Are Banks “Reserve Constrained”?

On Friday we discussed transactional money, and I showed two different measures of the money supply, M1 and M2. These both represent transactional money, with M2 being a slightly broader measure.

Today we're going to go over another measure of the money supply, known as the monetary base (MB). Those of you who enjoy discussing the Fed (myself included) may get a kick out of this one, because this is where all that wonderful QE comes into play.

Let's start with a chart. This is perhaps the most frequently presented chart regarding the money supply, and I've read many books which use this chart as the primary evidence for why our economy is ill-fated. While anything is possible, and I won't rule out the possibility of economic demise, a simple glance at this chart without understanding the larger context is not enough to scare me into getting rid of everything I own that's based in dollars.

If I reminded you that there have been three rounds of QE, could you spot them on the chart above? Moving from left to right, QE1 is represented by the first vertical line and the smaller vertical line just above it. After that we had a small settling period at which point QE2 began, the second of the large vertical lines. After another settling period, we had QE3 or QEternity, which is represented by the final and tallest vertical line. QE has taken the monetary base from about 0 billion to .7 Trillion, nearly a five-fold increase. That's a lot of money creation, and it's continuing as we speak.

So what exactly is the monetary base? And why is it important?

The monetary base is also referred to as base money, high-powered money, or reserve money. Its standard definition is the portion of commercial bank reserves that is maintained in accounts with the central bank, plus the total currency circulating in the public (including vault cash). The monetary base can be thought of as representing the liabilities of the Federal Reserve; however, it may be easier to think of the monetary base as simply the amount of central bank reserves.

[Hear More: Ronald Stoeferle: Monetary Tectonics - The Tug of War Between Inflation and Deflation]

In previous articles we talked about how money can multiply from an initial sum into much more, as a byproduct of fractional reserve banking and low reserve requirements. You can think of the monetary base as the amount of starting money upon which further "multiplication" can take place. This interpretation is partially what leads many to worry about a tremendous expansion of the money supply. However, a more detailed understanding of how central bank reserves function is needed before we can begin to support or deny that claim.

First, some background on central bank reserves. Reserves in the banking system can be changed in three, and only three, ways:

1. Through the purchase (or sale) of assets via open-market operations or (more recently) quantitative easing. When assets are purchased, new reserves are created from thin air and these new reserves increase the total amount of central bank reserves. Asset purchases and sales represent the overwhelming majority of changes to the amount of central bank reserves in the system.

2. The public changes the amount of cash (Federal Reserve Notes) it wants to hold. If the public wants to hold more cash, this extra cash is offset by an equal reduction in central bank reserves. This factor is of little significance in determining the amount of reserves in the banking system.

3. The government changes its deposits at the central bank by either receiving or transferring funds from the private sector. This will be discussed in more detail later. It is also of little significance regarding the overall level of reserves in the banking system.

Now as to why the monetary base, or amount of central bank reserves, is important:

When we discussed commercial bank money creation, we looked at the credit creation process and how it literally creates deposits out of thin air. As long as banks have sufficient reserves, or can attain sufficient reserves to back the deposits they create, this process of money creation can continue unabated. Well, the monetary base is what supports the much larger volume of commercial bank money that is created as businesses and individuals take out loans. In a simplified system in which a commercial bank must maintain a 10% reserve ratio, every of monetary base (central bank reserve) money has the potential to turn into of commercial bank money.

[See: Former Fed President Admits Central Banking, Paper Money a "Confidence Game"]

As we get into more details about the monetary base, it will be helpful if you are familiar with another chart. Below you can see the amount of Excess Reserves within the banking sector. At first glance, you will notice that this chart looks similar to the chart of the monetary base above, but with some very important distinctions.

The first thing I'd like to go over is the time period leading up to the first round of QE. A follow-up article will discuss how things have changed since QE was introduced.

In the chart above of excess reserves, you will notice that up until QE began, there were never any excess reserves in the banking system. This means that every dollar of central bank reserves was considered "required reserves" because it was needed to back deposits which had been created by commercial banks.

It is common to assume the following order of operations regarding money creation:

  1. Central bank increases the amount of reserves in the system
  2. There are now excess reserves in the system
  3. Commercial banks extend loans (create deposits) until all of their new "excess" reserves are now "required" reserves

This thought process is what leads many to the notion that commercial bank lending is "reserve constrained." Meaning as long as the central bank doesn't increase the amount of reserves, commercial lending (deposit creation) cannot increase past a certain limit. The logical extension of this thought process, looking at the vast amount of excess reserves now in the system from QE, is that banks are now going to be able to create so much money that hyperinflation is inevitable. But if you look closely at the chart above, you can tell from the fact that excess reserves stayed at zero up until QE, that the central bank never added "excess" reserves to the system which weren't already demanded. If it had, the horizontal line in the above chart would not be at zero the entire time until QE began, you would see small blips as excess reserves built up in advance of commercial bank credit creation converting them to "required" reserves.

So we know that the logic above is flawed, and the problem lies with the order of operations outlined above. Here's the real order of operations:

  1. Banks extend loans (create deposits) based on their own objectives, risk tolerances, and cost of capital
  2. Banks seek out reserves (if needed) to back their newly created deposits.
  3. Central bank adds reserves to the system (if needed) to appropriately maintain the target federal funds rate

This is a drastically different process than the first outlined above, and more accurately represents how an interest-rate targeting central bank (which the Federal Reserve is) operates. If the Fed has determined it wants to have the federal funds rate set at a certain level, it MUST add or decrease reserves to achieve that rate. Here are the two basic scenarios at play when there are no excess reserves in the system:

1. Banks extend credit at a faster rate than loans are being repaid. This increases the deposits for these banks and consequently forces them to have to borrow reserves. They look to other banks but other banks do not have excess reserves, and so are not interested in lending out their required reserves because they would have to adjust loans and deposits accordingly to meet their reserve ratio. There is more demand for reserves than there is supply. Thus the banks compete for these reserves, driving the federal funds rate up. If the central bank wants to maintain its target rate, it MUST add reserves to the system. This balances out supply with demand, and the federal funds rate stays near target.

2. Banks extend credit at a slower rate than loans are being repaid. This decreases the deposits for these banks and consequently leaves them with excess reserves. Since there is no need for these excess reserves, banks are happy to lend them to other banks at whatever rate the other banks are willing to pay. In this case we have more supply than demand, and so the federal funds rate would fall. Again, if the central bank wants to maintain its target rate, it MUST decrease reserves in the system. This once again balances supply with demand so that the federal funds rate can stay near target.

So in conclusion, commercial banks are never "reserve constrained" in the sense that their lending is limited by the amount of reserves in the system. The only thing that constrains them is the cost to obtain those reserves (the federal funds rate) which is managed by the Fed. Ultimately, the Fed will do whatever it needs to, from a reserve perspective, to maintain its target. It's done so for its entire existence and is likely to continue doing so for the foreseeable future.

Next time we'll analyze the QE components of the above two charts, discuss how QE integrates into the other measures of the money supply, and talk about how the game has changed now that the banking system is packed full of excess reserves.

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The above content was an excerpt of Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.

About the Author

Chief Investment Strategist
matt [at] modelinvesting [dot] com ()