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This is Not the 1930's...
and that means a Whole Lot of Inflation to Come, Part 2
How Big is this Inflation

Michael Pollaro
May 12, 2009

A few days ago, I penned this essay, "This is Not the 1930's..." making the case that the monetary and political framework of today is nothing like that of the early 1930's, that it is so biased towards inflation that not only is deflation highly unlikely, but the real concern must be inflation, and a whole lot of it too.

Today, I bring you Part 2 of this essay, an attempt to quantify how big this brewing inflation could become. Cutting to the chase, it could very well become the biggest in this nation's history.

Excess Reserves, a Whole Lot of Inflation in the Pipeline

Let's start this discussion from where we left off. Yes, deflation avoided and money supply up, but given the explosion in the Federal Reserve's balance sheet, one would have expected an explosion in money supply too. What happened?

The answer: the banks are peeling off the bulk of the Federal Reserve's largesse and, instead of pyramiding loans and investments on top of that money, they are building up their cash reserves. It's called excess reserves and it is quite a build:

Since the Federal Reserve began ballooning its balance sheet, some 98% of the banking reserves so supplied were channeled into excess reserves by the banks. Normally banks hold 3% to 4% of their reserves as excess reserves. Currently they hold about 92%. If they had instead pyramided loans and investments on top of those reserves, as per their normal practice, the money supply would have indeed exploded.

This begs three questions, the answers to which will tell us a lot about the prospects for these excess reserves in particular and inflation in general:

  • Why didn't the banks channel those reserves into loans and investments and what will in fact make them do so?
  • To the extent the banks do lend or invest, are not these reserves under the control of the Federal Reserve, i.e.; can't the Federal Reserve withdraw those reserves whenever they deem appropriate, thereby capping inflation?
  • What if the banks in the end don't lend or invest, or don't to the full extent of the Federal Reserve's reserve requirements; does that negate the inflation case?

Let's answer these questions one at a time:

Why didn't the banks channel those reserves into loans and investments and what will in fact make them do so?

To answer this question we must first understand what these excess reserves are and what they are not. As was the case in the 1930's they ARE NOT cash set aside by banks because of, or in fear of bank runs and therefore locked away for years to come. Why would they be, with FDIC insurance and all manner of government and Federal Reserve loans and guarantees readily available to soothe the nerves of depositors and to back-stop bankers? They ARE though a prudent way for banks to park funds while the government and Federal Reserve cleanse bank balance sheets, reflate the economy and pave the way for the pyramiding opportunities to come. Call it inflation in the pipeline, and a whole lot of it too.

Let me explain. In the post Great Depression era, in times of financial and economic crisis, banks bought US Treasuries, as they offered the safest way to ride out the crisis, build cash and ready oneself for the next boom. Not this time, at least in the size you would have expected. No this time banks are investing in excess reserves, risk free. And the reason is simple. The Federal Reserve for the first time in history pays interest on reserves, currently at .25%. That may seem small, but not compared to the Federal Reserve manipulated micro rates on 3 month Treasury bills or Federal Funds. Excess reserves are in fact the best risk adjusted deal on the block.

Pocket change, you say. True. But if you are a CEO of one of those too-big-to-fail banks and you can make money risk free by leaving it with the Federal Reserve, rebuild some capital in the midst of the biggest credit crisis since the Great Depression, and do it while the Treasury and the Federal Reserve absorb your loses, you do it. The game plan is to get across the finish line, with cash in your pocket, to be ready to disgorge that cash into the next reflation trade, to the maximum extent possible. And if you're lucky, or should I dare say "well connected," you might even get a few of those not-too-big-to-fail banks handed to you by the government on the cheap, after they have been purged of their toxic assets of course.

And where you say is this next wave of inflation, the one the banks are waiting to pounce on? No one knows for sure where all this is ultimately going, but in this man's opinion, the next inflation wave is likely to start where it always does - in or around the primary monetary injection point. And this time that's the government complex and all it touches. Indeed, the spender of last resort, led by Obama, and the printer of last resort, led by Bernanke, are already on the case in unprecedented fashion. Wherever they direct their energies, profit seeking banks, armed with a mountain of reserves, will soon follow.

To the extent the banks do lend or invest, are not these reserves under the control of the Federal Reserve, i.e.; can't the Federal Reserve withdraw those reserves whenever they deem appropriate, thereby capping inflation?

