Much Ado About Reserve Growth

Critics of the Fed have expressed concern about the inflationary implications of the huge expansion of the Fed’s balance sheet, particularly excess reserves. The reserve bulge was created  when the Fed expanded the alphabet soup programs in 2008. At the same time the Fed began paying interest on reserves, paying 1%, which was .75% above Fed Funds at the time. So the banks held the funds which they borrowed under these programs at the Fed because they got a higher rate from the Fed than what it cost them to borrow, and a better rate than they could safely get in the market.  The Fed was basically providing them a risk free subsidy to borrow and NOT lend. The net inflationary effect was therefore nil.

Commodity prices collapsed, coinciding exactly with the expansion of Fed credit precisely because banks stopped financing commodities holdings in order to take the safe spread being offered by the Fed. The Fed’s action actually caused credit to further dry up.

Commodities recovered somewhat in 2009, but nowhere near the levels they had reached in 2007. The expansion of the Fed’s balance sheet was not the cause of the recent rise in commodity prices. The Fed credit bulge remains locked up.  The causes of the recent rise can be argued, but it is not coming from those excess reserves held at the Fed.  Instead, it appears to be a bet that the Fed’s policy operations are inflationary, a thesis that is widely accepted but yet to be proven.

The extra “money” that the Fed printed via these programs has stayed locked up in the Fed’s vault. M2 grew a little faster than it had prior to the creation of these programs, but as the Fed stopped growing its balance sheet M2 growth soon returned to the trend path. It has been flat since March.  Futhermore, major components of broad money have been in decline. Retail Money Market Funds have been collapsing and Institutional Money Funds have also started down. Bank deposits are no higher than where they were last November. Somehow, through digital manipulation perhaps, M2 and MZM (not shown) have managed to stay flat, even though the components have been declining.

Now that alphabet soup programs are radically shrinking, the Fed keeps the reserve base stoked by buying MBS, GSEs, and Treasuries from the banks. The banks, rather than deploying the fresh cash, have mysteriously been leaving it on deposit at the Fed. Only the Primary Dealers have acted in some small way to deploy the funds speculatively, for the most part by aggressively manipulating stock prices higher, which is their typical knee jerk response when they have plenty of cash.

Why have the banks at large sat on their hands? The interest rate on the excess reserves at the Fed was lowered to the Fed Funds rate concurrent with the Fed moving the rate to effectively zero late last year. There was no longer  incentive for the banks to hold these funds at the Fed, yet they still do!

Reason?  (Continued below)

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There’s no loan demand, nowhere for them to invest the funds where they can earn a safe return. So when the Fed buys MBS securities from them, they hold the cash at the Fed, essentially earning nothing. The impact of the mountain of new Fed credit is therefore nil. Unless and until the banks deploy these funds, they are not inflationary. The runs off that printing press are still sitting in a locked vault in the basement at 33 Liberty Street, NY, NY.

They system is broke. Both lenders and borrowers continue to have one objective- get debt off the balance sheet. At the same time, when their capital is further impaired by writing down bad debt, they are forced to hold more cash at the Fed. Under the circumstances, the Fed’s massive expansion of the balance sheet is not inflationary. It is pushing on a string, and the string is just crumpling.

Maybe what we should worry about is the point at which the Fed’s balance sheet begins shrinking again. Can that be done without some manifestation of inflation, perhaps hyperinflation?

Maybe a financial accountant could expound on this, and correct me if I’m wrong, but if the bank deposits held at the Fed, a Fed liability, begin to decline, perhaps due to pressure from withdrawals by the banks’ depositors, then something on the asset side of the balance sheet would have to decline as well. Would not the Fed have to sell an equal portion of its securities holdings to meet the withdrawls, thereby shrinking Fed credit and blunting any expansionary or inflationary effects? Any decrease in the deposit liability would need to be met by an equal decrease in an asset, or increase in a different liability, but what?

This bulge on the Fed’s balance sheet looks like dead weight right now, does it not?  The inflationary effect should have come at the outset, but since the system couldn’t support it, does this not become a deflationary bomb waiting to explode?

And is this not why the Fed wants to promote the illusion of inflation as it loudly protests otherwise (wink, wink), so as not to encourage economic units to further pay down debt? My answer would be that I think that this thing is still an inverse pyramid, with the potential for a massive deflationary collapse still looming.

I say “potential” because I don’t know what will happen, but I want to remain open to any possible outcome. I don’t want to get locked in to a mindset that could prove disastrous. Although I spend  hours studying and reporting on the Fed’s actions and its balance sheet each week, I am not a financial accountant, and I may well be missing something. So I want to keep an open mind.

We are in uncharted waters here, and so is the Fed, and I have  documented over the past couple of years where the Fed has been surprised by the unintended and unanticipated consequences of its actions. By giving it a little thought, we have been able to see some of these things coming.

Bernanke has wildly been trying anything and everything to forestall collapse and bring on a moderate inflation. There’s still no assurance that he will be ultimately successful. There are many who believe that his policies will lead to hyperinflation. I am not so sure.

I do not believe that the current stock market run is any evidence of his ultimate success. We know exactly what is causing this move. I reported on that cause at the time it began, and continue to report on it. In 2007 and 2008 the Fed sucked the Primary Dealers dry, then realizing its error, it began pumping them up again last fall, accelerating the process in March. One thing seems certain. This  cannot be sustained indefinitely. The massive liquification of the primary dealers will either be withdrawn, probably within the next 6 months, or external forces will bring about massive destabilization, most likely within the next couple of years.

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