Friday, December 13, 2013

Why Interest Rates Will Eventually Explode to the Upside

I have long been warning in the EPJ Daily Alert that the $2.5 trillion sitting at the Federal Reserve as excess reserves is a ticking time bomb. If banks start to pull that money from the Fed and loan it out, price inflation could go to double-digit levels almost overnight.

The Federal Reserve is starting to recognize this. In a WSJ column by Jon Hilsenrath, who is considered to be close to Fed officials, Hilsenrath writes:
Since the Fed has pumped $2.5 trillion into the economy by purchasing bonds, the old system won't work unless the central bank pulls much of this money out[...]The stakes are enormous. Right now banks aren't lending this money aggressively. But as the economy expands and lending picks up, the Fed will need to tie up the money to ensure it doesn't cause the economy or financial markets to overheat.

"The Federal Reserve has never tightened monetary policy, or even tried to maintain short-term interest rates significantly above zero, with such abundant amounts of liquidity in the financial system," according to a draft of a new research paper by Brian Sack, the former head of the New York Fed's markets group, and Joseph Gagnon, an economist at the Peterson Institute for International Economics and a former Fed economist.

Bottom line, as I have been warning, the Fed needs to get these funds drained before they hit the economy. The problem is there is no good way to do it without driving interest rates through the roof. As I have long contended, Bernanke with all his experiments and new "tools" has been a mad scientist playing with the economy. This is what I wrote about excess reserves in August 2010, THREE YEARS AGO, in a post titled, The Case for Ben Bernanke as Mad Scientist:
Here we have a completely new tool introduced by Bernanke. The paying of interest on excess reserves, which probably has a lot to do with a trillion dollars sitting on the sidelines as excess reserves. No one knows for sure why all these excess reserves are sitting there, but they weren't there before Bernanke started paying interest on reserves. Why was this tool introduced in the middle of a crisis? Mad.

Bernanke even admits there is little experience with these tools (my emphasis):
I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions. However, the expected benefits of additional stimulus from further expanding the Fed's balance sheet would have to be weighed against potential risks and costs. One risk of further balance sheet expansion arises from the fact that, lacking much experience with this option, we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions... uncertainty about the quantitative effect of securities purchases increases the difficulty of calibrating and communicating policy responses

Here is Bernanke on his new tool, paying interest on excess reserves (my emphasis):
A third option for further monetary policy easing is to lower the rate of interest that the Fed pays banks on the reserves they hold with the Federal Reserve System. Inside the Fed this rate is known as the IOER rate, the "interest on excess reserves" rate. The IOER rate, currently set at 25 basis points, could be reduced to, say, 10 basis points or even to zero. On the margin, a reduction in the IOER rate would provide banks with an incentive to increase their lending to nonfinancial borrowers or to participants in short-term money markets, reducing short-term interest rates further and possibly leading to some expansion in money and credit aggregates. However, under current circumstances, the effect of reducing the IOER rate on financial conditions in isolation would likely be relatively small. The federal funds rate is currently averaging between 15 and 20 basis points and would almost certainly remain positive after the reduction in the IOER rate. Cutting the IOER rate even to zero would be unlikely therefore to reduce the federal funds rate by more than 10 to 15 basis points. The effect on longer-term rates would probably be even less, although that effect would depend in part on the signal that market participants took from the action about the likely future course of policy. Moreover, such an action could disrupt some key financial markets and institutions. Importantly for the Fed's purposes, a further reduction in very short-term interest rates could lead short-term money markets such as the federal funds market to become much less liquid, as near-zero returns might induce many participants and market-makers to exit. In normal times the Fed relies heavily on a well-functioning federal funds market to implement monetary policy, so we would want to be careful not to do permanent damage to that market.

Why would you implement such a new tool that is playing some role in attracting a trillion dollars, when to do something about it might do "permanent damage" to one of the fundamental tools of monetary policy, tested and used for decades, the Fed funds rate? Mad.

Insiders at the Fed are apparently realizing Bernanke's tools are mad. Here's Hilsenrath again (my emphasis)
The idea for the repo program bubbled up from the New York Fed's market group in part because another tool wasn't working well. Officials had seen a program known inside the Fed as IOER, for "interest on excess reserves," as the main avenue for managing short-term rates amid the flood of money in the system. Under this program, the Fed pays banks 0.25% for cash they keep at the central bank. In theory, when the Fed wants to raise short-term rates, it would raise this interest rate. Rather than lend out money, banks should want to keep it with the Fed.

