The New Supersized Fed

Fed watchers need to stop panicking when they look at the new supersized Fed balance sheet and monetary base. The Fed’s balance sheet doesn’t necessarily mean runaway inflation is in our future or that the Fed is out of control. The Fed got supersized because Bernanke & Company came to appreciate the U.S.’s special role in the world economy. The U.S. dollar is the world’s primary reserve currency and a supersized Fed is what this special status requires.

Many Fed watchers believe in a “cause and effect” relationship exists between the rapid buildup in the size of the Fed’s balance sheet and both runaway inflation and a debasement of the U.S. dollar. I don’t agree.

Old school Fed watchers need to set aside their decades old Fed expectations and relearn their trade. “Game changing” shocks of the past few years have made the Fed a very different and more complicated central bank than in the past.

While it’s great to look back on the simpler good old days of a small Fed balance sheet, the lack of Fed assets limited policy options. Since the U.S. dollar is the de-facto reserve currency for the world, like it or not the Fed has responsibility to provide liquidity for all dollar denominated trade in the world, whether or not it takes place within the U.S. A puny balance sheet that limits policy options is inconsistent with the reality of the Fed’s extended mission.

The issue that the Fed has to work through is that if it doesn’t have a large enough balance sheet and monetary base for global trade there will be acute U.S. dollar shortages around the world that will shut down the U.S. and global economy. Bernanke & Company adjusted to this reality by putting in place several new policy tools, all of which point to a bigger balance sheet.

Perhaps the biggest new Fed policy tool is one of its most technical; the Fed’s new ability to pay interest on reserves. Basically, that means that when banks deposit cash at the Federal Reserve, these deposits earn interest. In the past, bank deposits at the Fed didn’t earn interest. As a result, banks didn’t deposit their excess cash at the Fed and excess reserves for decades were stuck at a very low amount. But now that the Fed can pay interest on cash deposits, banks have a good reason to deposit their excess cash at the Fed and excess reserves, i.e., excess cash deposited at the Fed, has skyrocketed.

Fed watchers look at the new large excess reserve balances and conclude that these balances are evidence of an out of control Fed. They disregard the fact that the Fed can now pay interest on reserves. There is a great article written by David Altig, Senior Vice President and Research Director for the Atlanta Fed, that discusses the new level of excess reserves and explains why large levels of excess reserves aren’t necessarily bad or inflationary.

By getting excess cash balance deposited at the Fed, Altig argues that policy makers have many more options to implement monetary policy and quicker methods to withdraw reserves from the system. The ability to pull reserves from the monetary base is important when money supply rises as a result of an acceleration of the velocity of money (which may occur when bank lending accelerates).

Bernanke & Company learned a tough lesson during 2007 and much of 2008. They learned that if they don’t provide enough liquidity to the global trade and banking system the rest of the world will take down the U.S. economy. In February the Bank for International Settlements published research that discussed how the European banks had a $2 trillion shortage of US dollars and couldn’t settle their debts because of an acute shortage of dollars. This resulted in LIBOR rocketing upward, even for government insured interbank deposits where there was no credit risk. The LIBOR spike ripple effects started to swamp the U.S. economy through a large rise in effective interest rates for U.S. loans tied to LIBOR and the near collapse of the banking and trade system which started to destroy export and import businesses.

Even the Chinese Central Bank Governor Zhou Xiaochuan understands that the Fed needs to make sure that its balance sheet and monetary base has to be supersized to provide liquidity for global commerce and banking. Zhou was quoted suggesting that use of the U.S. dollar as the primary medium for global trade has created special burdens for the Fed which cause irresolvable conflicts. Zhou recently wrote…

Issuing countries of reserve currencies are constantly confronted with the dilemma between achieving their domestic monetary policy goals and meeting other countries’ demand for reserve currencies. On the one hand, the monetary authorities cannot simply focus on domestic goals without carrying out their international responsibilities; on the other hand, they cannot pursue different domestic and international objectives at the same time. They may either fail to adequately meet the demand of a growing global economy for liquidity as they try to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand. The Triffin Dilemma, i.e., the issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world, still exists.

The Fed is trying to prove Zhou wrong by “threading the needle” and creating enough liquidity so that global trade and international banks don’t die because of a lack of liquidity while at the same time not over stimulating the domestic economy or over expanding money supply.

So far Bernanke & Company seems to be getting it right but only time will tell if they will be able to satisfy both the domestic and international needs for money without tipping too far in the direction of inflation or deflation, liquidity or crisis. And, only time will tell if Zhou is correct that the competing demands of the domestic economy and international trade are inconsistent and cannot be reconciled. Either way, I am pretty sure that the new normal of a supersized Fed balance sheet and monetary base is going to be with us for a while and is necessary to prevent a meltdown of the global banking and trade system.

