A Lookback at the Financial Crisis - Monetary Policy and Inflation
Nearly a decade ago, our Federal Reserve Board of Governors (the Fed) engaged in an aggressive monetary expansion operation, which we all knew as Quantitative Easing or “QE.” To avert what many saw as the next Depression, the Fed bought trillions of dollars in U.S. Treasuries and mortgage-backed securities from December 2008 to October 2014; thereby lowering long-term interest rates, stabilizing markets, and encouraging lending. The Fed printed vast amounts of money to make these purchases on the secondary market. Within a couple years, the Fed had trillions of dollars in new assets on its balance sheet. Many pundits were alarmed and warned that this would cause rampant inflation.
Why did this inflation fear not materialize? We took a look at the dynamics of the Fed’s balance sheet in an attempt to explain the answer.
The overlying concept is rather simple –
The Fed made these massive debt purchases from many of the big banks, like JP Morgan and Goldman Sachs. In turn, these big banks immediately took their proceeds and reinvested them back into what we could call a Fed “savings account” at a favorable rate of interest. So, the trillions of dollars in newly printed money by the Fed did not hit secondary markets en masse. The paper airplane just flew around in a circle and landed back in the hands of the Fed! The Fed paid a “teaser” interest rate to the big banks on their savings accounts, normally about 25bps above the Federal Funds rate, to incentivize the big banks to just keep most of their reserves at the Fed, rather than withdraw them and lend them out to the rest of the financial system. This return, or “interest on excess reserves” slowed the velocity of money into the marketplace. In addition, some of these funds were required as part of financial “stress-testing” where the big banks had to have adequate liquidity, readily convertible into cash during periods of financial stress.
Now, let’s go back to the Fed balance sheet. The Fed bought trillions in securities that sat on the asset side of their balance sheet. But, it was on the liability side of the Fed balance sheet where the excess reserves of the big banks were reinvested and held. This Fed liability went from zero in 2008 to over $4 trillion in 2014 (see chart below). So, this massive increase to the money supply did not release the floodgates of currency in circulation. Most of it simply moved from asset to liability on the Fed general ledger. What we see below is a visual interpretation of our story. The money supply and currency in circulation grew steadily over the QE period and beyond, while the excess reserve balance held at the Fed exploded.
Money supply and currency in circulation grew steadily while the excess reserve balance with the Fed skyrocketed
We also see in the chart above how excess reserves have decreased post-QE. The Fed had a solution to wipe out this problem of excess reserves on paper – it would just “destroy” it over time! In essence, the U.S. Treasury makes payments to the Fed for maturing holdings on their books. Then the Fed destroys the reserves since the Treasury’s payments create an asset against a liability to itself – essentially scratching off the holding on the ledger.
This Fed ecosystem of monetary policy probably assured Ben Bernanke, the Fed Chair from 2006 to 2014, that inflation would remain tame during this crisis. So, what resulted was the intended consequence of driving down long-term interest rates, stabilizing markets and eventually encouraging lending again. The absolute result was anything but perfect, and the new Fed Chair will have to contend with how to continue gradually winding down this excess reserve balance over time.