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The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.


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May 06, 2009


When is rapid growth in a central bank's balance sheet not cause for concern?

The unprecedented growth in the Federal Reserve's balance sheet during the past year has generated considerable debate about potential problems for the economy down the road (see for example, here, here, and here). But a big change in the size of a central bank's balance sheet in a relatively short space of time is not necessarily a precondition for problems down the road. A case in point is New Zealand circa 2006.

In July 2006, the Reserve Bank of New Zealand (RBNZ) changed the monetary policy operating system from a channel or corridor system (like that used in Australia and Canada) to a floor system (see Neild 2006 for a description of this transition). Under this floor system, the RBNZ stopped offering free collateralized daylight credit to banks for settlement purposes. In other words, they removed the distinction between daylight and overnight reserves. Also under this new system, reserves were remunerated at the official cash rate (OCR), the RBNZ's target interest rate. Banks have access to RBNZ credit if needed as well, but at a rate 50 basis points above the OCR.

By the end of 2006 the target supply of bank reserves had increased sufficiently to allow for the smooth operation of the New Zealand payment system. The new level fluctuated around NZD 8 billion and represented an increase of 400 times the level under the previous regime. Todd Keister, Antonie Martin, and James McAndrews from the New York Fed have an interesting article describing the economics of a floor system. In that paper the authors stress that a floor system severs the link between the quantity of reserves and the target interest rate. A central bank could increase the supply of reserves—either for settlement or liquidity purposes—without changing the stance of monetary policy (the target interest rate).

Well, that's the theory. What about in practice? Did New Zealand's economy collapse under the weight of an inflationary spiral created by an explosion in the central bank money? In short, the answer is no. Because these newly created reserves were staying within the banking system there was no upward pressure on the broader money supply. For instance, M1 (currency plus checkable deposits) was NZD $22.9 billion in July 2006, and a year later it stood at $22.2 billion—a change that would not scare even the most hardcore monetarist.

Could a floor system work in the United States? Possibly. For one thing, with total reserve balances at the Fed about 18 times as large as they were a year ago there has been a sharp decline in demand for daylight overdrafts. Average daylight overdrafts for funds were $52 billion in the first quarter of 2008, but a year later that level had fallen to around $8.9 billion. With so many reserves in the system, the need for intraday borrowing from the Fed has decreased sharply. Of course, there are some big differences between the financial systems of New Zealand and the United States, including the fact that not all institutions depositing funds with the Fed are eligible to earn interest on reserves. But I do think the floor system provides some interesting food for thought—kiwifruit, perhaps.

By John Robertson, a vice president in the Research Department at the Atlanta Fed

May 6, 2009 in Federal Reserve and Monetary Policy | Permalink

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Comments

An interesting article. Another case in point is the Bank of England, which began paying interest on reserves in 2006 as part of a reserve-averaging scheme designed to reduce the volatility of money market interest rates. The result was that the stock of reserves increased almost immediately from less than £1bn to around £20bn (ie just under 2% of UK GDP) with no discernable impact on inflation or economic activity.

Posted by: RebelEconomist | May 07, 2009 at 09:53 AM

This concentration on reserves is left over from the days of the gold standard, when they actually meant something. They are just entries in a spreadsheet, now - it's really surprised me that economists who ought to know better have thought that this reserve expansion (which is just substituting one form of asset for another on bank balances sheets) was going to have any effect beyond lowering a few long -term rates a few basis points.

Posted by: Jim Baird | May 08, 2009 at 10:35 AM

The answer to this one is easy - NEVER!

Posted by: bailey | May 14, 2009 at 05:48 AM

Isn't the Fed already operating a floor system, in effect, by paying interest on reserves at the official policy rate? My understanding is that this is about the only way to manage the expansion of the balance sheet required for credit easing.

Posted by: tom | May 14, 2009 at 02:34 PM

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