Like Quantitative Easing, lower reserve requirements lead to an increase in the money supply. If the reserve ratio falls, then the same amount of reserves can support a larger amount of checkable deposits. At the lower reserve requirement, the same monetary base can support a larger money supply. There are several perceived benefits to reducing reserve requirements. Reductions in reserve requirements can quickly solve liquidity problems for banks with insufficient reserves. Furthermore, changes in the reserve requirements affect all banks equally. This means lowering reserve requirements is an effective way to temporarily relieve the Eurozone banking system’s systemic liquidity problem.
Much like QE, a lower reserve requirement leads to lower interest rates. A lower reserve requirement reduces the quantity of reserves demanded. The interest rate on overnight loans of reserves between banks will fall. Reducing reserve requirements is meant to stimulate overnight, interbank lending. The interbank lending market in Europe has frozen up, and ECB officials hope reducing reserve requirements will encourage interbank lending. Reserve requirements are not typically used as a policy tool. Changes in reserve requirements have an extremely powerful effect on the money supply. Central bankers typically try to affect the money supply only gradually, and it is difficult to engineer small changes in the money supply with reserve requirements.
A quick example will illustrate the powerful inflationary impact of reducing reserve requirements. For perspective, let’s compare the inflationary impact of the ECB reserve requirement cut to QE2 in the U.S. The U.S. banking system had reserves of $1,038 trillion prior to QE2. With a 10% reserve ratio, this level of reserves could support $10,380 trillion of checkable deposits. QE2 increased reserves U.S. by $600 billion to $1,638 trillion. With a 10% legal reserve ratio, the post QE2 level of reserves can support $16,380 trillion of checkable deposits. QE2 could potentially lead to an increase in checkable deposits of 57.8%.
The Eurozone banking system currently has €400 billion of reserves. €400 billion of reserves with the former 2% reserve ratio could support checkable deposits of $20 trillion. Cutting the reserve requirement from 2% to 1% means €400 of reserves can support $40 trillion of checkable deposits. The ECB’s cut means the same €400 billion of reserves can support twice as many checkable deposits. To summarize, QE2 could potentially lead to an increase in checkable deposits of 57.8% in the U.S. In contrast the ECB’s reserve ratio cut could potentially lead to an increase in checkable deposits of 100%. This means the ECB’s reserve ratio cut has far more inflationary potential than QE2.
U.S. banks have not drastically expanded checkable deposits since QE2. This doesn’t mean that QE2 won’t be wildly inflationary. Similarly, it’s unlikely that the European banks will immediately expand checkable deposits. Again, this doesn’t mean that cutting the reserve requirement in half isn’t wildly inflationary. The reserve requirement is a powerful monetary policy tool. It’s so powerful that central banks rarely use it. The ECB would not have used this powerful tool if they wanted only a minor effect. The ECB’s recent action to reduce the reserve requirement is wildly inflationary. In fact, it has the potential to be much more inflationary than QE2. The ECB’s move to cut the reserve ratio in half is bullish for hard assets like gold and silver.
