Excess Reserves

During the fall of 2008, the big banks were bailed out.  They were bailed out by Bush, Congress, and the Federal Reserve.  The Fed more than doubled the monetary base in a short period of time.  This was a unique event in modern American history.

The massive increase in monetary inflation did not translate into massive price inflation.  The money that was created by the Fed went to the banks.  The banks have held this money as excess reserves.  Normally, the banks are only required to hold about 10% of deposits in reserve.  The other 90% is lent out.  If a bank dips below the 10% requirement, it borrows money at the overnight rate.  This is the Fed funds rate that is talked about so often.  Because most banks don't have to borrow to meet their reserve requirement these days, the Fed funds rate is near zero.  The Fed says it is holding the rate near zero, but it is really the excess reserves held by banks that is keeping the rate near zero.  With massive excess reserves, most banks don't have to worry about falling below the reserve requirement right now.

Since this money created out of thin air has been parked at the banks, it has not resulted in massive price inflation.  The money is not being lent out or spent.  It is also preventing the fractional reserve process from taking place.  In normal times, somebody would deposit, let's say, $1,000.  Knowing that only a small number of people show up at any given time to withdraw money from their account, the bank would lend up to 90% of deposits.  In this case, the bank would lend out $900.  This $900 might end up in another bank and this bank would lend out 90% of $900 or $810.  This process keeps going.  This is fractional reserve banking.  It keeps going unless a lot of people start showing up at the bank to redeem their money.  This is a run on the bank.  The FDIC was created in the 1930s to protect people's money.  This has prevented runs on banks (for the record, I'm not saying this is a good thing).  The fractional reserve process can also be reversed if banks stop lending money.

Two years ago, the Fed did something unusual, besides the massive increase in the monetary base.  The Fed bought mortgage backed securities instead of U.S. government bonds.  All or most of these mortgage backed securities were probably high risk loans.  Due to the popping of the housing bubble, there are a lot of bad loans that people can't or won't pay.  The Fed bought these for more than what they were worth.  This money went directly to the banks that used the money to increase their reserves.  The banks are probably scared to lend out this money because of what potentially lies ahead.

The next round of quantitative easing (QE2) involves the Fed buying $600 billion in U.S. government bonds.  This is a different scenario than buying mortgage backed securities.  However, this money could still end up parked at the banks.  Even if this newly created money went into the hands of average Americans, they will deposit it at a bank.  If the bank keeps this money on deposit and doesn't lend any of it out, excess reserves can still go up more.  This would again prohibit the process of fractional reserve lending.  It would prevent a quick jump in prices.

This is a possibility, but it is also just as possible that this newly created money won't sit at the banks.  This is what we need to watch.  If the excess reserves don't increase with what is supposed to be an increase in the monetary base coming up, then we should expect high price inflation within a relatively short period of time, say a year.