We read a lot about excesses these days: excess government spending, excess budget deficits, excess money supply expansions, excess foreign exchange reserves. One other excess worth watching in the US is excess bank reserves over and above the banks’ required reserves. These excess reserves could unleash a torrent of economic activity and spark the rapid inflation that some say is imminent.

Here’s how inflation would arise. Under a fractional reserve banking system, a bank is allowed to lend only a fraction of the money deposited in checking, savings and other accounts. In the US, large banks must hold 10% of deposits as cash or reserves at a Federal Reserve bank. (reserves are like a checking account the banks have with the Fed). The remaining 90% they can lend out to businesses or consumers. When they do, those loans are spent by the borrowers and ultimately deposited back into the banking system. These newly created deposits can stimulate further lending up to the 90% limit, thereby creating even more deposits. Since deposits are spendable by their holders they represent a part of the money supply in an economy. And since the lending of excess reserves has a multiplier effect on total deposits, it also increases the money supply several times over. There is a limit though, and in a simply situation, the total money supply increase from a one dollar increase in deposits would be the reciprocal of the reserve requirement, or (1/0.10 = 10) ten times. In other words, a one dollar increase in excess reserves can cause a ten-fold increase in the money supply. Finally, if the money supply increase is too rapid compared to the growth of GDP, then inflation will arise.

Normally, and by normally I mean in every month from Jan 1959 to August 2008, banks lent almost all of their excess reserves (the data is here). The reason is simple; by charging an interest rate on loans that exceeds the rate paid to depositors, banks make a profit. Once the financial crisis hit in September 2008 though, things changed. Suddenly banks were holding on to excess reserves rather than lending them out; the risks were too great. In successive months excess reserves exceeded required reserves by two, three and four times. That trend continues today. In the latest Fed report excess reserves in the US banking system topped 1.3 trillion dollars. This means excess reserves are almost twenty times required reserves. Never before has this occurred.

But is this dangerous? What is the problem?

The main problem is a potential one; namely the inflationary impact if these reserves were quickly lent out to the public. If this were to occur the US money supply could rise ten times the excess reserve level, or by well over 10 trillion dollars. For comparison sake the M1 money supply currently is about 1.8 trillion dollars. Putting more than five times the current money supply into circulation suddenly is certainly enough to cause a severe hyperinflation.

However, this is not happening yet. The inflationary effect of the Fed’s expansionary monetary policy (like the QE2) has not occurred in part because these lendable reserves remain unlent. That could change soon though especially since inflation is unlikely to occur until after economic growth begins to pick up steam. In other words, good news today that our economic troubles are passing may be the harbinger that unleashes these reserves and spurs the inflation that so many people worry about.

But this inflation is not a foregone conclusion. The Fed has an important new tool at its disposal to prevent the rapid expansion of loans. Beginning in late 2008, as the financial crisis hit, the Fed implemented a new rule allowing it to pay interest on excess reserves held by banks at the Fed. This means that the Fed essentially changed excess reserve holdings from a checking account for banks into a savings account. To prevent lending from rising too rapidly, and thus to stem the inflationary pressures, the Fed can simply raise the deposit rate on excess reserves. This power gives the Fed considerably more leverage to control the outstanding money supply and thus allows it to control inflation more effectively.

Let’s only hope the Fed can manage these excesses as adeptly as they promise.