Thursday, December 17, 2009

The Panic Over the Soaring Monetary Base Was a Bernanke Bluff

This is big. It is going to knock for a big loop all those concerned about the inflationary consequences of the soaring monetary base. The Federal Reserve Bank of New York today released a report, "Why Are Banks Holding So Many Excess Reserves?".

Fed economists Todd Keister and James McAndrews state that while the high level of reserves in the U.S. banking system during the financial crisis reflects the large scale of the Federal Reserve’s policy initiatives, it conveys no information about the effect of these initiatives on bank lending or on the level of economic activity. This is another way of saying what I have been saying right along, watch the money supply, not the monetary base.

Keister and McAndrews explain that the buildup of reserves in the banking system is a by-product of the liquidity facilities and other credit programs introduced by the Federal Reserve in response to the crisis. They also discuss the importance of paying interest on reserves when the level of excess reserves is unusually high. But the key point they make remains that the majority of the newly created reserves end up being held as excess reserves and, therefore, the data on excess reserves provide no useful insight into the lending decisions and other activities of banks. Got that? The trillion dollars sitting as excess reserves has had no impact on the economy, and as the Fed stops it's emergency facilities, it is going to be drained. The trillion never went into the economy and never will.

If Keister and McAndrews are correct, and I believe they are, then the Fed will have little problem in ending its emergency lending facility activities. The banks by maintaining those funds as excess reserves (for whatever reason, even if it is simply to earn interest) have in reality kept those funds out of the economic system. As the Fed ends its liquidity emergency facilities they will have to pay back the borrowed funds.

The alarmists, who have thus pointed to the surge in the monetary base as a sign of soaring Fed monetary "easing" and who have been shouting about the inflationary consequences, are going to go into cardiac arrest once they see the monetary base crash when the Fed winds down its emergency facilities and the banks use the excess reserves to pay back the facility funds. The super-decline in the monetary base, as was the super-increase in the monetary base, will of course mean nothing relative to the actual money supply, which is where one should have been keeping one's eyes all along.

In a way Bernanke played a huge shell game on the global financial world. All the so called easing never happened. Let me repeat, what was touted by almost every economist in the world as the extremely loose monetary policy, didn't happen. The money never entered the system. It was a bluff. Bernanke has set us up for Crash II and few see it coming. I wouldn't want to play poker against him.

Read the full Fed report here

UPDATE: I want to emphasise that the purpose of this post is to show that looking at the monetary base instead of the actual money supply was an error and that as the report says the reserves that were simply excess reserves had no impact on the economy. However, the Fed report does to some degree imply that the trillion in excess reserves is with one set of banks and the extra credit facility money is with another set of banks. I do not believe this is the case, or Bernanke better hope it is not the case as he stops the emergency credit facilities. I will have more on this tomorrow in Part 2.

UPDATE 2: Part 2 of my analysis is up here.


  1. to me it appears that what Bernanke did was ship mountains of money to the megabanks via all these various credit facilities, and the banks just turned around and stashed them with the Fed as excess reserves. No new money enters the system, but the banks get to have the excess reserves in "their" name to serve as a sort of rainy day fund in case the asset writedowns, mark-to-market accounting (prior to its suspension), and panicked credit markets really would have resulted in an inability for these megabanks to survive. Meanwhile, as time passes and these various Fed facilities are "wound down", the megabanks can repair themselves via the steep yield curve (borrow from the Fed at 0% and lend to the US Gov at 3%).

    Seems like a clever plot if you ask me. Too bad the Executive Branch and the Congress didn't get the memo and blew up their balance sheet. Unless that was all part of the plot too, ie. to massively increase the supply of available paper for the megabanks to gobble up and hog yield.

    Too bad this all comes at the expense of the rest of us through higher future taxes and a depreciated $.

  2. Fascinating. I waffle back and forth between thinking The Bearded One is a moron and a genius. A mad genius perhaps.

    Regardless, the problem still remains, instead of the inflationary pressure from a flood of printed money bottled up inside the Fed/banking shell game that eventually will burst out, we have a false asset bubble from EXPECTED money printing?

    How can you have Crash II without true mal-investment?

    I am confused about what you are saying. How does this end? The monetary base kept increasing from all of the asset purchases, but the M2 virtually stopped because the money was funnelled back to the Fed? Monetary base falls, people puke gold and euros, equities finally catch on and stock market sells off hard? How does this help Ben? This makes him look bad. People tolerate the specter of inflation a lot better than a halving of the S&P....

  3. This leads to another question for the further out years, Mr. Wenzel.

    Who buys the (anticipated) huge issuance of new US Govt paper in the following years, considering there really is no indication at all from the present Politicos that these deficit levels will not become more or less "permanent"?

    It seems like the whole thesis is as the Fed reins in these various facilities, then the excess reserves fall concomittantly. Where is the money to buy this paper going to come from, considering the Fed can't keep rates at zero forever (can they?)?

    So maybe most, but not all of the money presently sitting as excess reserves at the Fed will be extinguished. Some will probably be left to purchase Govt debt.

    Regardless, I cannot think of a single line of analysis that does not result in some pretty significant inflation down the road. Maybe you can do a post on your personal inflation expectations and the probability you assign to the various possibilities. To me, this inflation/deflation debate is the most important macroeconomic issue today.

  4. @Ryan

    You got it.

    @Matt M.

