How US Fed Policy Could Prolong Inflation

In 2008–09, the US Federal Reserve started buying government bonds and mortgage-backed securities from the financial market, paying sellers with central-bank money—that is, reserves. Reserves, like cash, are among the most liquid and safest assets on the planet, and one might think that such operations, repeated a number of times since, should make the financial markets safer. But what if they do not?

Instead of helping the market with easy liquidity, the Fed’s quantitative easing, as the approach is called, is hurting it by creating an addiction, argue New York University’s Viral V. Acharya, Chicago Booth’s Raghuram G. Rajan, Booth research professional Rahul Singh Chauhan, and Frankfurt School of Finance & Management’s Sascha Steffen. Withdrawing the liquidity will cause withdrawal pangs and instability, they contend—and the longer the central bank expands its balance sheet with reserves, the longer it will take to bring down the reserves and normalize conditions safely.

The researchers analyzed bank-level data starting in 2008, when the Fed spent trillions buying long-term government bonds and other financial instruments from the private sector. The low interest rates that resulted from this quantitative easing were meant to entice businesses to take out loans so they would grow and create jobs—the idea being that when the economy had rebounded and consumers were again spending, the Fed could easily and safely shrink its reserves by selling the US Treasurys it had bought, or letting them mature and roll off its balance sheet.

But sustained quantitative easing (and subsequent tightening) may be less benign, and more difficult to reverse, than previously thought. When reserves expanded from less than 5 percent of GDP in 2008 to more than 15 percent in 2014, commercial banks began generating substantial potential claims on available liquidity, the researchers find. Fed-created reserves are assets, and commercial banks often finance them with short-term liabilities such as deposits. Banks’ deposits grew from about 50 percent of GDP to 60 percent over the same period, according to the analysis. Within deposits, banks shifted from longer-term time deposits to short-term demand deposits, increasing the need for reserves if depositors demanded their money back. Because reserves are safe but low-yielding investments, banks sought additional revenue streams by simultaneously offering higher credit-card limits to households and larger credit lines to corporations and investors. Their outstanding credit lines increased from 12 percent of GDP to more than 15 percent by September 2014.