Sprinkled among all the official talk
about efforts to end the current recession, you'll hear assurances, notably
from Federal Reserve Chairman Ben Bernanke, that when the economy does
revive, it won't be allowed to blast off into runaway inflation. The Fed,
we're being promised, will prevent such a launch by reabsorbing the hundreds
of billions of dollars of excess liquidity it recently created to halt the
credit crisis.
Delivering on those assurances won't be
easy. There is no reliable, real-time guide to how much cash the economy
needs, so deciding when to drain excess reserves from the banking system (by
selling off T-bills or other Fed assets) and judging how rapidly to do the
draining will be largely guesswork. And the consequences of guessing wrong
will be unforgiving. Drain too fast, and the recovery stalls. Drain too
slowly and price inflation comes charging out of the chute.
Figuring out how much cash is just right
for the economy has always been the Fed's central puzzle. And until late last
year, coming up with a workably close answer, day after day, was the only
thing the Fed really needed to focus on. Executing its decisions was easy.
Since it could create money, the Fed had unlimited power to expand liquidity
by buying Treasury securities (or anything else). And since it owned a
mountain of Treasuries built up from past purchases ($480 billion as of last
September), it had the power to drain liquidity by selling from its holdings.
That Was Then...
That picture of the Fed's power may be
changing. Even if the Fed were to show unprecedented skill (or enjoy
unprecedented good luck) in judging when to drain the excess liquidity that
today is an inflationary time bomb, it might find itself without the
wherewithal to do so. We can estimate how close the Federal Reserve is to
such a trap by examining its assets and seeing how they compare with the
excess "reserves" held by commercial banks. It is the excess
reserves that the Fed will need to soak up at some point to prevent the time
bomb from detonating.
I put "reserves" in quotes
because they aren't what you might think they are. They're not money that
banks put away as a provision for bad loans or for handling a surge in
withdrawals. So-called reserves are more like the transmission fluid running
through the machinery that the Federal Reserve uses to control the size of
the economy's money supply.
If a bank wants to issue demand deposits
to its customers, by law and Federal Reserve regulation, the bank must hold
"reserves" equal to 10% of those deposits. Only two things count as
reserves - cash in a bank's vault and deposits that a bank holds at a Federal
Reserve Bank. The Fed can easily increase the total reserves available to
banks by buying T-bills or other assets, and in ordinary circumstances it can
easily drain reserves from banks by selling T-bills or something else. By
altering the amount of reserves available to banks, the Fed alters their
ability to maintain demand deposits for their customers, which in turn
increases or decreases the M1 money supply.
The last time the Federal Reserve
balance sheet looked somewhat normal (by historical standards) was in
September of last year. Here is the asset picture from last fall, summarized.
Federal Reserve Assets, September 10, 2008
|
$Billions
|
Gold certificate account
|
11
|
Special drawing rights certificate account
|
2.2
|
Coin
|
1.4
|
U.S. Treasury
securities
|
480
|
Repurchase agreements
|
127
|
Term auction credit
|
150
|
Other loans
|
24
|
Holdings of Maiden Lane LLC (net)
|
29
|
Items in process of collection
|
1.4
|
Bank premises
|
2.2
|
Other assets
|
97
|
Total assets
|
924
|
On the same date last September, the
reserves of commercial banks and other depository institutions exceeded the
legally required amounts by $22 billion. If the Fed had wanted to absorb
those excess reserves, to keep them from feeding an expansion in the money
supply, it would have had the means to do so - and by a wide margin. It could
have done it in an instant by selling $22 billion of its $480 billion of
Treasury securities. Or it could have done it overnight by refraining from
rolling over $22 billion of its $127 billion of repurchase agreements.
Between those two asset sources, the Fed had 28 times the power needed to mop
up all excess reserves.
The Fed was more than well prepared. But
it is noteworthy that if you examine the rest of the Fed's assets, you'll
find that none of them would have been available for the job of smoothly
absorbing excess reserves. In principle, the Fed had the option of refraining
from renewing $22 billion of term auction credit - but that would have
threatened the banks that were relying on the credit.
This Is Now...
The current picture of the Fed's ability
to absorb excess reserves is far different from last September, as revealed
by the asset side of the Fed's balance sheet at the end of July.