    In this post I was focusing on the monetary base and its uselessness as a tool to predict economic activity whe you have such high excess reserves, but remember there was REAL money printing between 9-08 and 2-09, that has to be liquidated. And that was at a walloping 15% annualized rate, so we don't know how that also slowed crash I--in addition to normal technical reactions upward against such a panic sell off--that ultimately result in at least trace back of previous stock market lows.

  5. @Ryan
    Very well said. Helped me understand

    I got it. Thanks for clearing that up.

  6. Mental block I don't understand why would this cause Crash 2 then?

  7. "The trillion dollars sitting as excess reserves has had no impact on the economy"

    I explained it to a friend as "kinetic inflation", that could potentially be turned into "mechanical inflation".

  8. Two points:

    (1) I think this is going to be analogous to the paper a few years ago by two Fed economists reassuring everyone that the housing market was fine. (You know, the paper you ripped to shreds at the time.)

    (2) Surely you don't mean to say, "Has had no effect on the economy." If it had no effect, then Bernanke could've sat back and done nothing with buying MBS and other housing debt, and we would still be in the same position we're in right now. You're not saying that, right?

  9. So, what happens to the excess monetary base? As far I as can see, there are two options: either the excess is sopped up by the Fed in one way or another or, the money gets leaked into the economy and begins affecting the money supply.

    In the first case, the sopping activities generates high interest rates. I think many "alarmists" see this as unlikely given the large Federal deficit.

    In the second case, we have dollar devaluation.

    If there is some mechanism for sopping up the base without directly generating higher interest rates, there is still the separate issue of financing the deficit. If that comes from existing monetary stock, interest rates must rise. However, if that comes from an increased monetary base, then we have inflation.

    I'm hoping this analysis is too simplistic and I'm missing some obvious solution.

  10. @Lori

    I didn't go into detail in my post, but my extended comment would be:"Thus, Bernanke intentionally has not seen this increase in reserves as a way to increase the monet supply. Indeed, the money supply has not grown since 02-09. Therefore the current Fed distorted capital structure is no longer being supported by the Fed and will result in a second down leg to the economy and stock market."

  11. Isn't this report someone disingenous when they show a T-account of a Bank A in Normal Times with Deposits of 100, Reserves of 10, and Loans of 50. Or in the second account, deposits of 100, reserves of 10 and deposits of 130. Wouldn't this be more like deposits of 100, reserves of 10, and loans of 1000?

  12. @Bob Murphy

    RE point 1. I actually think these guys have it pretty much down (except for who is holding the excess reserves--see my upcoming second post on this which should be up byy this afternonn.)

    RE point 2. Perhaps it is more accurate to say it hasn't had an impact in the way most economist have been shouting about, i.e. no new inflationary impact, no new impact on economy, on impact on the capital structure, no impact on the stock market OTHER THAN it helped maintain the status quo by moving reserves to banks that needed it versus the original banks that held the excess reserves. It was a stabilization effort. They didn't build a larger yacht, they plugged a hole in the current yacht.

  13. @Mark Addleman

    The "sopping up" will be done by winding down the current emergency credit facilities.

    The sopping up of the excess reserves will not necessarily mean a spike in the Fed funds rate. If the excess reserves are for the most part now held by the banks that have been borrowing from the Fed credit facilities, they just pay the loan back with the excess reserves.

  14. Some thoughts from a community banker in Mayberry:

    1. We hold excess reserves at the Fed because the Federal Home Loan Bank we belong to is paying 0.01%. We never before held money at the Fed until they started paying interest last year.

    2. We have excess reserves because we hold (or held) mortgage-backed securities that prepaid at a much higher speed, additionally, loan demand is down (we're down 5% in total outstanding), and deposits are up (YOY up 5.64%).

    3. The excess reserves is our money, not the Fed's. They can have it, but at a price, just like if someone wanted a loan or a municipality wanted to float a bond issue. The mortgage-backed securities the Fed holds aren't going to be bought back by the banks at anywhere near the price the Fed is hoping to sell them back for.

    4. Since the Fed doesn't have total control over that Trillion dollars and the banks won't overpay for the mortgage backs the Fed need to sell, what's a poor central banker to do?

    5. There's no historical context, that I'm aware of, that gives me confidence that we can get back to normal without severe pain. We are flying over the open ocean on visual, not instruments, with Ben Bernanke at the controls, Tim Geithner as the co-captain, and their wise Mandarins sitting in first class. God help us.

  15. The new Fed Current Issues article is so fraught with errors it almost doesn't warrant a response; however, I'll post one for giggles. The authors seems to have neglected to consider (i) how high the rate of interest the Fed will have to pay banks in order to deter them from otherwise lending or investing, (ii) the fact that such rate will have to increase dynamically and infinitely (in order to forever prevent such reserves from entering the monetary base), and (iii) that the payment of interest itself will increase bank reserves (thereby also dynamically contributing to the amount of interest payments the fed would have to make. For the record, let me add one general comment. The authors have constructed an article that denies that there are any costs to the inflationary policies adopted by the Fed. An article that is premised on there being no downside, and all upside, should ring any astute reader's alarm bells.

  16. Why would we expect the banks to pay back their Fed loans? Do we know the loan terms? I can imagine a few scenarios.

    (1) Variable interest rates (something other than the Fed funds rate) which will rise to the point past the rate at which the bank believes it can loan the money

    (2) Some kind of arm-twisting (perhaps this is the reason the Fed is seeking more regulatory authority?)

    If it's the first option, then it seems there would be some kind of arbitrage opportunity but I'm too tired in my cramped airplane seat to figure out if the bank could actually take advantage of it... :)