Wednesday, June 1, 2011

Why It Is Going to be Whipsaw City, in the Second Half, for Most Economic Analysts

This is what I wrote on December 18, 2010 in a post titled, The Coming 'Sugar High' Economic Recovery:
As for the turnaround, it is totally a Ben Bernanke produced event, so it will be as manipulated of a "recovery" as one can get, followed by severe inflation. In other words, the economy will look good, maybe, for the first two quarters of 2011
and that's about it. I explained this to a D.C. insider who got it right away and said, "So it's going to be a 'sugar high' recovery." That nails it exactly.

As we come close to the end of the first two quarters that I wrote about back in December 2010, this is todays top headline at CNBC:
'Sugar High That Has Buoyed US Economy Is Wearing Out'
CNBC then quotes Mike Riddell, a fund manager at M&G Investments in London:
"It seems that almost every bit of data about the health of the US economy has disappointed expectations recently," said Riddell, in a note sent to CNBC on Wednesday.
Bottom line, most analysts are trend followers who forecast out the trend of the former month. They have no theory to understand the twists and turns of the economy (Or they hold a convulted Keynesian theory that must confuse them even more).

Right now, the economy is in an extremely vulnerable state that can result in it turning in a number of different directions. And few understand what even needs to be monitored. Whether there is a QE3,or not, is about number 5 on the list of monetary factors I am looking it. What happens to excess reserves, required reserves, seasonally adjusted money growth versus non-seasonally adjusted growth, the Fed funds rate versus the interest paid on excess reserves are all more important than if there is a QE3 (I monitor all these factors in the EPJ Daily Alert).

There are countervailing forces among these factors right now which make things trickier to forecast than ever. If there ever needs to be a time to monitor money factors very closely, it is the present. Otherwise, it is whipsaw city. All those watching Bernanke for an indication about QE3 are looking in the wrong direction. Bernanke is a mad scientist, who understands maybe half of the new tools he has created. As I wrote a week or so ago in an EPJ Daily Alert, Bernanke's QE2 is a scam. What you have to watch is the factors I outlined above, and the chief economist of financial research at the New York Fed, James McAndrews, has written an entire piece exposing Bernanke's quantitative easing nonsense and what needs to be monitored to understand what is going on in the economy. I reproduce from the the May 23, EPJ Daily Alert :

Long term EPJ Daily Alert readers know that I have been something of a
lone wolf advising that what needs to be watched is excess reserves
since Bernanke started paying interest on them rather than just Fed
assets. QE2 was kept largely under control from creating too much new
money because most of the funds went into excess reserves.

To my total amazement, the chief economist of financial research at
the New York Fed, James McAndrews, put out a report Monday, detailing
what has been my position right along, that QE2 did not have a greater
impact because the reserves went into excess reserves and they did so
because the Fed is paying interest on excess reserves.

I find that I am in nearly complete agreement with McAndrews
explanation, with the one caveat that he seems to believe that
reserves can be kept out of the system by controlling the rate paid on
excess reserves. True enough they can, technically. But the rate on
excess reserves is now 0.25%, if rates go back up to pre-crisis levels
of around 5%, I find it hard to believe that the Fed will boost rates
quick enough to the 5% level to stop the flow of some reserves into
the system. How many and at what speed will be the issue.

With that significant warning, McAndrews correctly makes the point
that QE2 was not that inflationary, but he neglects to emphasise that
now that QE2 is over, the excess reserve overhang remains and it has
the potential to become highly inflationary, even if there isn't a

I reproduce McAndrew's full report below because of its major
significance in helping understand how Bernanke's new "tools" have
changed the game and monitoring monetary policy using pre-Bernanke
monetary watch posts, such as the assets on the Fed's balance sheet,
will lead to incorrect analysis.

Here's McAndrews:

Will the Federal Reserve’s Asset Purchases Lead to Higher Inflation?

By Jamie McAndrews

A common refrain among critics of the Federal Reserve’s large-scale
asset purchases (“LSAPs”) of Treasury securities is that the Fed is
simply printing money to purchase the assets, and that this money
growth will lead to much higher inflation. Are those charges accurate?
In this post, I explain that the Fed’s asset purchases do not
necessarily lead to higher money growth, and that the Fed’s ability
(since 2008) to pay interest on banks’ reserves provides a critical
new tool to constrain future money growth. With this innovation, an
increase in bank reserves no longer mechanically triggers a series of
responses that could lead to excessive money growth and higher

To follow my argument, think of the relationship between Fed asset
purchases and inflation in terms of a pipeline with several sections.
The first section of the pipeline relates to reserve balances. When
the Fed purchases assets, it pays for the purchases by creating
reserve balances. These reserve balances can put pressure on later
sections of the pipeline—the money supply and inflation rate. Now,
however, there is a new valve—interest on reserves—that provides an
outlet from the pipeline to a reservoir, enabling policymakers to
reduce the pressure from reserves.

