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short essays and reports on the economic issues of the day
2009 ■ Number 30

Negating the Inflation Potential of the
Fed’s Lending Programs
Daniel L. Thornton, Vice President and Economic Adviser
he Term Auction Facility (TAF), instituted in
December 2007, was the first in a series of Fed lending facilities designed to allocate credit (and thus
liquidity) to certain institutions and markets. The most
recent of these lending facilities is the Term Asset-Backed
Securities Loan Facility (TALF), which began operation in
March 2009. Initially the Fed sterilized the effect these loans
would have had on the monetary base by selling government
securities. Beginning in mid-September 2008, though, the
Fed allowed the effect of its lending activities to pass through
to the monetary base. Since August 2008, the monetary
base has more than doubled, to about $1.7 trillion dollars.
Moreover, given the Fed’s intention to purchase additional
long-term Treasuries and mortgage-backed securities, the
base could expand much further. Many analysts have
expressed concern about the potential inflationary consequences if the extraordinary increase in the monetary base
were allowed to persist. This synopsis analyzes the desirability of two suggestions for reducing the inflationary consequences of the Fed’s new lending facilities: paying interest
on reserves and allowing the Fed to issue debt.
The Fed has wanted to pay interest on reserves for more
than 30 years. Initially, the desire was to reduce the reserve
tax associated with the Federal Reserve’s imposed reserve
requirements. More recently, analysts suggested that paying
interest on reserves would provide the Fed with an additional
monetary policy tool.1 Specifically, it was thought that the
funds rate could be anchored at the Federal Open Market
Committee (FOMC)’s target for the funds rate by paying the
target rate on reserves. With the funds rate anchored by
the interest rate paid on reserves, the FOMC would be free
to use open market operations to pursue other objectives.
The Fed began paying interest on reserves on October 9,
2008. Rather than paying interest only on required reserves,
however, the Fed pays interest on both required and excess
reserves. Currently, the rate is the upper end of the FOMC’s
target for the federal funds rate, 25 basis points. Some
analysts believe that because the Fed is paying interest on


excess reserves, depository institutions will be content to
hold excess reserves—rather than lend them and, thereby,
increase the supply of money. (It is believed that an increase
in the monetary base that is not accompanied by an increase
in the money supply will not be inflationary.)

The sale of typical securities
would force the Fed to contract
its lending programs, whereas
the sale of Fed bills would not.
Paying interest on reserves is not likely to effectively
prevent inflation for at least two reasons. First, depository
institutions have an incentive to lend out excess reserves
whenever the risk-adjusted interest rate on loans exceeds
the rate paid on excess reserves. Because lending rates are
typically much higher than the FOMC’s target for the federal
funds rate, at some point depository institutions will have
an incentive to make loans rather than hold excess reserves.
The Fed would have to pay a relatively high rate of interest
on excess reserves to prevent this scenario. Given the extraordinary level of excess reserves, the cost to the Fed would
be very high. Of course, the Fed would pay the interest by
simply increasing the depository institution’s account at the
Fed, causing excess reserves to increase further.
A second problem arises because depository institutions
sweep their deposits to reduce their effective reserve requirements from their statutory level.2 The effective average
reserve requirement on transactions deposits is significantly
lower than the 10 percent statutory requirement. With excess
reserves currently at about $790 billion (compared with
about $2 billion in August 2008), depository institutions
could increase the M1 money supply measure dramatically
with a relatively small decline in excess reserves. For example, if the effective reserve requirement is 5 percent, transactions deposits could increase by more than $400 billion

Economic SYNOPSES

Federal Reserve Bank of St. Louis

(about a 25 percent increase from its current level) with
just a $20 billion reduction in excess reserves. Consequently,
excess reserves could remain “large” and the money supply
could expand significantly.
The second suggestion for controlling the inflationary
consequences of the recent monetary base growth is to allow
the Fed to issue debt, sometimes called Fed bills. This would
require congressional action because the Fed is not authorized to do this under the current provisions of the Federal
Reserve Act.
The sale of Fed bills would reduce the monetary base
in exactly the same way as a Fed sale of government or other
securities that it holds. The difference, of course, would be
that the sale of typical securities would force the Fed to
contract its lending programs, whereas the sale of Fed bills
would not. This authority would enable the Fed to not only
reduce the monetary base without reducing the credit it has
extended during the current financial market turmoil, but
also make loans to specific institutions or markets at any
time in the future without increasing the monetary base.
Given the authority to issue its own debt, the Fed would
be able to reallocate credit in the market for whatever purpose it deems necessary or desirable without affecting the
funds rate, the monetary base, or the growth of monetary
Issuance of Fed bills is a reallocation of credit because
the Fed would be borrowing from one segment of the market (i.e., from whomever purchases Fed bills) and relending
those funds to another.3 Apart from the issue of the efficacy
of such credit reallocation practices, this new authority
might compromise the Fed’s independence. Specifically,


the Fed might be pressured to extend credit to a particular
institution, group of institutions, or market. The issue of
Fed independence here differs from the historical issue of
Fed independence, which centered on the extent to which
the Fed would be required to finance government deficits
by increasing the money supply. This issue of independence
is different because the Fed would be able to reallocate
credit without financing government spending per se.
Nevertheless, by borrowing in the market and relending to
specific institutions or markets, the Fed would be given a
role that has heretofore been the purview of Congress. The
borrowing and relending activities of the Fed would not
be fundamentally different from the activities of Freddie
Mac and Fanny Mae, two government-sponsored agencies
that issued debt and lent the proceeds in the real estate
market. If the Fed were to become less independent from
Congress in this respect, it may become less independent
in choosing the extent to which it should finance deficit
spending. The evidence indicates that less-independent
central banks tend to perform more poorly in keeping
inflation low and stable.4 ■

For example, see Goodfriend, Marvin. “Interest on Reserves and Monetary
Policy.” Federal Reserve Bank of New York Economic Policy Review, May 2002,
8(1), pp. 13-29.


See Anderson, Richard G. and Rasche, Robert H. “Retail Sweep Programs and
Bank Reserves, 1994-1999.” Federal Reserve Bank of St. Louis Review, January/
February 2001, 83(1), pp. 51-72.

3 See Thornton, Daniel L. “The Fed, Liquidity, and Credit Allocation.” Federal
Reserve Bank of St. Louis Review, January/February 2009, 91(1), pp. 13-22.

For example, see Alesina, Alberto and Summers, Lawrence H. “Central Bank
Independence and Macroeconomic Performance: Some Comparative Evidence.”
Journal of Money, Credit, and Banking, May 1993, 25(2), pp. 151-62.

Posted on July 1, 2009
Views expressed do not necessarily reflect official positions of the Federal Reserve System.