Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use Reserve Requirements as a Policy Tool
Transcript
- Lucas: So let’s talk about reserve requirements — the minimum fraction of deposits that banks must hold as reserves, typically at the central bank. It’s one of the oldest tools in the monetary policy toolkit, but for most advanced economies, it’s been gathering dust. Luna: Right, I think a lot of people assume it’s basically obsolete. The Fed hasn’t changed reserve requirements in years, and the ECB even set theirs to zero back in 2012. Lucas: Exactly. But that doesn’t mean the tool is dead. In fact, in several major emerging economies — China, India, Brazil — reserve requirements are still actively adjusted and seen as a powerful signal. The People’s Bank of China, the PBOC, uses changes in the reserve requirement ratio almost as frequently as it adjusts its benchmark lending rates. Luna: And the PBOC just cut their reserve requirement ratio again last quarter, right? I remember reading about that — something like 50 basis points in April 2026. Lucas: That’s right. They reduced it by 50 basis points to 9.5 percent. For context, the PBOC’s reserve requirement ratio peaked at 21.5 percent back in 2011, so they’ve been steadily bringing it down. Each cut frees up a huge amount of bank capital for lending. Luna: Let’s back up for a second — what’s the actual mechanism? When the central bank lowers reserve requirements, what happens at the bank level? Lucas: It works through what’s called the money multiplier. If the reserve requirement is 10 percent, a bank can lend out 90 percent of each deposit dollar. Lower that to 9.5 percent, and suddenly they can lend 90.5 percent. That might sound tiny, but on a trillion-dollar deposit base, it’s billions in new lending capacity. Luna: So it’s essentially a quantity-based tool — it expands the money supply directly. That’s different from interest rates, which work through price incentives. Lucas: Exactly. And that’s why central banks in advanced economies have moved away from it. Since the 2008 crisis, the Fed and the ECB have relied more on interest on reserves, or IOR, to control the floor of the federal funds rate. With abundant reserves from quantitative easing, reserve requirements become almost redundant. Luna: But not everyone has the luxury of abundant reserves. For a central bank like the PBOC, which still has a relatively large banking system with lots of deposits, reserve requirements give them a direct lever to manage credit growth without having to rely solely on interest rates. Lucas: And there’s the signalling channel too. When the PBOC cuts the reserve requirement ratio, it’s a very public signal that they want banks to lend more. Markets react accordingly. For example, after the April cut, Chinese stocks rallied about 2 percent the next day. Luna: Let’s also talk about the flip side — raising reserve requirements. That’s typically used to cool an overheating economy or manage capital inflows. Lucas: Right. Brazil has done that. In the early 2010s, when capital was flooding into emerging markets, the Brazilian central bank raised reserve requirements on certain types of deposits to mop up excess liquidity without triggering an interest rate hike that would attract even more foreign capital. It’s a targeted tool. Luna: So reserve requirements can be used as a kind of macroprudential tool as well, not just monetary policy. Lucas: Exactly. That’s why many economists now view them as a hybrid tool. They affect the money supply and credit conditions, but they can also be used to target specific risks, like foreign currency deposits or short-term wholesale funding. Luna: And what about the unintended consequences? If banks are forced to hold more reserves, doesn’t that act like a tax on their profitability? Lucas: It does. If the central bank pays below-market interest on reserves — or zero — then higher reserve requirements effectively impose an implicit tax on banks. That’s one reason the Fed and ECB prefer to pay interest on reserves at the policy rate, so reserve requirements become less distortionary. Luna: But the PBOC does pay interest on required reserves, right? Not at market rates, though. Lucas: Correct. The PBOC pays about 1.6 percent on required reserves, which is well below its one-year lending rate of around 3.4 percent. So there’s still a subsidy from banks to the central bank. But it’s less of a burden than paying zero. Luna: So the tool is alive and well, just not in the places most of our listeners are based. Let’s bring it back to the US for a sec — could the Fed ever bring back active reserve requirement changes? Lucas: It’s not impossible. The Fed eliminated reserve requirements entirely in March 2020 as part of its pandemic response, moving to a so-called ample-reserves framework. But if the Fed ever wanted to reduce its balance sheet significantly or return to a scarce-reserves regime, reserve requirements could come back into play. Luna: That would be a major shift. For now, though, it’s really in emerging markets where this tool matters most. And if you’re investing in or doing business in those economies, you need to watch reserve requirement changes as closely as you watch interest rate decisions. Lucas: Absolutely. So to wrap it up — reserve requirements are a classic but still-relevant tool, especially outside the G7. They work through the money multiplier, they send strong signals, and they can be used for both monetary and macroprudential purposes. Luna: And if today’s episode helped you connect some dots on how central banks really operate in different parts of the world, that’s exactly why we make this show ad-free — so we can dive into these details without interruption. Lucas: Yeah, and if you found it useful, the way to keep that going is simple. We’re listener-supported, which means no sponsors, no ads. If you want to chip in, buy me a coffee dot com slash fexingo. That’s buy me a coffee dot com slash fexingo. Luna: Anyway, back to the topic — one last thought: with the PBOC cutting reserve requirements and the Fed on hold, we’re seeing a real divergence in how central banks use their toolkit. It’s a good reminder that one size doesn’t fit all. Lucas: And that’s what makes following global monetary policy so interesting. Until next time.