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Quantitative Easing, Part 2

In my previous blog post, I mentioned that all the trillions of dollars the Fed has “printed” actually has not been printed. The new money has largely been parked in the form of excess reserves in the largest banks. The post concluded that as long as the money remains parked in excess reserves, inflation is likely to remain in abeyance.

The next logical question is: What happens when the money gets up and drives out of the parking lot and into the shopping malls? Isn’t that when we get runaway inflation for sure?

What would have to happen for all this money to get “printed” and into the economy? The excess reserves must be loaned out to consumers, businesses and investors. If consumers borrowed and spent $2 trillion in a short time, prices would certainly go up. If investors borrowed $2 trillion to build new office buildings, retail shopping centers and hotels, prices would certainly go up.

Of course, the Fed has plans to prevent this from happening. Its game plan has three parts: 1) paying interest to the banks on their excess reserves, 2) using reverse-repurchase options to soak up excess cash in nonbank institutions and 3) raising the Federal Funds rate.

In the past, the Fed would just raise the Fed Funds rate until it got high enough to choke off excess loan demand. In effect, the Fed would outbid consumers and businesses for the loanable funds. It would make rates go high enough until loan demand was reduced to desirable levels. To accomplish this, the Fed would actually sell bonds it owns to the banks. This removes lending capacity from the banks and effectively ends the worry about excessive lending and any threat of inflation.

However, the future is not the past. In 2014, the Fed doesn’t want to sell the bonds it holds back to the banks. The Fed worries that if it does this, the interest rates on longer-term Treasury bonds and mortgage rates for homebuyers could increase and choke off the economic recovery.

So how does the Fed soak up the excess cash without selling bonds back to the banks? It will pay banks interest on their excess reserves. If and when the Fed feels the pressure of rising inflation, it will pay banks a high enough rate to encourage them not to lend to private sector businesses and consumers. In effect, the Fed will outbid the private sector for loan funds.

The second tool is referred to as reverse purchase agreements (affectionately referred to as reverse repos). Because the Fed doesn’t want to sell the bonds it owns, why not sell them to banks and money market funds for a few days, weeks or months and then buy them back at a higher price? Sound complicated, esoteric and bewildering to the average American? It is.

But the bottom line is that the Fed will structure these reverse repos so that banks and money market funds will continue to park their cash with the Fed and not go overboard in lending to the private sector. The profit on these repos must be high enough to entice banks and money market funds to choose to buy them rather than make loans to the private sector.

If and when our economy gets strong enough that consumers, businesses and investors want to borrow trillions of dollars in excess reserves, the Fed will raise interest rates on excess reserves and reverse repurchase agreements high enough to entice lenders to keep all that money safely parked with the Fed and not spend it at the shopping mall.

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