Wednesday, March 13, 2013

Alan Blinder Discusses the Fed's Balance Sheet

Alan Blinder has a piece in the Wall Street Journal on the size of the Fed's balance sheet and why it does and does not matter. Mostly this looks fine, but at the end of the article, he discusses a possible exit strategy from some difficult choices for the Fed:
Is there a way out? Here's one thing that could help. As I have argued for some time, the Fed should reduce the interest rate it pays on the roughly $1.7 trillion of banks' excess reserves. If it did so, banks would keep less cash on deposit at the Fed. The liberated funds would probably flow mainly into the money markets, but some would probably find their way into increased lending—which would give the economy a little boost.

In either case, if banks wanted to hold fewer reserves—a Fed liability—the Fed could, and naturally would, shrink its assets by an equal amount. Balance sheets do, after all, balance. And that would make the eventual exit easier.
This is incorrect. No funds are "liberated" if the Fed reduces the interest rate on reserves. Outside money (currency plus reserves) does not go away unless the Fed actually sells assets. For example, a reduction in the interest rate on reserves from 0.25% to 0% would reduce the willingness of financial institutions to hold reserves, but that can only mean that, ultimately, that currency will increase and reserves will decrease by the same amount, in nominal terms. Prices would have to change as a result. For example, suppose that the demand for currency is fixed in real terms. Then prices have to rise as a result of the reduction in the interest rate on reserves. The balance sheet would be smaller, in real terms. Obviously this is not a "way out," as the key problem has to do with what happens if inflation gets too high and the Fed needs to tighten. See my post on The Balance Sheet and the Fed's Future.


  1. FT Alphaville on this:

  2. Another piece on FT Alphaville:

  3. Hmm, Alan Blinder is usually way more careful than that. You just couldn't let it go, could you? :)

    1. Just interested in the ideas, nothing personal. I saw Blinder a short time ago. He was in St. Louis talking to a group at the Weidenbaum Center at the University. Obviously he has a lot of Fed experience, but as this indicates, he doesn't always get it right.

    2. On a separate note, I am seriously considering to adopt your textbook for my intermediate macroeconomics class (I am now using Jones). I have however some questions. Is it OK if I email you directly to discuss them?

  4. Stephen,

    "Prices would have to change as a result. For example, suppose that the demand for currency is fixed in real terms."

    I don't agree with how you are framing this. Currency will increase if either banks decide to hold currency or the representative household decides to convert deposits to currency because deposit rates are too low. But no matter *who* is deciding to convert interest bearing deposit/reserves to currency, the important point is that they are doing to because they *prefer* to hold the currency to the interest earning instrument. That isn't going to make them want to spend it. A least, not anymore than if there were no currency and you imposed the same drop in deposit rates. It's the drop in the real rate which quite directly induces people to invest and spend more. Currency has nothing to do with it.