Even before posting this article I can already hear the purveyors of the conventional wisdom accusing me of incompetence for not realizing that the current crisis is the Fed’s fault because they kept interest rates too low for too long after 9/11 and they are at it again.

I don’t believe in the conventional wisdom. Monetary policy, interest rates and money supply aren’t the proximate cause of the current crisis. The causes are much easier to recognize and don’t take a PhD in economics to understand. Fraud, mismanagement and overleverage (along with a good dose of white collar crime) put us in the predicament we are in. Too much money supply has about as much to do with the current crisis as Eve blaming her weakness on too many apples in the Garden of Eden. Post 9/11 monetary policy is a convenient scapegoat for those that are trying to deflect attention from their own misdeeds and incompetence.

After publishing my last article suggesting that the Fed may not be running up money supply like a drunken sailor I was roundly criticized for not understanding that even though the results of the Fed’s irresponsible actions weren’t showing up in M1, M2 or estimated M3, the bad effects of Fed policy can be found if I just look hard enough. So, in the next few days I will take a look at recently distributed data to see if there is any evidence of “money” and “credit” being out of control.

Comments

[conceptwizard:]

In June of 2008, before he was Treasury Secretary in the Obama administration, Timothy Geithner, as head of the New York Federal Reserve, wrote an article for the Financial Times following his attendance at the 2008 Bilderberg conference, in which he wrote that, “Banks and investment banks whose health is crucial to the global financial system should operate under a unified regulatory framework,” and he said that, “the US Federal Reserve should play a "central role" in the new regulatory framework, working closely with supervisors in the US and around the world.”

In February of 2009, the Times Online reported that a “New world order in banking [is] necessary,” and that, “It is increasingly evident that the world needs a new banking system and that it should not bear much resemblance to the one that has failed so spectacularly.” But of course, the ones that are shaping this new banking system are the champions of the previous banking system. The solutions that will follow are simply the extensions of the current system, only sped up through the necessity posed by the current crisis.

So it stands to reason that the FED has taken on a new role.

Jun 16 12:58 PM

[Speedspirit:]

The Fed created a crisis on its own and now wants more power bigger balance sheet and a new system to inflate into another bubble of greed. Saving bad banks was whos idea, the FED and whos stick saving the markets, friends of the FED. The author states "The causes are much easier to recognize and don’t take a PhD in economics to understand. Fraud, mismanagement and overleverage (along with a good dose of white collar crime) put us in the predicament we are in." The FED. And who are they working in conjunction with....(if you care to know who then you already know, I'm tired of preaching to the deaf,dumb and blind.)

Jun 16 07:13 PM

[banyon:]

Is your username and this article a sophisticated attempt at irony? That is about the only explanation I have.

"The issue that the Fed has to work through is that if it doesn’t have a large enough balance sheet and monetary base for global trade there will be acute U.S. dollar shortages around the world that will shut down the U.S. and global economy. Bernanke & Company adjusted to this reality by putting in place several new policy tools, all of which point to a bigger balance sheet."

Actually, no, that's not the issue that the Fed has at all, that it was too tiny in the past. The issue it has is that it has printed unprecedented (by exponential factors) amounts of money and that it must find unprecedented amounts of willing borrowers to buy all the new debt underwriting the new money at rates that will be appealing to do so, while AT THE SAME TIME it tries to keep interest rates low so that an economic recovery won't be forestalled.

Additionally, there's literally no example in history of any government printing such a massive amount of money and it not resulting in pretty massive inflation.

Jun 16 07:18 PM

[bobomite:]

Thomas Jefferson said, "If the America people ever allow private banks to control the issuance of their currencies, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the people of all their prosperity until their children will wake up homeless on the continent their fathers conquered."

Just another way to look at the expanding Fed balance sheet. The author got one thing right - this isn't going to change anytime soon.

Jun 16 08:28 PM

[Moon Kil Woong:]

If the Fed was the tree in which the fruit of good and evil hung on, the copious production of apples coupled by the stench of rotting apples would probably have kept Eve far away. Not only does the Fed constantly encourage too much money supply, in good times and bad, but is also the principal architect for the housing bubble that created this current recession. Making them any more powerful is absurd. They aren't even a legitimate arm of the government.