The Old Pipeline View: Why Fed Asset Purchases Will Generate Higher Inflation

There are three parts to the argument that Fed asset purchases will
lead to much higher inflation. First, there is the connection between
Fed asset purchases and reserves. When the Fed buys assets from the
public, it pays for them by electronically crediting banks’ accounts
at the Fed with reserves. Second, there is a connection between
reserves and money growth. When banks’ reserve balances increase, they
can use these additional reserves to make more loans to households and
businesses—an outcome that can lead to further growth in the broad
money supply in the economy. Third, there is a connection between
higher credit and money growth and inflation. For example, excessive
credit expansion can bring on higher money growth, excess demand
pressures, and overheating in the economy, which in turn can raise
inflation expectations and increase the inflation rate.

My view is that this description of the pipeline between Fed asset
purchases and inflation is accurate except for the connection between
reserves and money growth. I’ll show that asset purchases to date have
not led to unusually rapid growth in the money supply, and I’ll also
explain why a large amount of reserves need not induce rapid growth in
money over time.

A Useful Review: Money and Reserves

Money is usually defined as a generally accepted medium of exchange,
used to purchase a good or service or to retire a debt. Money takes
many forms in modern society, such as cash, deposit accounts at banks,
shares in money market mutual funds, and savings account balances and
other liabilities issued by banks, credit unions, and thrifts. The
Federal Reserve tracks two measures of money—the monetary aggregates
M1 and M2. Currency and demand deposits at banks are the largest
individual components of both M1 and M2, but M2—the broader
measure—also includes savings deposits, small time deposits, and
retail money funds (for fuller definitions, see Federal Reserve
Statistical Release H.6).

Reserves are balances that commercial banks hold in accounts at
Federal Reserve Banks. When the Fed purchases assets from the public,
it pays for them by electronically crediting funds to banks’ reserve
balances at the Fed. Reserves are part of the monetary base, another
monetary aggregate tracked by the Federal Reserve. The monetary base
consists mainly of currency and reserves (for a fuller definition, see
Federal Reserve Statistical Release H.3). In contrast to currency and
demand deposits at banks, which can be held by anyone, accounts at
Federal Reserve Banks can be held only by banks and a few other
special institutions such as the government-sponsored enterprises
Fannie Mae and Freddie Mac.

An important change in the nature of reserve balances occurred on
October 9, 2008, when banks began to earn interest on the reserve
balances they held at Federal Reserve Banks. As we shall see, this
transformation of reserves from a non-interest-bearing asset (like
currency) to an interest-bearing asset is significant.

With these concepts understood, we can now address our main
question: Will the Fed’s asset purchases lead to inflation?

How Do Fed Purchases Affect the Money Supply?

My counterargument to those who contend that Fed asset purchases will
generate higher inflation will focus on the second section of the
pipeline—the possible link between reserves and growth in money. When
the Fed purchases a security from the public, it first credits the
seller’s bank with reserves. In turn, the bank credits the seller’s
checking account with a deposit. As long as the seller does not
withdraw the deposit, the money supply, measured by either M1 or M2,
will have increased by the exact amount of the Fed’s purchase. It is
important to note that in the example just given, the money supply
increased because of the behavior of all parties: the Fed in creating
reserves, the bank in creating deposits, and the depositor in
maintaining the deposit.

In other circumstances, the increase in the money supply following
a purchase by the Fed can be either less than or greater than the
amount of the Fed’s asset purchase. If the depositors in the economy
are deleveraging, that is, if they choose to repay debts (such as
previous loans) after the bank credits their accounts with deposits,
the increase in the money supply following a Fed purchase can be less
than the amount of the Fed purchase. As a depositor repays a debt it
owes to a bank, the bank’s loans and deposits decrease. If depositors
are repaying loans at the same time that deposits are increasing as a
result of asset purchases by the Fed, then the net effect could be a
decrease in deposits, if the repayment of loans exceeds the asset

Alternatively, if bank customers demand new loans from banks, and
banks use the reserves created by the Fed to extend loans to
customers, then the money supply could grow by more than the amount of
the Fed purchase.