They sure are under the Federal Reserve's control and taking them back is exactly what Ben Bernanke says he plans to do. Of course we want the banks to lend, says Bernanke, and we will do everything thing in our power to make it happen. But all this talk about runway inflation is totally misplaced. You see, says Bernanke, once the credit markets return to normal and we are assured of economic recovery, we are going to withdraw these excess reserves, forthwith. Presto, no inflation problem.

You can never rule anything out, but I for one will be quite surprised if Bernanke's Federal Reserve will be withdrawing, or even wanting to withdraw much, if any of those reserves any time soon. And for two very good reasons:

First, it is not just the size of the reserves that are in question; it's the composition of the assets behind it. Well over half of the Federal Reserve's balance sheet is toxic - long-dated, and still deteriorating mortgage and consumer claims likely marked at prices well above market clearing rates. Gone are the days when the Federal Reserve's balance sheet was Treasury IOUs.

Now, in order to withdraw reserves, the Federal Reserve must sell securities. But, if the Federal Reserve is increasingly being "asked" to fund mounting government spending programs by buying Treasury IOUs, that means the only assets it has for sale is overpriced toxic securities. Under those circumstances, do you think the Federal Reserve might have a hard time reducing its balance sheet and withdrawing reserves? Do you think the market knows it too? The last thing the Federal Reserve will want to do is dump these assets onto the market. The mere mention would cause the prices on these assets to tank and interest rates to surge.

Indeed, there is likely only one buyer for these assets at anywhere near current marks, and that's our spender of last resort, the government. And if the Federal Reserve does in fact decide to sell these assets to the government (for example for optics), how do you think the government is going to pay for it? By issuing IOUs to the Federal Reserve in return for money printed out of thin air, that's how. Conjures up a picture of a dog chasing its tail, doesn't it.

Second, everything the government and the Federal Reserve are doing today is not going to turn the economy around. In fact, it's almost guaranteed to make things worse. A country can not print and spend its way to prosperity, especially one as distorted as ours, particularly when the government, the bastion of inefficiency and waste, is doing all the heavy lifting. The 1930's are a case in point. As such, this is hardly an environment that lends itself to a contraction in the Federal Reserve's balance sheet in the eyes of a Ben Bernanke. That's for sure.

What if the banks in the end don't lend or invest, or don't to the full extent of the Federal Reserve's reserve requirements; does that negate the inflation case?

Let's start with the undeniable fact that even though banks are stock piling reserves, the money supply is still growing at double digit rates. As Doug Noland chronicled, the government, its agencies and the Federal Reserve have all stepped up and are injecting money directly into the economy. The banks have been bystanders, yet, we inflation at double digit rates.

This then raises an interesting question. With all the new inflation tools at its disposal, maybe the Federal Reserve doesn't need the banks to inflate, at least to the same extent it has in the past. Think for a minute. Are not Fannie Mae and Freddie Mac lending money to home buyers and is this not being financed by the Federal Reserve, both directly through purchases of their debt and indirectly through monies supplied by the US Treasury? Is not the FDIC bailing out bank depositors, ultimately back-stopped by the Federal Reserve's printing press? Is not the government spending huge and growing sums of money, increasingly being financed by the Federal Reserve? Yes, yes and yes.

Now consider this. What if the banking system is nationalized, a la Fannie and Freddie? Or like AIG. It could happen, if not in name then in substance. Then the banks will be told what do, wont' they. Now that's a scary thought, don't you think?

A whole lot of inflation is in our future, one way or another.

How Big this Inflation Cometh

Ok, lots of inflation and lots more to come. Lets try to size it.

In his April 3rd Interest Rate Observer, James Grant reported that the combined Federal Reserve and US government response to this economic crisis, defined as the change in the Federal Reserve's balance sheet plus the US government's fiscal deficit as a percent of GDP, is some 30% of GDP. To put that number into perspective, that's 10 times the postwar recession average of 2.9% and 3.5 times the previous record of 8.3% seen in you guessed it, the Great Depression.

The size of today's government's reflation efforts truly dwarfs anything we have seen in the past and suggests some truly eye-popping price inflation rates in the future. On that score, it's interesting to note that the greatest price surge in the post gold standard / FDIC era, one that saw the CPI rocket to 15%, began during the 1973-74 recession with a combined Federal Reserve and government response of a mere 4% of GDP. At today's 30%, and we are not done yet, one can only imagine the kind of price inflation that awaits us this time around.

May 10, 2009
Michael Pollaro

321gold Ltd