We have yet to see what evil has been wrought under zirp policy. Apparently, the Fed has now proved that they can go much lower (all the way to zirp) than Greenspan in creating fetid green dollar mulch to grow all sorts of putrid bubbles. If prolonged low rates was the cause for the second worse economic decline after the great depression what is the Fed doing pursuing a prolonged lower rate policy? I really is laughable. Is this the work of a moron or the genius of a big fat snake in a tree. Either way, we are eating their apples even if there is no knowlege of good contained in them.

Jun 16 08:49 PM

[Madcow2:]

The only viable path forward is to grant the FED unlimited power to prevail upon an orderly, long-term, deflationary debt collapse. We're not headed to Zimbabwe, and this is not the end of the world. So long as you're not in debt, have plenty of cash, and know how to take advantage of shorting opportunities, everything is going to be just fine. People and businesses that are in trouble now because they STUPIDLY borrowed money to finance asset purchases - or who now find themselves in trouble because their "buy and hold" equity investment strategy isn't working out GET WHAT THEY DESERVE. In a couple years, we're going to see people crying and complaining about the vaporization of their life insurance policies and seeking restitution. This is all just simply pathetic.

Jun 16 10:13 PM

[dybydx:]

mr sunshine, to quote the chinese official, "show me the arithmetics".

the US econ is large, but its not large enuf to absorb the impact of so many trillions being printed out of thin air.

the 2yr 10 yr spread has spiked over 270bps lately. historically this had been quite indicative of inflation down the road.

Jun 16 11:21 PM

[johngonole:]

I appreciated everything the author wrote to the very end where he basically buried his head in the sand by writing,

"Fraud, mismanagement and overleverage (along with a good dose of white collar crime) put us in the predicament we are in."

Outright fruad in dollar terms was very small. The "overleverage" that resulted from "mismanagement" was a direct result of banks having way too much money to lend out. Money supply was too large. Knowing that interest rates were at 60 year lows they tried to hedge their "Interest rate risk" with derivatives and ARMS. They also moved their loans up the risk latter in an attempt to avoid short term interest rates crushing their interest rate spread on long term loans they were making. Basically they were doing very risky things to gain market share, earnings, and mitigate interest rate risk. Why do the have to mitigate interest rate risk.....An overactive Fed.

How can companies plan long term when interest rates are bouncing around all over the place year after year. Borrow at the wrong time and you lose your competitve advantage. Its one thing to have to predict future demand for your business and another thing to try to predict where interest rates will be in a year and how it might impact your business. The free market isn't really free when the Fed is constantly interfering.

Jun 17 12:50 AM

[JudeJin:]

fed's balance sheet is 2 trillion dollars?! so what!! china has 2 trillion dollars in foreign reserve!

if china wants to dump dollar, dollar loses world reserve currency status faster than you can wipe your stupid ass dry!

if you count in the printing power of the fed, of course nobody beats it in the world!

Jun 17 10:53 AM

[User 305589:]

''Fraud, mismanagement and overleverage (along with a good dose of white collar crime) put us in the predicament we are in.''

In short, you flatly refuse any systemic reason for a systemic crisis - it was just individual misbehaviour by some people and some companies - albeit important ones.

I strongly suggest you read Bill Fleckenstein's ''Greenspan's bubbles'' which is a superb account of the crisis and its originas, even though I do not agree on each and everything with Fleckenstein.
Apart from that, your expectations/belief regarding the Fed's primary purpose and the rationale for its exiistence of course cannot but lead you to conclusions suuch as those written above. If you really believe that the Fed's objective is ''monetary stability'', ''fighting inflation'', ''protecting the public well-being'' then of course, you will find some justification for each of their actions, and if you don't you could still blame it on someone's incompetence.
If on the other hand, you go the origins of the fed, look at those who created and control it, who depend on it, who proft from its actions and inactions, then you will see an entirely different picture emerging. And in this picture (though there is also room for fraud and personal misbehaviour) some fraud here, some greed there and some excessive leverage are just the symptoms of a deeply corrupt system that continues to enrich bankers by depriving the common man at wharp speed and that is utilizing the crisis to even speed up the process.
want a proof?
Just look at what's happening: hundreds of billions of taxpayer money are used to buy toxic, often almost worthless crap from the big banks. The taxpayer, in turn gets a boatload of debt that needs to be financed by issuing treasury bonds - which are bought hand over fist by the banks.
In the end the very banks that are saved with the taxpayer's money (first extraction of money from the public) hold the taxpyer's debt that was incurred to save them - and collect interest on it FROM THE TAXPAYER till the end of days. Is it just me who sees only ONE SIDE WINNING BIG and the other one losing - no matter what the economy or the markets do??

Jun 17 12:58 PM