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Professor Lindenbrook's avatar

If the Fed increases fractional reserve requirements, would that create enough deflation to keep them solvent?

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Key Signals's avatar

It depends on how much they expand reserves. I think that to move the GDP (deflation) needle significantly higher, each time, the Fed has had to geometrically expand its balance sheet. This is also another reason why inflation has geometrically expanded above target. The US is a mature developed economy that does not respond in the old predictable ways that economists have been taught, hence the problems with the Phillips Curve and Beveridge Curve. Japan has learned this lesson the soonest of the developed economies. But Japan is still learning, as we all are. There is a case for a debate about what the Fed's mandate should be. I actually think that Bernanke has started it with his new book. But in this partisan environment it will be a waste of time, since they can't seem agree about anything these days. So the Fed is on its own, basically, trying to rewrite its new mandate whilst appearing to adhere to its existing one. It's idealistic, and not ideal, but at least its not an ideology that can get caught up in the political mess. Evidently, financial stability policy is the new Holy Grail, hence we see the Fed's fixation with asset prices becoming greater than its fixation with inflation. Rational exuberance, about asset prices, is the new target rather than an inflation target. I doubt that the Fed will ever provide dot plots for asset prices, but it may be possible to infer them from what is provided. I presume that the Fed has a notional growth rate for the S&P, in its mind, as the quasi/proxy index for the "deflation rate" to which you refer. I'm guessing that its greater than 2% and lower than 10%. From these yardsticks the Fed will then back out the level of banking reserves it thinks are required to sustain the median "deflation rate" over time. Obviously, they overestimated the reserve level, during the COVID response, based on the subsequent performance of stocks and price inflation.

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Professor Lindenbrook's avatar

Great answer, thank you! I must admit I hadn't thought about the Fed changing its mandate to include asset price growth rate. It's definitely going to be interesting watching it evolve.

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Key Signals's avatar

How they change it without appearing to have failed is, probably, what is really holding them back. I think it's just kind of grown on them, over time, as their balance sheet has grown. They always assumed that they could shrink it, but now they are not so sure, if they can, so they have to assume that it is a systemic risk , potentially, larger than their dual mandate risks. At circa $9 trillion, with potentially $4 trillion in fiscal stimulus incoming, too big to fail is too close to home!

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