This is Not the 1930's...
and that means a Whole Lot of
Inflation to Come, Part
How Big is this Inflation
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.
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
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
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
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
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
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
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
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
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
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
May 10, 2009