Federal
Reserve Assets, July 22, 2009
|
$Billions
|
Gold certificate
account
|
11
|
Special drawing rights certificate account
|
2.2
|
Coin
|
1.8
|
U.S. Treasury
securities
|
693
|
Federal agency debt securities
|
103
|
Mortgage-backed securities
|
545
|
Repurchase agreements
|
0
|
Term auction credit
|
238
|
Other loans
|
109
|
Commercial Paper Funding Facility LLC (net)
|
110
|
Holdings of Maiden Lane LLC I, II & III (net)
|
61
|
Items in process of collection
|
0.4
|
Bank premises
|
2.2
|
Central bank liquidity swaps
|
90
|
Other assets (12)
|
76
|
Total assets
|
2,041
|
Notice that the asset total has more
than doubled since last September, from $924 billion to $2,041 billion. The
Fed engineered most of that increase by buying assets (most notably
mortgaged-backed securities of dubious value) and lending to distressed
institutions it considered too big to fail. It paid for all its new assets
with brand-new dollars, which added dramatically to bank reserves and hence
to inflation-threatening excess reserves.
On the same date, July 22, excess
reserves were $744 billion.
That is a big and dangerous number. When
the current recession begins to ease, short-term interest rates will rise
from their current near-zero levels. Banks will then be in a hurry to lend or
invest their excess reserves. Things would move fast. If the Fed did nothing,
the big unloading of excess reserves might take just a few months.
Each dollar of excess reserves that
banks lend or invest translates into about a $1.65 increase in the M1 money
supply. So the $774 billion in excess reserves would translate into about a
$1.27 trillion increase in M1 - which, in percentage terms, would be a
springboard leap upward for the money supply, over the course of just a few
months, of 76%. That would quickly produce catastrophic rates of price
inflation - not as bad as Zimbabwe, for sure, but worse than a bad year for
Bolivia or for other countries where llama herding is a key industry.
Total Fed holdings of assets it could
use to mop up that $744 billion of excess reserves and avoid such a
catastrophe -- Treasury securities, agency securities, and repurchase
agreements - rose modestly, to $793 billion, since last September. Thus today
the Fed still has enough - but now just barely enough - easy-to-use assets to
absorb the dangerous excess reserves.
So the Federal Reserve isn't quite in a
trap yet. It will still need extraordinary skill, rare good luck,
clairvoyance, ESP, championship-level Ouija skills and a bat-like capacity to
navigate in the dark to deploy its resources at just the right time and at
just the right pace to avoid setting off a damaging, 1970s-style inflation.
But it does have the resources - unless the problem of excess reserves gets
worse.
Credit Crisis Phase II
What might add to the problem of excess
reserves and make it unmanageable is Phase II of the Credit Crisis.
Today Phase II is just a maybe, a
possible next round of bank troubles coming from bad commercial real estate
loans and the resetting of interest rates on a bumper crop of option-ARM home
mortgages. If Phase II arrives, the Federal Reserve will be forced to buy up
another $1 trillion or so of toxic paper to once again haul the banking
system back from the edge of collapse. That would increase banks' excess
reserves by another $1 trillion without doing much to increase the Fed's
ability to eventually reabsorb the additional reserves. In that case the Fed
would be in real danger of losing control over the money supply and getting
caught in a hyperinflation trap.
The reckoning would come when the
economy began to recover from the recession. At that point, dealing with
excess reserves to prevent the money supply from rapidly doubling would be a
matter of urgency. Lacking assets it could sell to absorb excess reserves, the Fed would have only one weapon left -- the
interest rate it pays on those reserves. By setting the rate high enough, it
could discourage banks from lending the reserves and adding to the money
supply.
But life would start to get very
complicated for the average Fed governor. The interest rate that would make
this work, for a while, would be the rate on Fed funds. But that rate would
be rising with an economic recovery, and the Federal Reserve would be paying
the rate on perhaps $2 trillion.
Where would the Fed get the money to pay
its interest bill? Its primary source of income would be the pile of toxic
paper it has been accumulating in trying to rescue the banking system. So the
Federal Reserve would find itself in exactly the same position that ill-run
commercial banks have been in since last fall -- living on overnight credit
and hoping that a portfolio of bad loans will somehow generate enough cash to
cover the interest cost. Of course, if the Fed's portfolio of troubled loans
failed to produce enough cash, the Fed, unlike a commercial bank, would have
recourse to buying time by printing still more money -- but that would add
further to bank reserves. You can see where the road leads. It leads to
Zimbabwe.
Runaway inflation is already baked in the cake, and
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Terry Coxon
Caseyresearch.com
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