The Fed’s Program of Two-Stage Sterilization

The nature of monetary policy as practiced by the Federal Reserve was radically transformed under Ben Bernanke in response to the crisis in 2008. Many expected that quantitative easing (QE), large-scale asset purchases by the Federal Reserve that more than quadrupled the quantity of base money between the end of 2008 and the end of 2014, would generate substantial inflation — perhaps even hyperinflation — in the United States.

Such expectations proved incorrect. Inflation has averaged a little less than 2 percent over the last decade. But, with the Fed committed to injecting up to $75 billion each day in the overnight repo market through October 10 and up to $30 billion in 14-day term repos on September 24, 26, and 27, such fears seem likely to resurface.

My colleagues and I have explained time and time again why inflation has failed to materialize. In brief, the Federal Reserve has removed around half of the quantity of base money from circulation through the payment of interest on excess reserves.

The payment of interest on excess reserves can explain why the full increase in base money has failed to generate comparable inflation. But it does not explain why inflation has been low and stable over the last decade.

This issue was first brought to my attention when I compared the total quantity of base money with the quantity of base money in circulation. Not only did the quantity of base money in circulation fail to reflect the substantial increases in the base money that accompanied the QE programs, it has also experienced a much lower level of volatility than the total quantity of base money.

Another indicator that something more is at work with monetary policy is suggested by the stability of the size of the Federal Reserve’s balance sheet, which stands in contrast to the relatively high level of volatility reflected in changes of the total quantity of base money.

Somehow, the Federal Reserve is removing base money from circulation with precision in order to maintain a steady level of base money in circulation. The Federal Reserve is thus engaging in two stages of sterilization. In the first stage, it removes a significant amount of base money from circulation by paying interest on excess reserves. In the second stage, it manipulates other accounts at the Federal Reserve that influence the quantity of base money in circulation.

With respect to the second stage, Jerry L. Jordan points to changes in Treasury balances held at the Federal Reserve. In addition to the account of the Treasury, the Federal Reserve identifies other liabilities that it holds and notes that changes in these accounts impact the level of deposits in the banking system: reverse repurchase agreements (repos), deposits of depository institutions (mandatory and excess), and deposits other than reserves.

The last of these include term deposits, the Treasury’s general account and supplemental financing account, foreign official accounts, service-related deposits, and other deposits. The sum of these categories is approximately equal to the difference between the size of the Federal Reserve’s balance sheet and the total quantity of base money.

How does second-stage sterilization work? An increase in deposits held at the Federal Reserve as excess reserves (initial stage of sterilization) or foreign deposits is offset by a reduction of deposits that would otherwise support lending in the banking system. Dollars cannot simultaneously support loans by acting as deposits within the private banking system and be held in these accounts at the Federal Reserve. Similar effects operate for the other accounts at the Federal Reserve. The Federal Reserve also intervenes in the market for reverse repurchase agreements. An increase in repos, for example, draws money from the market by the Federal Reserve temporarily selling securities with an agreement for the Federal Reserve to repurchase the security in the future.

As can be seen in the following chart, changes in the volume of funds in these accounts coincide with the volatility in the quantity of base money. The difference between the Fed’s balance sheet (green line) and base money (blue line) reflects the discrepancy between factors absorbing reserve funds (red line) and base money in circulation (orange line). And the volatility of these factors is driven almost entirely by changes in other deposits, repos, and capital liabilities as can be seen by the steady growth path of the factors absorbing reserve funds when these items are subtracted (purple line).

Again, the purpose of adjusting other deposits, repos, and capital liabilities is to stabilize the quantity of base money in circulation. Thus, the purple and orange lines are nearly identical.

The wonder of this operation is twofold. First, the low and stable inflation observed over the last decade suggests that the Federal Reserve knows exactly what it is doing. That is surprising. One would not expect a new tool to be wielded so well, all the more so given the lack of experience with such tools at other central banks around the world. Second, very few observers outside of the Federal Reserve System seem to even be aware of the Fed’s regime change, let alone understand how the new mechanism works.

It seems clear that the Federal Reserve is manipulating the composition of its balance sheet to ensure that the quantity of money in circulation is stable. And, at least to date, it has done so with an impressive degree of precision. Given its large balance sheet, this is perhaps the best one could hope for. But a gradual unwinding of its balance sheet and a return to traditional monetary policy making, which limits the extent to which the Fed allocates credit, would be better still.

 

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