Bernanke's sticky accelerator

This morning's WSJ Heard on the Street column($) by Peter Eavis asks the same question that many other people are now asking after the "exit plan" that Fed Chief Ben Bernanke outlined in a speech yesterday and recent troubles at Toyota Motor Company.

A driver with a record of accelerating cars into ditches may not be the best person to test a new braking system. But that is the task being entrusted to the Federal Reserve.

The most recent boom-bust convulsion should have destroyed the illusion of an all-knowing Fed fine-tuning the economy with monetary policy. And now the central bank may find it harder than ever to set interest rates appropriately. It has to work out how to control a $1 trillion pool of cash idling in the banking system.

The banks don't have to hold this cash—it is in excess of the amount they must have to support their liabilities. But they likely have chosen to because they still are skittish.

The big question is what happens when that fear lifts. Banks could activate these "excess reserves," rapidly creating new credit in the economy that could stoke inflation. Aware of this threat, Fed Chairman Ben Bernanke Wednesday outlined tools under consideration for controlling excess reserves.

Interest that the Fed pays on these excess reserves is now viewed as a key tool to be used by the central bank in controlling the amount of money that makes its way into the economy in the broader money supply, if and when that finally begins to happen again.

And, at this point, that's still a big if.

Conventional wisdom is that, if the Fed pays, say, two percent interest on these excess reserves, then banks would be crazy to lend that money out to anyone else at anything less than two percent since the bank has zero risk with the money parked at the Fed.

This video from the Associated Press fills in a few of the details.


Does anyone know how the "money multiplier" relates to excess reserves?

I've not thought about this much, but, it seems as though it's one thing to lend these reserves out to another bank and charge interest on them, but it's another to use them as a basis to create consumer loans where the loan amount would be some multiple of the amount that they are required to keep as reserves.