Central bankers have historically used reserve requirements for a wide range of purposes. Today, they can be used to reduce the collateral damage of hiking interest rates.
Inflation is not over. Core consumer prices are still rising by 5.5% year on year in the US and by 7.5% in the euro area. Global disruption of supply chains, fiscal stimuli, harvests and war drove prices to levels unseen in recent history.
Many drivers of inflation are sector specific: energy has become expensive to import, while global agriculture and Taiwan’s semiconductors are struck by extreme weather. For their part, consumer-facing multinationals and bowling alleys are simply jumping on the bandwagon. Meanwhile, higher prices, the European Central Bank has discovered, are driving corporate profits through the roof.
Despite the complexity of underlying causes, central bankers quickly reverted to a familiar inflation-fighting role, one they acquired in the 1980s. By raising rates, central banks are trying to bring the financial system to a halt. Down the line, this lowers consumer spending and corporate investment. If rates go high enough, inflation will – almost inevitably – go down.
Housing markets are already close to collapse, but central bankers say they will continue until people start losing their jobs. In this sense, the defaults of Credit Suisse and Silicon Valley Bank are a feature, not a bug. But hesitation is creeping in. Banks and venture capital funds have now received quasi-bailouts via creative use of deposit insurance schemes, state-orchestrated mergers and generous central bank credit.
Even from the perspective of central banks’ mandates, raising rates too quickly has clear downsides. Higher rates reduce the value of loans with a fixed return. But it strikes hardest at those banks which do what is best for the economy: funding long-term investments. Even at this stage, the US has had to take extraordinary measures to keep its small- and medium-sized banks afloat. US Treasury Secretary Janet Yellen, quizzed on this point in Congress, struggled to explain how anything short of a blanket guarantee for deposits over $250,000 would save the sector.
Clean investment hit hard
Central bankers have conceded that the current approach may actually cause inflation. For renewable energy projects, the financing typically amounts to a third of the cost per megawatt hour. In contrast to energy production that runs on oil and gas, the variable costs of renewable energy are low and stable. However, these projects – such as placing windmills offshore – often have high upfront costs and repayment of investments can stretch out over decades. The insulation of houses and energy-efficient manufacturing techniques have similarly high upfront costs. Raising interest rates strikes these investments the hardest, exactly those needed to avoid a rerun of last year’s double-digit inflation.
Paul de Grauwe, chair of European political economy for the European Institute at the London School of Economics, and Yuemei Ji, associate professor of economics at University College London, called attention to the untapped potential of reserve requirements. Raising rates is costly for central banks that pay interest on the deposits they have issued to banks. As De Grauwe and Ji point out, already at the current level of interest rates, the Federal Reserve owes $140bn to banks as interest payments on roughly $3tn of bank reserves. The ECB, with its deposit rate at 3%, is on the hook for €132bn.
The key tweak they and others propose is to make the reserves ‘unremunerated’: no longer paying interest on reserves will sap bank profits, while strengthening the central bank’s balance sheet. But that is not the only thing these requirements are good for.
Two birds with one stone
As a historian of central banking, I have always been impressed by the versatility of reserve requirements. The idea is simple and it has a long history. Many central banks require their banks to hold some of their assets as central bank reserves. Initially, this requirement served to ensure that banks would be able to meet deposit outflows and stabilise the demand for central banks cash. Reserves also take up space on the bank’s balance sheet. If left unremunerated, reserve requirements not only make central banks more profitable, but also make banks less profitable.
Throughout the post-war era, central banks have raised unremunerated reserves to constrain bank lending. They also used more selective requirements to make specific asset classes more attractive to hold compared to others. Due to their long history, central banks often retain ample scope within their mandates for targeted reserve policies.
Used well, reserve requirements can reduce bank lending while spreading the pain in a more measured way. A tiered reserve requirement calculated as a share of non-green assets would kill many birds with one stone. It would help reduce inflationary lending while promoting sustainable investments. Investment in renewable energy would contribute to fighting climate change and air pollution, while creating more stable and predictable energy costs, promoting long-term price stability.
Being visible is something that can make central bankers uncomfortable. The strength of reserve requirements may also create a political obstacle: they allow for a more overt allocation of the pain of disinflation. Still, their mandates have always allowed central banks to make measured choices, and it results in better policy. A creative use of reserve requirements will ultimately create a more solid, long-term basis for financial and price stability.
It is time for central banks to rethink the instruments of monetary policy.
Jens van ’t Klooster is Assistant Professor of Political Economy at the University of Amsterdam. He would like to thank Sascha Bützer and Ben Folit-Weinberg for helpful comments on an earlier version of this article.