Monday, February 8, 2010

Is Clueless Ben about to Crash the Economy, Big Time?

This is the most remarkable financial report that I have ever seen. It comes from Jon Hilsenrath at WSJ:
Federal Reserve Chairman Ben Bernanke will begin this week to lay out a blueprint for a credit tightening, to be followed once the Fed decides the economy has recovered sufficiently.

The centerpiece will be a new tool Congress gave the central bank in October 2008: an interest rate the Fed pays banks on money they leave on reserve at the central bank. Known as "interest on excess reserves," this rate is now 0.25%.

The Fed is still at least several months away from raising interest rates or beginning to drain the flood of money it poured into the financial system in 2008 and 2009. But looking ahead to when the economy is strong enough to warrant tightening credit, officials have been discussing for months which financial levers to pull, when to start and how best to communicate their intent.

When the Fed is ready to tap the brakes, it plans to raise the rate paid on excess reserves, according to Fed officials in interviews and recent speeches. The higher rate would entice banks to tie up money they otherwise might lend to customers or other banks. The Fed expects such a maneuver to pull up other key short-term rates, including the federal-funds rate at which banks lend to each other overnight—long the main tool for steering the economy.
Over the last six months M2(nsa) has grown at only a 1.7% annualized rate. One of the slowest money growth rates in decades.

The current stock market weakness and weakness in gold are the direct result of this slow growth. For some at the Fed to think they have to tighten credit at some future point from here is simply remarkable, although a stable non-growth money supply would be ideal, it appears that the Fed is not looking at the situation from this perspective, rather they believe they are maintaining an easy money policy simply because interest rates are low.

Short-term rates are low not because of easy money, but because of an enormous flight to safety as a result of the financial crisis. The flight to safety has resulted in a very strong desire to hold cash and near cash instruments, such as Treasury bills. This is the factor behind the low rates, not the Fed. If the Fed actually attempts to raise rates under these conditions, and it appears some members see such a likelihood down the road, the Fed would more than likely end up shrinking the money supply, which in turn would make the Great Depression look like a Super Bowl party.

This confusion by Fed members including Bernanke is not new. In January, I pointed out this confusion on Bernanke's part. I also warned about this confusion, after a Bernanke speech in December 2009.

It now appears that this confusion will lead to policy errors on the part of the Fed where they tighten money supply, thinking it is near out of control just because interest rates are low, when in fact there has been under 2% money supply growth.

I repeat, a tightening under current conditions could result in an actual shrinkage of the money supply, which would bring about huge price deflation.

The only other possible interpretation, and there is nothing to indicate Bernanke is thinking this way, is that what Bernanke really means is that he will raise the rate on excess reserves IF banks begin to aggressively use the excessive reserves to make new loans, which would result in a rapid increase in the money supply. Under these conditions, a hike in the interest rate paid on excess reserves would be justified. However, there is no indication from Bernanke's speeches that he gets the subtleties of this quite different scenario.

Stay tuned.


  1. I just can't get on board with your certainty that rates are below where they would be without the Fed. You blame the demand to hold cash and short-term bills for safety as the reason rates are pushed so low, but how can you justify this will the Fed buying all sorts of debt? (announced and possibly unannounced throught the Household sector story you had a month or so ago.)

    If the Fed didn't exist there would be a huge vacuum of demand for all sorts of things and I just can't imagine that people would really accept a near zero t-bill yield.

    Can you clear this us for me? I still don't get it.

  2. Matt,

    The answer is the huge supply of excess reserves. The only reason banks are holding funds there is because A. They need to pay the money back to the Fed when the credit facilities wind down. So the entire money printing is phony. The fed prints the money, the banks deposit it with the Fed and when the Fed calls it back, the banks just move it from one Fed account to another. The money just hasn't entered the system.

    B. If the banks weren't happy with what they were earning at the Fed, and on T-bills etc. They wouldn't be putting money out at these rates. Remember, these rates are below the effective fed funds rate. They could always put it out in the Fed funds market that they aren't tells you that they are happy getting what they can with complete safety and security---which makes it the real rate.

    If the effective funds rate were lower, it would be a different story.