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Now we know why the Fed’s money printing binge
never translated to inflation
“We had initially asked to pay interest [in 2006] on
reserves for technical reasons. But in 2008, we needed the authority to solve
an increasingly serious problem: the risk that our emergency lending, which
had the side effect of increasing bank reserves, would lead short-term
interest rates to fall below our federal funds target and thereby cause us to
lose control of monetary policy. When banks have lots of reserves, they have
less need to borrow from each other, which pushes down the interest rate on
that borrowing — the federal funds rate.” Ben Bernanke, The Courage to Act
It has been an enduring mystery to many why the enormous
amount of money created by the Federal Reserve in the wake of the 2008 crisis
never translated to a general price inflation. After all, as Milton Friedman
lectured us, “inflation is always and everywhere a monetary phenomena.” So
why didn’t the enormous amount of money created by the Fed during its
quantitative easing program – some $3.5 trillion added to the bank reserve
credit – launch double-digit price inflation, or worse?
The answer, as it turns out, lies in a little discussed
and understood line item on the Fed’s balance sheet labelled “Reserve
balances with Federal Reserve Banks,” or “excess reserves” as it is called in
the banking trade. The line item was the result of the Emergency Economic
Stabilization Act passed by Congress in 2008, also known as the Wall Street
bailout. In it, the Fed was given the authority to pay interest on excess
reserve deposits made by commercial banks. Those excess reserves, in turn,
were created by the Fed through its quantitative easing program when it
purchased massive amounts of mortgage backed securities (MBS) and Treasury
paper from the banks.
Up until recently, the excess reserve mechanism operated
quietly in background with little in the way of public notice on the part of
either Wall Street analysts or the mainstream financial media. Excess
reserves began to get more exposure in the wake of the recent Fed
announcement on raising rates. Various mainstream media sources, including
the Wall Street Journal’s John Carney in a Heard on the Street column, cited
it as “the main tool” the Fed would use to force interest rates higher.
How the Fed sterilized quantitative easing
I must confess that up until Art Cashin mentioned the
rate on excess reserves in a CNBC interview, followed the next day by Carney’s
column, I had never heard of the commercial banks’ excess reserves on deposit
at the Fed. I would be willing to venture a guess that most of our readers
hadn’t heard of it either. At the same time, we are not talking about some
small matter when it comes to these reserves.
At present, the Fed balance sheet shows $2.4 trillion in
excess reserves on deposit. In 2008, that figure hovered near zero. (Excess
reserves are the amount commercial banks have in reserves not required to
back deposits.) A quick calculation tells us that early 70% of the $3.5
trillion pumped into the commercial banking system by the Fed through its QE
program made its way back to the Fed in the form of excess reserves! This
recyling program amounts to little more than a thinly disguised sterilization
of Wall Street’s bailout in order to defer the inflationary dangers it might
have generated. If you’ve been wondering why the recovery never made it to
Main Street, you now have the explanation. In the end, financial institutions
were saved, but the real economy was left gasping for air.
 
From the beginning the interest rate paid by the Fed on excess reserves was
higher than the rate it received on fed-funds transactions. When interest
rates were zero, the Fed paid .25%. When it raised the fed-funds rate to .25%
on December 16, it also raised the rate on excess reserves to .5%. Clearly,
the Fed has an interest in discouraging deposit withdrawals, but it remains
an open question whether or not the commercial banks will go along with the
program under the new interest rate regime. Unless there is some sort of quid
pro quo that the Fed hasn’t told us about, banks might find it in their best
interest to leverage up their loan portfolios and put that money to work in
the general economy. If so, as Ben Bernanke explains in our masthead quote,
the Fed might find itself at odds with the commercial banks over its new
interest rate policy.
Here’s how economists Ben Craig and Matthew Koepke framed
the issue in a paper for the Cleveland Fed back in February of this year:
“The simplicity of the one-to-one correspondence
between the Federal Reserve’s balance sheet and excess reserves hides the
difficulty involved in predicting how banks are likely to behave in the
presence of the expanded reserves. Unfortunately, understanding this behavior
is what matters for deciding on an appropriate policy for excess reserves.
The fact that banks are holding excess reserves in
response to the risks and interest rates that they face suggests that the
reserves are not likely to cause large, unexpected increases in their loan
portfolios. However, it is not clear what banks are likely to do in the
future when the perceived conditions change or which conditions are likely to
bring about a massive change in their use of excess reserves. Recent history
is not much help in determining the answer to this question because no
balances this big have been seen in recent times. . .
So the Federal Reserve has no easy policy choices,
particularly in the absence of a large body of accepted theory on how banks
can be expected to handle their oceans of cash under changing conditions.”
(See Excess reserves: Oceans of Cash, Craig and Koepke, Federal Reserve
Bank of Cleveland, February, 2015)
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Excess reserves create whole new world for Fed,
the economy and investors
It is the part about how commercial banks will react when
the perceive conditions change that may send a shudder or two through the
markets as we head into 2016. The following are a few quick observations
meant as a framework. We will be monitoring this situation carefully as 2016
progresses, as I am sure, will be a good many others.
