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This chart to the left seems pretty scary. Talk of excess reserves predict apocalyptic inflation, reducing our dollars to tissue paper in the near future. Gold prices are soaring, but why? A big worry is the amount of reserves depository institutions are sitting on right now. Textbooks  give good answers under normal circumstances, such as the money multiplier issue, inflationary pressure later….but we are not quite under normal circumstances now are we? Why are inflationary expectations so low; as a matter of fact are worries of deflation growing, especially in former-inflation-hawks?

First off, why so much excess reserves? The answer is simple: The Federal Reserve. The way the Fed funneled funds to different firms was through these depository institutions, therefore these accounts are actually held by firms such as Bear Sterns in JP Morgan Chase. Also, different vehicles to provide credit and relief increased reserves by default; programs including: “credit programs for primary dealers and other
financial institutions, opened currency swap lines with foreign central banks, purchased mortgage-backed securities guaranteed
by certain government-sponsored enterprises (GSEs), and directly purchased debt issued by housing-related GSEs.”

Under the concept of the money multiplier, a bank with X amount of deposits holds a required amount of reserves, and lends out the rest, “renting” capital to consumers and businesses, thereby growing the monetary base through regular market operations. Therefore, a banking system with towering amounts of reserves above what’s required by the Fed, has money sitting in the vault, not benefiting the bank, the economy, anything.  This is not what the banks want, they have incentive to lend, but when they do, the massive amounts of reserves should theoretically flood the market, therefore generating inflation. This is all under normal circumstances, but like mentioned above, we’re not in Kansas anymore are we?

Textbooks assume that banks do not earn interest on their reserves, therefore they have incentive to lend them out. Except, the Fed has recently been granted the ability to pay interest on reserves, therefore affecting demand of loanable funds, as opposed to the supply through Federal Open Market Operations. Banks are now encouraged to hold reserves more so because of their safety the Fed guarantees at a comparable rate, and grants the Fed more control over the target rate. Therefore, when eventually the Fed needs to target higher rates, they will have more control to do so. Milton Friedman actually argued for the Fed to begin paying interest on required reserves, because without being paid, these reserves are simply a distortion of the market and a tax on banks. The cost effects of the Fed paying interest on reserves is minimal as well; the CBO estimated that these payments will reduce Treasury revenues by about $1.4 billion over the next 5 year period.

Therefore, inflationary worries are remote, and if it rears it’s ugly head, the Fed now has more control to stifle it quickly. But the growth in excess reserves throughout this recession does not indicate our economy inching closer to an inflationary cliff, rather it is simply a by-product of Federal Reserve credit to large firms and markets that were affected by the financial meltdown, and has actually been much recovered as revenue to the Treasury. These are historic times, and from an economic standpoint, the Fed has taken history-making measures in order to stabilize markets, and these efforts continue to influence markets.