Reserve Balance and Bank Lending

Here are some thoughts to what might happen over the next year on inflationary pressures as the result of the Federal Reserve’s newest policy. (December FOMC statement here: http://www.federalreserve.gov/newsevents/press/monetary/20121212a.htm)

As sterilization (selling short term Treasury securities to buy long term Treasury securities) ends, the Federal Reserve’s balance sheet is expected to increase over the next year with purchases of Treasury securities and agency mortgage-backed securities.

As the Federal Reserve continues to buy assets, (A) and (B) increase. Because the Federal Reserve purchases these assets in the secondary market, primary dealers and other participants that sell the securities to the Federal Reserve will be credited with money. These money ultimately find its way to banks in the form of deposits (D).

As deposit (D) increase, the banks will have to make loans (G), buy other assets (H), or hold it as reserve (C). Loans (G) and other assets (H) of the banks would correspond to money (F) in the Central Bank’s accounts. Reserves (C) of the banks would correspond to reserves (B) in the Central Bank’s account.

Pressure on inflation would be greater if money (F) increases instead of reserves (B) increases. Thus, inflationary pressure depends on what the banks do with the increase in depositions. Interest on excess reserves (IOER) is 0.25%, while deposits at some places pay 0.75%. (See here for example: https://home.ingdirect.com/rates; note that the 6 month CD pays 0.40% while the savings account pays 0.75%, which says something about the expected market conditions in the months ahead)

So, the possibilities for the banks appear to be:

1. holds the new deposit as reserves and lower the deposit rate,
2. make loans with a higher risk-adjusted return than the risk-free 0.25% via IOER, or
3. buy other assets with a higher risk-adjusted return than the risk-free 0.25 via IOER.

Option 3 would lead to a potential wealth effect – if banks buy stocks and the purchases push up the stock prices. Option 2 likely depends on the demand on loans, since supply of loans is unlikely to be the constraint with economy on recovery. I suppose either case would lead to potential inflationary pressure.