Inflation Arithmetic

February 10, 1958

Most of us still give lip service to the ideal of preventing further inflation; yet we advocate the very policies that increase inflation. Even the banking community is not exempt.

A few weeks ago, the Economic Policy Commission of the American Bankers Association proposed a general lowering of reserve requirements against deposits. The reserve requirements against checking deposits are now 20 percent for banks in “central reserve” cities (New York and Chicago); 18 percent for banks in 48 “reserve” cities; and 12 percent for “country” banks. The ABA recommends that these be reduced eventually to only 10 percent against demand deposits for all member banks no matter where located. In addition, it recommends that reserves against time deposits be reduced from 5 percent to 2 percent, and finally that vault cash be counted as part of required reserves.

FED PLANS

The member banks are not alone in such recommendations. Serious Washington reports indicate that the Federal Reserve Board is planning to increase the nation’s supply of bank credit sharply by reducing bank reserve requirements, and has failed to reach agreement merely about the exact timing of the announcement and the specific plan. It is meanwhile significant that the cut in the Federal Reserve discount rate from 3½ to 3 percent in mid-November was followed by a further cut in late January to 2¾ percent.

The huge inflationary potential in the ABA proposal can be seen from a simple calculation. On Dec. 25, the required reserves of all Federal Reserve member banks came to $18.9 billion. Calculating these respectively for central reserve city banks, reserve city banks, and country banks, we find that they would have permitted the member banks to make sufficient loans and investments to create demand deposits totaling about $117 billion. In other words, the average required reserves worked out to about 16 percent of demand deposits. If, now, the member banks are allowed to keep reserves of only 10 percent against demand deposits, they could create demand deposits of $189 billion—an increase of more than 60 percent in this part of the money supply.

We have still to consider the existing inflationary potential of the Federal Reserve Banks themselves. At one time they were required to keep gold and cash reserves of 35 and 40 percent against deposit and note liabilities respectively. But since 1945 they have been required to keep only 25 percent reserves in gold certificates against deposit and note liabilities combined. On Jan. 29, they kept a gold certificate reserve of $22 billion, or 47.3 percent, against combined note and deposit liabilities of about $46.7 billion. If they increased their own liabilities to reduce their gold certificate reserves to only 25 percent, those liabilities would go to some $88 billion. Depending on the percentage of the increase that went into creating deposits for the member banks, those deposits could increase from the present $19 billion to $40 billion or even to $60 billion. If the member banks then kept only 10 percent reserve against deposits, their demand deposits would increase from the present $117 billion to $400 billion or even $600 billion!

POTENTIAL INFLATION

Several conclusions are suggested by these theoretical calculations. There are enormous inflationary potentialities even under the present Federal Reserve law. These inflationary potentialities could and should be cut off by a change in the law. If the private banking community, the Federal Reserve authorities, or Congress want to cut off these possibilities, this is the place to begin. The big city banks are right when they argue that the present differentials in reserve requirements are obsolete and unfair. But the way to cure this discrepancy is not to lower the reserve requirements for everybody, but to equalize them (over a long period) at the present average level.

The agitation for lower reserves shows the inflationary psychology that follows when the gold standard is abandoned. If the reserves themselves are only paper, even bankers begin to wonder why it is necessary to keep them at all.