To mitigate risks inherent in fractional-reserve banking, governments regulate banks and provide deposit insurance. Because these activities are not sufficient, a central bank is set up as lender of last resort. In the U.S., it is the Fed. To better understand the necessity of central banking in fractional-banking, one must understand how the Fed conducts monetary policy in various scenarios. In the course I regularly teach, these modes are referred to as historic, normal, emergency, and crisis.
Prior to 2003, the federal funds market was in historic mode. It is characterized by downward sloping demand crossing over reserves supply, a vertical line representing total bank reserves. Their intersection gives the quantity of federal funds and the federal funds rate. Historically, the Fed set the discount rate below this rate, which incentivized borrowing from the discount window rather than from other banks. To dissuade banks from doing this, the Fed required banks to exhaust all other sources and justify credit needs. In the absence of this and discount lending stigma, reserves supply would have kinked horizontally at the discount rate.
Ninety years after its founding, the Fed discovered that markets work. In 2003, it changed the discount rate to a non-binding price ceiling by setting it above its federal funds rate target. Doing this dis-incentivized discount lending and kinked reserves supply at the discount rate. When reserves demand intersects the vertical section of supply, the federal funds market is in normal mode. In it, the Fed exploits free market principles by instructing the New York Fed to buy and sell U.S. securities to keep the federal funds rate near its target. These transactions are called open market operations, which the Fed discovered accidentally in the post-World War I era.
If a banking emergency, like the one sparked by Lehman’s collapse, increases reserves demand enough so that it intersects the horizontal section of reserves supply, the federal funds market is in emergency mode. In it, the federal funds rate equals the discount rate, and the quantity of reserves demanded exceeds total banking reserves at the moment the emergency strikes. This shortage is filled with discount loans. According to Fed data, discount lending surged 578% in a month’s time following Lehman’s demise.
Since October of 2008, the federal funds market has been in crisis mode. The difference between it and normal mode is in the demand curve. When the Fed was about to purchase all of that paper from banks after TARP was enacted, it had to recognize that doing so would be an open market purchase of biblical proportions. This unprecedented action would have pushed the federal funds rate into negative territory. To avoid this, the Fed set a binding price floor called Interest on Reserves (IOR). IOR kinks demand horizontally because banks would rather lend their reserves to the Fed at IOR than to other banks at a negative rate. This means the equilibrium federal funds rate equals IOR, which explains why quantitative easing has not affected the federal funds rate.
When the economy begins to grow more robustly, banks will lend less and less to the Fed. Some (politicians and priests of the economic orthodoxy) may say this is indicative of the crisis being averted by wise fiscal and monetary policy. As GDP continues to grow, demand’s downward sloping section will eventually cross the vertical section of supply. Meanwhile, $1.5 trillion in excess reserves will spill out, and potentially metastasize into $3 to $10 trillion in new money. This is the hyperinflation that many fear.
The Fed knows banks will not keep excess reserves bottled indefinitely. To keep the inflation genie in the bottle, the Fed may incrementally raise IOR while selling securities. However, selling off assets would flood banks with cash. Because banks can buy securities from whomever they want, the Fed cannot sell assets to other central banks or firms. If it does, it and Treasury, which has to auction bonds to cover those coming due and fiscal budget deficits, would be competing for the same buyers, which would spike interest rates.