Why the Fed Swaps, Announced Today, Will Expand the Monetary Base

Tony Crescenzi,Senior VP,Strategist and Portfolio Manager at Pimco explains how the swaps announced by the Fed will expand the Fed's monetary base:

[A]ny use of the Fed’s swap facility expands the Fed’s monetary base: all dollars, no matter where they are deposited, whether it be Kazakhstan, Japan, or Mexico, wind up back in an American bank. This means that any time a foreign central bank engages in a swap with the Federal Reserve, the Fed will create new money in order to make the swap. Use of the Fed’s liquidity swap line in late 2008 was the main cause of a surge in the Fed’s monetary base at that time. The peak for the swap line was about $600 billion in December 2008. Some observers will therefore say that the swap line is a backdoor way to engage in more quantitative easing.

Keep in mind that the monetary base is important, however, money in the base does not mean it is necessarily money in the economy. For example, most of the money created by the Fed in 2008,and up until recently, went into excess reserves and thus did not impact the economy. Bernanke may not be so lucky this time. If the money stays in the system and doesn't end up in excess reserves, the price inflationary consequences will be huge.. The money created by the swaps is being used to bailout Greek, Spain etc debt. That money is likely to end up being used to buy even more PIIGS debt, which means it will end up in the hands of the Greeks, Spaniards, etc. and not as excess reserves. German Chancellor Angela Merkel fought tooth and nail to prevent the ECB from .monetizing the PIIGS debt, so instead, Bernanke has stepped in to inflate.  Bernanke is playing with fire here and Americans are all likely to get burned with soaring prices.

Is the Big Inflation About to Hit?

It's a little early to tell, but Bob Murphy has emailed me a very interesting article that points to a change in strategies by banks.

The article was written by Jeff Cox at CNBC. The key points to the article are:

Surprisingly strong Treasury auctions in March had help from banks, which normally stay away from such events.

Banks snapped up $5.7 billion of the total $34 billion auctioned in 10-year notes and 30-year bonds, providing demand for auctions that many analysts thought would flop....At the same time, bank credit fell 5.1 percent in the month and loans and leases dropped 6.4 percent, according to the Federal Reserve .

The pattern suggests that banks have been starting to put their large cash balances to work, but is not an indication that bank balance sheets as a whole have started to grow," Deutsche Bank said in a research note.

The suggestion is that banks are using Treasurys as a way to get some return on their money that they might otherwise reap from making loans.

That banks would get so involved with long-dated securities came as additional surprise since they aren't usually such active participants at auctions and generally buy mostly short-dated notes. Under normal circumstances banks don't have much interest in keeping long-term rates low as that could compress the yield curve and cut into the profits they could make on lending.

Yet combined with their purchase of agency-backed debt such as mortgages and student loans, banks bought a total of $40 billion from the Treasury in March, according to analysts at Deutsche Bank.

But there's also another less-obvious reason banks could be stepping in to the Treasury market: A type of tacit quid pro quo with the Federal Reserve to keep short-term rates low by helping the government finance its debt through Treasury auctions.

Art Cashin, director of floor operations at UBS, noted after the 30-year auction suspicions among traders about who was doing the buying. In remarks to CNBC, he spoke of "all manner of conspiracy theories floating around. Is the Fed putting on a fake moustache and a raincoat and coming in as an indirect buyer?"

While there's disagreement among analysts whether the actions are part of an explicit pact between the two sides, some suspect a gentleman's agreement in which both sides benefit.

"Banks are stealing money from the public, giving consumers zero percent interest on deposits, and instead of turning over risk to the over-indebted consumers, they're loaning money to the government," says Michael Pento, chief economist at Delta Global Advisors in Parsippany, N.J. "I'm sure it's at the behest of (Fed Chairman) Ben Bernanke—we're going to keep rates low but you must facilitate the Treasury auctions going off smoothly."

The Fed funds rate is near zero, meaning that banks can borrow at almost no cost and lend out at the prevailing rate—or invest in vehicles such as Treasurys.

The 10-year yield edged over 4 percent in the days after the weak March auction for the benchmark note but has fallen precipitously since then, trading around the 3.75 percent area and helping to keep government borrowing costs down.

Now, the fact that bank loans dropped during the period would suggest on first blush that the Treasury is crowding out the private sector, i.e. banks are buying Treasury debt instead of loaning funds out to businesses.

But, there is one other intriguing piece of data.

Excess reserves fell by $41 billion in the month of March. That is almost the exact amount that banks bought in Treasury and agency-backed debt. Does this mean that the banks are starting to move some of the trillion dollars in excess reserves they are holding and starting to pump them into the system? Possibly.

One other piece of data suggests that there is a countervailing drain going on somewhere. 3 month annualized M2 growth is actually negative, so I am not ready to sound the alarm bells just yet, but I am watching things very carefully.

What needs to be monitored is how much more Treasury and agency debt banks buy, any further down trends in excess reserves, and, of course, M2 growth. If M2 growth starts to pick up with declining excess reserves and banks buying government paper, it is a signal that we are headed into a new inflation phase. It means the Fed can't keep interest rates down, without sneaky inflation via getting banks to start using excess reserves. Again it is still early, and these numbers do move around a bit, but if a trend starts to develop over the next couple of months the early warning inflation alarm bell will have to be sounded.