Hefty bank balance sheets will stymie Fed's 2% inflation goal

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Much has been made, understandably, of the Federal Reserve's efforts to cool inflation and bring annual price gains back down to 2%. Though there may still be a "long and bumpy road" ahead, the expectation is that the economy will get there eventually.

Less has been written about what may happen when the Fed is successful. How will inflation be controlled over the long term as the economy recovers? Due to enormous changes in bank balance sheets over the last 15 years — and the Fed's consequent loss of control over the levers of monetary policy — the answer may not be as simple as one might think.

In fact, there is a very real possibility that the U.S. economy will have a 5% inflation rate over the next three to five years or more.  

It is generally agreed that the recent surge in inflation was caused by low interest rates and the Fed's creation of trillions of dollars of credit in the banking system. We are now engaged in reversing those inflationary effects by raising interest rates. But what about the trillions in bank reserves? The Fed acknowledges that it needs to reduce those reserves by selling securities, but this presents a very large challenge.

That's because, since 2008, the Fed has far less ability to control bank reserves. Amid the crash, the Fed purchased over $1 trillion of assets to stabilize the capital markets, resulting in large excess reserves in the banking system. After the crisis, the Fed was hesitant to sell securities to drain that liquidity out of the credit markets for fear of creating a credit crunch. Instead, the Fed's net asset holdings were held steady from 2014 to early 2020. Because banks had excess reserves remaining from the Great Recession, the money supply grew by over 5% annually in response to market forces, even though the Fed was not acting to expand it. 

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During the pandemic, the Fed's quantitative easing facilitated a further growth of bank reserves, with the supply of circulating cash, checking and money market accounts, and time deposits under $100,000 growing from $15.4 trillion in February 2020 to $21.8 trillion in April of 2022, an increase of 42% By 2022, commercial banks had reserves in the Fed system of over $3 trillion. In contrast, bank reserves at the Fed in September 2008 were only $10 billion. At that time, the Fed did not pay interest on bank reserves, so banks kept their money working elsewhere. But since October 2011, banks have been able to earn interest on their reserves, currently 4.4%. This reduces the incentive to lend out the reserves and further expands the money supply.

Banks also have more free reserves relative to their deposit balances than before the pandemic. The reserve-to-deposit ratio, which is an indicator of how much capacity banks have to expand the money supply, went from 5% in 2008 before the crisis to a peak of almost 30% in 2013. The ratio never returned to its pre-crisis level; it had declined to 13% in 2019 but soared again with the new quantitative easing during the pandemic. Reserves were still 18 % of deposits at the end of November 2022.

All this means that, beginning in 2023 and most likely for years to come, banks will have the liquidity to increase the money supply far more than what we have seen to date.

In short, when this year's expected economic downturn is over, economic growth will resume. Banks will have enormous reserve balances to finance that growth and, possibly, inflation. On top of the normal spending in a full-employment economy, the U.S. is projected to have deficits of more than 5% of GDP.

This will produce inflation of 5% or more — even if the Fed has a neutral monetary policy stance. That's why, as we look beyond 2023, it's critical that the Fed focus more on changes in banks' reserve-to-deposit ratios and the growth of the money supply.