What has, in fact, happened with the money supply since the
beginning of the LSAP programs in late 2008? As measured by the growth
in M1, money growth has been less than the amount of the Fed’s
purchases (see chart)—a development that is consistent with the
deleveraging, or net repayment of loans, by bank customers that has
occurred since late 2008. The Federal Reserve Bank of New York’s
Quarterly Report on Household Debt and Credit for the first quarter of
2011 indicated that “as of March 31, 2011, total consumer indebtedness
was $11.5 trillion, a reduction of $1.03 trillion (8.2 percent) from
its peak level at the close of 2008Q3.” So deleveraging by U.S.
consumers has been substantial during the period of the LSAPs.

The New Pipeline View: Why a Surge in Money Growth Isn’t Inevitable

As of early 2011, there was little evidence of aggressive lending by
banks, and the recent behavior of the broader money supply, economic
activity, and inflation suggests that money growth has not been
excessive. Nevertheless, there are commentators who view the high
level of reserves resulting from the Fed’s asset purchases as
“inflation tinder.” Won’t those reserve balances inevitably lead to
high money growth at some point, as banks seek to lend them out? Here
I can clearly state that the answer is no.

The basis for my answer is that the introduction of interest on
reserves has altered the linkage between reserves and money growth.
Before banks were eligible to earn interest on their reserve balances,
they had strong incentives to avoid holding “excess reserves”—reserves
in excess of the amount they are required to hold by regulation. High
levels of excess reserves in the old regime would be expected to
generate a high growth rate of loans, and consequently high money
growth whenever the banks’ risk-adjusted expected return on loans was

In the new regime, the Fed can vary the rate of interest on
reserves to directly affect banks’ incentives to lend out excess
reserves. For example, a bank holding excess reserves will not have an
economic incentive to lend out those reserves if the risk-adjusted
expected return on the loan is below the rate the bank earns on its
reserve balances. In terms of our analogy to a pipeline, the rate of
interest paid on reserves now acts as a valve, reducing the pressure
that Fed purchases might place on banks to increase lending and
thereby spur money growth. When higher interest rates are paid on
reserves, the reserves are put in a sort of reservoir, relieving a
flow that could ultimately generate higher inflation.

In its December 14, 2010, statement, the Federal Open Market
Committee (FOMC) indicated that it “will employ its policy tools as
necessary to support the economic recovery and to help ensure that
inflation, over time, is at levels consistent with its mandate.” The
FOMC may choose future policies that result in faster or slower money
growth, but the presence of large amounts of reserve balances on
banks’ balance sheets by itself does not inevitably commit the FOMC to
a high future money growth policy. Instead, if Fed policymakers
believe that it is preferable to rein in bank lending and money
growth, they can raise the rate of interest paid on reserves and
thereby dampen banks’ incentives to lend out reserve balances.
In one of the most difficult environments, ever, to understand what is going on in the economy, most analysts aren't even looking at the correct data. It's going to get real tricky out there and the trend followers will get smashed real hard. Next up, they have no idea how hard price inflation is going to hit in the second half. Buckle your seat belt.


  1. Alright, Doc! I'm counting on you (and Gary North) to give me a heads up on when to sidestep from my gold/silver bet. You convinced me, that you are monitoring the right metrics.

    It should be a bumpy, exciting ride!

  2. Bob,

    What if the Fed just keeps a healthy spread, in favor of reserves, between excess reserves and the Fed funds rate? Could this keep the excess reserves tied up indefinitely?

  3. All this talk of "reserves" is total nonsense. Its a reserveless system. Why have reserves of digital credit? Whats the purpose of that? Its all digital, its all fake, there are no reserves! The non-federal reserveless syndicate. Its going down. Ron Paul 2012!!!

  4. "What if the Fed just keeps a healthy spread, in favor of reserves, between excess reserves and the Fed funds rate? Could this keep the excess reserves tied up indefinitely? "

    No. At some point, banks will see their money is better placed in alternative investments that offer higher returns, particularly as price inflation continues (boosting prices like those of stocks.) The Fed could try offer more to beat this out but it'll end up paying more for it, exacerbating inflationary pressures further if it prints money to do so. Bob Murphy has an article on this that's worth reading.

  5. Do you have the Bob Murphy link Inquisitor? I'd love to read that.