By Ben Brunson, Special for USDR
The U.S. Federal Reserve has begun the process of tapering. That means that the Fed is reducing the extraordinary amount of quantitative easing – or money creation – that it has been engineering since the financial crisis of 2008. The Fed was buying as much as $85 billion in new securities per month last year and has already dropped that targeted monthly purchase rate down to $45 billion, with more tapering likely.
Over the past five years, the Fed has maintained a very aggressive and accommodative policy of monetary stimulus to support the moribund economy. The two primary policy weapons used have been interest rates, which have been kept near zero, and monetary growth. To accomplish monetary growth, the Fed purchases securities, typically obligations of the U.S. government or its agencies. When it does, it is creating money that did not exist previously. If it sells securities that it owns, it is shrinking the money supply.
Since the end of 2008, M2, the broad measure of the U.S. money supply that is used by the Fed, has grown by $2.8 trillion, to $11 trillion. However, during this same period the Fed actually purchased over $3.5 trillion in U.S. government and mortgage agency debt. So how can it be that the money supply has grown less than the amount of new money created by the Fed? The answer to that question is the reason why the next five years will present unique challenges to new Fed Chair Janet Yellen.
Let’s step back and review the art of money supply creation. It is an art because much of the process is outside of the direct control of the Fed. But wait, didn’t you just tell us that the Fed creates money by buying securities? Yes, that is quite true. As far as that portion of money creation is concerned, the Fed has total and complete control over the process. However, that is not all of the story. When the Fed creates new money, it winds up as new bank reserves. This fact is very important in the process. New bank reserves means that banks can lend more. The process of bank lending – the exchange of an IOU for the credit of money into a banking account – is also the creation of new money.
What limits the amount of bank lending? In the current global banking system, banks are required to maintain reserves of cash on hand and deposits with Central Banks equal to a certain percentage of the deposits they have. The current marginal reserve percentage in the U.S. is 10%. Therefore, if the Fed creates $100 of new money that is deposited in banks and becomes bank reserves, then banks can immediately lend out $90, which, in turn, will create $90 of new bank deposits. Why only $90 in new loans? Because the banks have to maintain $10 in reserve, or 10% of the original deposits.
But wait, that cycle can repeat. The new loans become new deposits within the banking system. The $90 in new deposits creates the ability for banks to lend out $81 in new loans ($90 less the reserve requirement of 10%). Again, this process can repeat. Taken to its theoretical conclusion, the $100 in new bank reserves created by the Fed, at the 10% reserve requirement ratio, can translate into $1,000 of new bank deposits. Bank deposits represent the major component of M2 – they are, by definition, money.
Okay, now that we have established the basic process of money supply creation, you are left with a bigger question mark than when we started. How can it be that the Fed has created $3.5 trillion in reserves but the money supply has increased by less than that? Didn’t we just establish that new reserves of $3.5 trillion could translate into as much as $35 trillion in new deposits (money)? The answer to that is very simple and will have a profound impact on actions taken by the Fed in coming years.
Simply put, banks have not been lending money since 2008. Instead of new loans and the deposits that they create, banks have maintained a growing balance of excess reserves on deposit with the Fed. How much money are we talking about? According to official Fed figures, as of March 19, 2014, U.S. commercial banks have $2.56 trillion in excess reserve deposits at the Fed. The Fed has helped to fuel thislevel of excess reserves by a decision it made in October 2008 to begin paying interest on excess reserves equal to 25 basis points (0.25%).
How does this level of excess reserves compare historically? Prior to 2008, the average level of excess reserves maintained at the Fed for the previous 50 years was approximately zero. The post-crisis banking world – and its implications on the money supply – have undergone a sea change from the well-established patterns prior to 2008.
What has this new paradigm meant to the Fed? The first and most obvious impact is that Fed monetary policy since 2008 has, in effect, been pushing on a string. The old relationships between quantitative money creation by the Fed and growth in M2 have been broken and have yet to be re-established. As a result, most of the money created by the Fed has gone not to fuel the domestic consumer economy, but to an ever-increasing level of commercial bank liquidity. Banks are, in effect, sitting on the money.
The implications for the Fed are profound. As of today, roughly $2.6 trillion of reserve capital is now under the collective control of commercial bank management and no longer under the direct control of the Fed. If for some reason every bank decided to lend money tomorrow, those excess reserves could translate into as much as $26 trillion in new money creation in a very short period of time. The impact of that would be a catastrophic level of inflation.
The Fed under Janet Yellen faces a set of facts and circumstances that are unique. Ironically, this situation is of its own making. Should the Fed decide to start raising rates (increasing the Fed Funds Rate) and stop paying interest on excess reserves (which would be a return to the long-established status quo), banks would probably begin lending again. In that case, the actions the Fed would need to take would go far beyond tapering. The Fed would be forced to sell securities and soak up (remove) bank reserves from the system to reign in lending growth. The impact on interest rates would be significant. I would expect the yield curve to shift upward, but also to flatten as short-term rates would rise faster than long-term rates. Where rates go ultimately would be a function of the market’s view of the Fed’s ability to control inflation.
In any event, Ms. Yellen will almost certainly become one of the most important Fed Chairs. Whether it will be for her deft maneuvering or for the rise of uncontrolled inflation is to be determined. Stay tuned …