First, the monetary inflation inherent to the original
money creation is still alive and well and sitting on the balance sheet of
the Federal Reserve. The excess deposits are still owned and remain under the
control of the commercial banks. In a 2014 essay published by Heritage
Foundation economists, Norbert J. Michel and Stephen Moore a compelling
concern largely overlooked by financial markets with respect to the excess
reserves overhang:
“Arguably most immediate risk from the Fed’s policies
is that banks could use those newly created excess reserves too quickly.
Banks now have an additional $2.6 trillion in excess reserves, which means
that they can create up to approximately $26 trillion in new money. In other
words, banks now have the power to create more than twice the amount of money
currently in the U.S. economy, thus heightening the risk of future inflation.
As the economy improves, the Fed may have to pay higher interest rates on
these reserves to keep banks from dramatically increasing their lending.
Paying higher rates, all else being constant, would exacerbate any ‘losses’
suffered by the Fed, thus increasing [its] political problems.”
(See Quantitative easing, the Fed’s balance sheet and central bank
solvency, Michel and Moore, the Heritage
Foundation, August, 2014)
In that paragraph we read not just the potential for
inflation, but the potential for virulent inflation, and that is why the Fed
is willing to pay more on its liabilities (the excess reserve rate) than it
takes in on its assets (the fed-funds rate).
Second, the prevailing concern among market players is
that the disinflationary risks that brought about the 2008 crisis remain the
predominant economic challenge today. If so, the Fed may have just escalated
those concerns by raising rates. Should the Fed have its way and the banks
refrain from leveraging-up their excess reserves, inflationary concerns could
turn quickly to disinflationary considerations, including the prospect of a
repeat of the 2008 debacle, also brought on by a disinflationary economic
environment. The shut down of junk bond funds like Third Avenue Management,
Stone Lion Capital and Lucidus capital, involving multi-billions, might be
the canary in the coal mine in this regard.
Though the rate increases appear small at this juncture
in percentage terms, the prospect of additional increases will weigh heavily
on the minds of global money managers. Though the increases themselves seem
small at a .25%, their aggregate effect on profit and loss statements could
be significant. Rapid deleveraging in a wide range of markets appears
inevitable. That prospect, though, is only one among many overlapping
concerns with respect to the systemic risks unleashed by a disinflationary
unwinding of positions. Rising interest rates have a way of flushing out the
over-leveraged, the under-capitalized and the overly-dependent. As Warren
Buffett once put it, “only when the tide goes out do you discover who’s been
swimming naked.”
Gold still the best option for the average
investor hedging uncertainties
Last, I would be remiss if I did not end with a word or
two on the role gold might play as all of this sorts itself out. Of the two
outcomes just highlighted, disinflation seems the most probable at this
juncture. Inflation, it it occurs, will take some time to manifest in the
economy itself. No matter the outcome, though, gold and silver coins and
bullion remain the best hedge for the average private investor. The greater
part of global gold demand today has little to do with gold’s reputation as
an inflation hedge. The metal is being accumulated by everyone from private
individuals, to huge institutions, central banks and nation states themselves
as a hedge against the next financial crisis no matter what form it takes –
inflation, disinflation, deflation or hyperinflation.
Gold rose like a phoenix from the ashes of the last
financial crisis because it is a store of value and portfolio insurance, not
because its market price was about to bolt through the roof (though higher
prices were its subsequent fate). We are in a much different situation today
than we were back in 2008 and the excess reserve overhang will play heavily
in the next stage of the on-going financial crisis. The financial system as a
whole still suffers from the damage done by the last phase of the crisis, and
it will be on a hair trigger in the new interest rate environment.
If another “event” were to occur today, it would start
with a much weaker line-up on the playing field than the last time around and
a Fed with fewer, less reliable tools in its toolbox. We suspect that gold
and silver demand will continue to grow as the dangers and uncertainties just
outlined begin to manifest themselves in the financial marketplace. It will
serve as safe harbor on this ocean of excess reserves. Those who understand
the virtues of gold ownership are not going to suddenly go to their national
currencies, or the banking system, or the New York Stock Exchange as a
defense. They will go to gold and silver.
__________________________________________
Michael J. Kosares is the founder of USAGOLD and the
author of “The ABCs of Gold Investing – How To Protect and Build Your Wealth
With Gold.” He has over forty years experience in the physical gold business.
He is also the editor of News & Views, the firm’s newsletter which is
offered free of charge and specializes in issues and opinion of importance to
owners of gold coins and bullion.
Disclaimer – Opinions expressed on the USAGOLD.com
website do not constitute an offer to buy or sell, or the solicitation of an
offer to buy or sell any precious metals product, nor should they be viewed
in any way as investment advice or advice to buy, sell or hold. USAGOLD, Inc.
recommends the purchase of physical precious metals for asset preservation
purposes, not speculation. Utilization of these opinions for speculative
purposes is neither suggested nor advised. Commentary is strictly for
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the accuracy, timeliness or completeness of the information found here.
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