May 05, 2022

A balance sheet reduction has a corresponding impact on the monetary base which, and all else the same, reduces the quantity of M2 reducing the excess money supply and thus the underlying inflation rate. The impact of balance sheet /monetary base reduction on M2 and the inflation rate depends on the impact which of the uses of the monetary base is impacted by the reduction. The monetary base has three distinct uses in the economy: As currency in circulation, the banks required reserves and the banks excess reserves. Furthermore, under a fractional reserve banking system, these three components are intertwined, and their composition is determined by the relative attractiveness to the users. Hence changes in the relative attractiveness determines the shifts in demand among the different components. The Fed though its financial repression and interest rate policy can alter the relative attractiveness, net income /interest rate or opportunity costs of holding each of these components. In doing so, the fed action can induce a change in any of these three components reduces the monetary base as well as altering its composition. In the process the fed action impacts M2, the bank credit creation, the inflation rate, and the price of credit. We now outline what must happen to yields as the fed returns to the Volker Price rule, i.e., 2% inflation nation rate. We look for the bond yields to rise to the 5% range. The new equilibrium leads to a reduction in the ratio of bank loans to US Treasury requiring a narrowing of the spread between these two securities. We look for bank loans to increase but by less than the increase in treasury securities. To reduce the currency holding, the opportunity costs of holding cash must increase, hence we expect the interest rate on deposits to increase, but that increase will be less than the rates charged on bank laws. Finally, while the higher income generated by the required reserves makes the excess reserves leas attractive. Reducing the payment on excess reserves accelerates its reduction.

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