Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 9th October 2011.

Public opinion is against the Fed creating more money to support banks. This doesn't mean that if push came to shove the Fed would not create a lot more money with the aim of supporting the banks, although it does suggest that the Fed will have to tread carefully in the future lest it lose any semblance of independence¹. Public opinion is not, however, against monetary inflation per se, and neither are most economists and financial-market pundits. That this is true is seen in the way most people continue to vote, in the nature of recent protests, and in the types of policy recommendations that are commonplace in the press. The sad truth is that "the people" are in favour of inflationary policy provided that they see themselves as near-term beneficiaries of the inflation. More to the point, they tend to be very much against anti-inflationary policies that necessitate reduced "entitlements". In any case, for the purpose of this discussion we will make the unrealistic² assumption that the Fed's ability to directly create new money is now severely constrained, and outline how, under such circumstances, the central bank would still have the ability to bring about a multi-trillion-dollar expansion of the US money supply.

The key is the 1.6 trillion dollars of reserves that the commercial banking system holds at the Fed. About 95% of this total reserve is defined as "excess", meaning that it is in excess of what is legally required to back demand deposits. Currently, banks get paid an interest rate of 0.25%/year on the reserves they hold at the Fed. This appears to be a trivial amount, but due to the fact that most banks are now unusually risk averse this 0.25%/year interest rate constitutes a significant incentive to do nothing with the reserves.

The Fed could easily change the risk/reward equation for the commercial banks by ceasing to pay interest on reserves defined as "excess", and if this proved to be insufficient then the Fed could alter the risk/reward even more by charging banks for holding excess reserves. This would force the banks to find a way of putting their excess reserves to work, which could only be done on an industry-wide basis via huge growth in the total quantity of demand deposits (huge growth in the supply of money, that is). Furthermore, this action would be fully justified in the minds of most people, because most people believe that the current economic malaise is partly the result of private banks holding a lot of money in reserve rather than making loans.

In order to convert 1.5 trillion dollars of "excess reserves" into "required reserves", the commercial banking industry would have to expand its deposit base by many times that amount. This prompts the question: Would it be possible for banks to collectively lend several trillion dollars of new deposit currency into existence over the next couple of years?

The answer is no. For the reasons covered in earlier commentaries, there is minimal scope for commercial banks to put their excess reserves to work by making new business, consumer and housing loans. The reality is that a secular de-leveraging is underway in the private sector. However, the existing stock of Treasury debt is huge and this stock will likely be added to at the rate of 1-2 trillion dollars per year over the next few years. This is where the opportunity lies for commercial banks to greatly expand their deposit bases without taking much additional risk.

We are referring to the potential for commercial banks to make use of their excess reserves by monetising (purchasing with newly-created money) trillions of dollars of Treasury securities. Here's a brief explanation of how it would work: A bank buys $100M of T-Bonds from a hedge fund (or a pension fund or some other T-Bond investor) and settles the purchase by depositing $100M into the investor's bank account. This results in $100M being added to the money supply and causes $10M to shift from the "excess reserves" to the "required reserves" category (assuming a 10% reserve requirement).

Notice that the Fed had no direct involvement in the above-described money supply addition. The Fed simply created the incentive for the private bank to act as the monetary inflation tool.

We don't know that the next round of monetary inflation will be driven by commercial banks putting their excess reserves to work via the monetisation of government debt securities, but it does appear to be a neat solution for those in power who believe that the economy needs more inflation. The economy gets a large injection of new money, the government gets a deep-pocketed buyer for its debt, and the Fed avoids criticism.

¹ A central banker once said something along the lines of "if we ever asserted our independence, we'd lose our independence", meaning, of course, that central banks are never really independent of government.

² The Bank of England resumed "quantitative easing" last week, and it's only a matter of time before the Fed does the same. A modern central banker is like the proverbial man with a hammer who views everything as a nail. In the central banker's case, every bout of economic weakness is viewed as a reason to pump more money into the economy. That's why we use the word "unrealistic" when referring to the assumption that the Fed's ability to directly create new money is now severely constrained.

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