Philadelphia Fed President Charles Plosser correctly understands the danger posed by the $2.5 trillion of excess reserves created as a result of the Fed’s Zero Interest Rate Policy (ZIRP) and Quantitative Easing (QE) programs. Currently the ratio of required reserves to M1, the most narrow measure of the money supply, is around five percent. The ratio of required reserves to M2, the broadest measure of the money supply, is around one present. So, these excess reserves could support an addition $50 trillion of M1 or an additional $250 trillion of M2. To put this in perspective, right now M1 stands at $2.778 trillion and M2 stands at $11.215 trillion. Thus, Plosser’s concern.
But these excess reserves have created an opportunity, too. Rather than try to destroy these reserves by, for example, selling its roughly $2.5 trillion in Treasury bills on the open market, the Fed could raise required reserves on M1 to 100%. That would prevent the banks from manufacturing money via their lending operations at a twenty-to-one ratio (the inverse of the five percent effective reserve rate). Then M1 could expand only if the Fed continued to monetize the debt by creating new reserves. The next step would be for the Fed to cease monetizing the federal debt. At this point reserves would be frozen at their current level as would M1, and the US would have a more sound monetary system.
Of course, this strategy depends upon weak men at the Fed standing up to powerful men at the US Treasury. Where is Paul Volcker when we need him?