In reality, the IOER program hasn't worked well, in part because some big market players including Fannie Mae and Freddie Mac can't participate. The fed funds rate has hovered well below the Fed's 0.25% floor for years. That isn't a problem now because the Fed wants to hold rates very low, but it raises concerns that the central bank won't have tight control of rates when the time comes to raise them.

If appears that only now have Fed officials realized how nutty the interest on excess reserve tool is and how dangerous the $2.5 TRILLION in excess reserves that have accumulated at the Fed is. What they don't seem to get is that their new tool/program to drain the reserves from the system is just as nutty. And the Hilsenrath column is all about this new nutty tool (my emphasis)
 An experimental bond-trading program being run at the Federal Reserve Bank of New York could fundamentally change the way the central bank sets interest rates.

Fed officials see the program, known as a "reverse repo" facility, as a potentially critical tool when they want to raise short-term rates in the future to fend off broader threats to the economy. Of particular concern for the Fed is finding a way to contain inflation once the trillions of dollars it has sent into the financial system get put to use as loans.
Does the Fed have any idea how high they will have to drive rates to compete with bank loans once banks start loaning the funds out? At a minimum, my guess is 5.00% on short term rates (The fed funds rate is currently only 0.08%) , BUT then the Fed driving up rates will cause banks to want to loan even more money out, requiring the Fed to raise rates even higher. It will be insane, the Feds only other alternative will be to allow the excess reserves to enter the system, which, as I say, will launch massive price inflation.

Save this post. Remember, you were warned about excess reserves here years ago at EPJ, now you are being warned about the incredible boom in interest rates that is coming because the Fed is going to have to attempt, at some point, to manage these excess reserves once they start leaving the Fed. As they say here in California, make sure you have an emergency earthquake kit packed and ready by the door.


  1. Those reserves are in Sriracha sauce and Bitcoin.
    You read it here first.

  2. Bernanke is like a kid futzing around with a chemistry set in his parents' basement. Eventually he'll stumble onto to some explosive combination and take out the entire neighborhood.

    I love all the talk from the Fed about all their neat tools. Tools shmools.

    They have effectively destroyed the capital markets and have distorted prices across all asset classes while pursuing their insane attempt to steer a soft landing from a bursted bubble they themselves inflated.

    There is no soft landing. The Fed is flying the economy into a cliff.

  3. "BUT then the Fed driving up rates will cause banks to want to loan even more money out, requiring the Fed to raise rates even higher"

    Could you explain this? I'm missing how this would be a certainty. Thanks!

    1. The explanation is that he believes demand is a given because of scarcity. That means that a higher price for money will not reduce the demand for money.

      Of course higher interest rates does not expand credit. Why? Because demand matters. Demand for loans will fall with the higher rates.

      If car prices rise, does a car dealership sell more cars? Of course they would want to sell more cars. They sell less though because demand is not a given. It falls with the higher price. Same applies to money or anything else.

    2. @Jerry WolfgangDecember 13, 2013 at 12:24 PM

      What the hell kind of babble are you spouting, Blinder is talking about exploding the money supply, which would mean massive new inflation. There is nothing else to consider. Your babbling about demand, hire price for cars, etc. is just your typical nonsense.that you post here.

  4. The economy is already over saturated with debt. People don't want any more.

  5. "But as the economy expands and lending picks up"

    Even though many economists say the economy is growing, nominal incomes have at the very least not moved or at worst have moved down.. Real income data is worse. They are about where they were in the 70's.

    Commodity prices are flat to down across the board. Outside of Washington DC, Northern California, Manhattan, and perhaps North Dakota, the USA is in a depression. If you take government spending out of GDP and you should, there is no growth, period. Looking abroad, China's boom looks more like a bust. The rest of the BRIC countries also look soft.

    The second largest economy in the world hasn't recovered from its 1980's boom. In a few years, Japan will be in a 40 year recession- no employment growth, no wage growth etc. Why should the largest economy in the world suddenly grow? Who are the banks going to lend to that they have not lend to already? Young consumers? Small business? Banks by nature are not aggressive unless they will be bailed out, and save for a few Wall Street banks, most banks get merged into one another.

    Interest rates on US long bonds certainly could go up a lot, but perhaps for reasons other than economic "growth."

  6. Canada right now is in a suspended housing bubble. The needle is going to be rising interest rates on McMansion mortgages now owned by happy people about to be royally blindsided. Our central planners think they can finesse this pop into a slow release of pressure somehow, but with average Canadian's debt to disposable income ration at 163% and rising, increased interest rates are going to unleash havok. Canada is gonna get clocked hard.

  7. The Fed could increase the reserve requirement to lock up the excess reserves. That the Fed is looking for new tools suggests they will not increase reserve requirements.

    End the Fed.