination, keeping the ratio at 0% makes a little more sense.
Firstly, progressive tightening is the Fed’s mantra. They only broke up with “transitory” end of last year and started contractionary policy last month in June. Hit the economy with all three tools and a recession may indeed be inevitable.
Secondly, a reserves requirement ratio change might not be effective enough to justify the potential panic it could cause. A 0% ratio doesn’t mean that all commercial banks are holding zero money, or that they’re lending money out like there’s no tomorrow — banks will still only lend if it’s profitable. But any further tightening announcement whatsoever will cause markets to tumble.
Yet, the fact that this third tool is both kept quiet about and firmly held at 0% tells us two key things.
First: the Fed isn’t a great predictor. This should be obvious by now. They were rather quiet in implementing the 0% back in 2020 even, likely because they weren’t sure if it’d lead to runaway inflation. Now, they aren’t sure how much is enough to reduce inflation without causing a recession. This is why policy is progressive. In my opinion, though, they shouldn’t be rebuked for being poor predictors — nobody’s particularly good at that, especially when making projections for an entire economy. However, they should get flak for conveying a false sense of confidence. There’s some rationale for doing so, but at this point, it’s counter-productive. They are clearly almost as clueless as we are about what’s ahead.
Secondly: be prepared for more ruckus down the road should inflation not slow down. Quantitative tightening hasn’t even really taken off yet (that’s only in September). If QT doesn’t do the trick, expect reserve requirements to change soon enough. If that happens, though, we’re in for some real havoc.
So hang in there, everyone.
Unfortunately, this is a rather solemn piece. I do think, however, that a lot of disruption is poised to happen well into this decade, and much of it has already begun. These can create solutions to many of the more fundamental problems present in the financial system.
But if you’re still solemn, feel free to go and read this story I wrote about Joe Biden at a Walmart — because let’s be real, inflation’s FAR from 9.1%. Or how economists do purchases at McDonald’s. And if you’re feeling optimistic still, good for you! Either way, I hope that you have a splendid week ahead.
Till next time,
Ja Ne!
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P.P.S. I created this newsletter to share, get roasted, and learn along the way. So if there’s anything you feel that I got wrong, or you’ve feedback in general, do let me know in the comments or DM me on Twitter!
Earlier , FED was running stress tests for US banks and prescribed reserve requirements (and other actions) as per results. This was from experience of 2007-8 financial crisis. Have not heard about them recently.