The Truth About Excess Reserves

Tyler enquires about excess reserves:

While the current iteration of the Fed, various recent voodoo economic theories, and assorted blogs, all claim that excess bank reserves are never an inflationary threat, it is precisely two Federal Reserve chairmen’s heretic claims that reserves will light an inflationary conflagration, that forced then president Truman to eliminate not one but two Fed Chairmen, and nearly result in the “independent” Federal Reserve being subsumed by the Treasury to do its monetization and market manipulation/intervention bidding. Which then begs the question: who is telling the truth about the linkage of reserve accumulation to inflation — the Fed of 1951, or every other Fed since, now firmly under the control of the Treasury-banker syndicate?

This is of course a live question. Excess reserves are at never-before-seen levels:

That’s right — throughout the postwar period, banks have almost always lent out all the way up to the reserve requirement.

So, does the accumulation of excess reserves lead to inflation?

Only so much as the frequentation of brothels leads to chlamydia and syphilis.

Excess reserves are only non-inflationary so long as the banks — the people holding the reserves — play along with the Fed-Treasury game of monetising debt and trying to hide the inflation . The banks don’t have to lend these reserves out, just as having sex with hookers doesn’t have to lead to an infection.

But eventually — so long as you do it enough — the condom will break.

As soon as banks start to lend beyond the economy’s inherent productivity (which lest we forget is around the same level as ten years ago) there is likely to be inflation.

So, will they?

I think that would mean biting the hand that has fed them. The financial complex owes a great deal to the Fed for bailing them out in 2008, and throwing a pig’s ear of slush money their way in 2009 and 2010 in the form of QE. Like any Fat Tony, Bernanke commands the allegiance of his minions. But even the most enduring mafia bosses sometimes get shot. There is no status quo that a black swan cannot shatter.

But there are greater inflationary risks (which also, we must note, may set alight the inflationary potential of the excess reserves). A severe oil shock — caused by (say) Iran closing the Strait of Hormuz, something that America, NATO and the UN seem totally set upon — is one. So too could be a global trade shock caused by a regional war — there are lots of danger zones (North Korea, Pakistan, Iran, Syria, Egypt, Libya, Lebanon, etc, etc, ad infinitum).

And how about the return of some of the trillions of dollars now floating around Asia?

As more Asian nations ditch the dollar for bilateral trade, more dollars will end up getting dumped back into the American market.

So while the amassing of excessive reserves perhaps does not pose quite the same inflationary risk as collapsing reserve currency status, I think it is safe to say that while the 00s securitisation bubble was akin to juggling dynamite, this trend of amassing excess reserves (done, lest we forget, as a stability measure to protect primary dealers against another shadow banking collapse) is closer to going to sleep upon a bed of dynamite. 

Now, maybe the broader deflationary trends from deleveraging in the economy dampen this threat significantly. Maybe high inflation in the next five to ten years is a tail-risk event. And perhaps the Fed has little choice about significantly, massively increasing the size of the monetary base to counteract these deflationary forces. On the other hand given the context of deflationary trends, maybe the world is becoming complacent about inflationary risks. We shall see.


Will the Fed Trigger Big Inflation?

What now after the Italian downgrade?

From Forbes:

Standard & Poor’s pulled another late move on Monday, downgrading Italy’s sovereign credit rating by one notch to A/A-1.  The credit rating agency cited weakening economic growth prospects as public and private borrowing costs rise, and a fragile political coalition failing to adequately respond to a challenging economic environment.

While the downgrade doesn’t come as a shock, as S&P had Italy under a negative outlook since May, it will rattle markets.  Europe’s sovereign debt woes have grappled nervous markets the last couple of weeks, with every word coming from Greece, Germany, or the ECB sparking massive moves on both sides of the Atlantic.

This has sent certain (risk-addled) European banks spiralling downward, leading the European Systemic Risk Board to warn policy-makers that the time may soon come to make a massive liquidity injection into European markets (i.e., throwing money at saving bad banks)

BNP Paribas:


In America, traders today were in a more bullish mood.

From Zero Hedge:

Shrugging off Italy’s rating downgrade (somewhat expected but continued negative outlook), funding stress in Europe (Libor levitating and Swiss/French banks divergent), cuts in global growth expectations (IMF and World Bank), concerns over systemic risk contagion (ESRB and World Bank), and escalating rhetoric in Sino-US trade wars, US equities have managed to reach up to Friday’s highs as rumors of AAPL being added to the Dow seemed enough for hapless traders.

More significant than excitement over Apple — and the main reason that markets today are levitating, in spite of all the turmoil — is the hope that Bernanke will throw more policy tools at the American economy.

Will he?

Although I have been specific about the idea that QE3 is definitely coming I don’t foresee QE3 being initiated this week. Why?

Firstly, because I think Joe Biden promised Wen Jiabao that America would hold off QE3 in the short-term to preserve the value of Chinese holdings.

Bernanke will probably initiate a program to roll the Fed’s holdings onto the long-end of the spectrum of bonds: as 2-year bonds in the Fed’s portfolio reach maturity, the Fed will replace those with 10-year bonds, to reduce net interest rates.

More significantly, I expect Bernanke to announce that the Federal Reserve will announce that it will no longer pay interest on excess reserves. Banks have accumulated massive excess reserves since the 2008 crisis, when the Fed determined to pay interest on reserves not lent — ostensibly to increase flexibility in the banking system in case of further collapse:

In theory, unleashing these excess reserves into the economy would get capital to productive ventures without infuriating bondholders and retirees any further with more quantitative easing. But in practice a surge in lending might do the precise opposite — unleashing a tidal wave of inflation, further diminishing the purchasing power of dollars.

The potential loans possible on these reserves could be up to $16 trillion. GDP is currently $14.99 trillion. Unless the GDP keeps pace with the money supply, these new loans would create the potential for substantial amounts of inflation.

Could this be the spark that triggers a runaway inflationary spiral? It could be. It’s not in the interest of either debtors, nor creditors — but that doesn’t remove the risk.