- Excess reserves in the financial system currently stand at $2.5T, or 95% of total reserves, historically unprecedented. The previous peak was 55% in 1935 during the Great Depression.
- Any tapering or increase in QE is therefore meaningless, as the money is not entering the system anyway in response to Fed actions.
- The Fed has effectively lost control of the money supply, and almost any way you look at it, bonds will soon be crushed.
It is difficult to describe the extraordinary circumstances in which the financial system currently finds itself without sounding a little crazy. It all comes down to two words: Excess reserves. These are monetary reserves above the Federal Reserve's reserve requirements that exist for all intents and purposes outside the financial system as they are not in circulation. Excess reserves are the proverbial napalm that could catch fire at any minute unpredictably, and the pile just keeps growing. Keep in mind that the only other time in history when there was any significant amount of excess reserves in the banking system was during the Great Depression, and even then they were nowhere near as high as they are now relative to total reserves outstanding.
Here is the graph. Notice that the series has been discontinued as of May 2013, likely because the graph has become too embarrassingly lopsided.
During the Great Depression, the peak amount of excess reserves was reached in 1935. December 1935 showed excess reserves at 55% of total reserves. Usually they are zero as can be seen in the graph above, so 55% may sound like a lot. But that's child's play compared to what we have now. As of the Federal Reserve's latest aggregate reserves report, excess reserves now stand at $2,528,153,000,000, written in long hand for full effect. That is a mindboggling 95% of total reserves outstanding.
This is hard to swallow. This huge sum is the big elephant in the room nobody wants to talk about, and when its existence is even mentioned, it is usually referred to as "extra cash sitting harmlessly on bank balance sheets," as if we should all collectively yawn at it.
I would like to take the rest of this article to flesh out four implications, and whether these excess reserves are indeed "harmless." They are as follows.
Implication #1: Quantitative Easing as well as Tapering are Meaningless
The first implication of having over $2.5T in excess reserves representing 95% of total reserves is that any further QE or so-called "tapering" of that QE are meaningless and inconsequential. Why is that? Because QE is designed to increase money supply in circulation, roughly the M2 numbers. Since over 95% of reserves are all backed up in excess anyway, any further QE is obviously not increasing money in circulation, at least not directly. This has been the case for some time now.
Tapering is equally meaningless for the same reason. The function of a taper would be to slow money growth. But let's say that the Fed completely stopped QE tomorrow. There would still be $2.5T in cash in reserve that will continue to leak through and expand the M2 supply. If excess reserves start to be loaned out in force, M2 will explode higher, exactly the opposite of what a taper would be trying to accomplish.
Let me preempt a possible challenge to this assertion. Some might claim that the primary purpose of either QE or tapering is to affect bond prices and thereby interest rates rather than money supply directly, an effect which would still hold sway regardless of how much excess reserves there are. While bond prices are indeed affected by Fed bond purchases, the primary function of the Federal Reserve is to control the money supply by using bond purchases as a tool. It is the money supply expansion which greases the wheels of the economy, not the bond purchases themselves. Those are just the means towards money supply expansion which the Fed accomplishes by creating the money to buy the bonds. But if the money thereby created is backed up in excess reserves, it doesn't expand the money supply.
Theoretically the Fed could execute QE by buying anything at all, even my sofa. The reason it chooses bonds as its tool is that the Fed is a creature of the Federal government and buying bonds gives the government access to the new money first. (No, it is not a "private corporation" as some try to claim. There are no private corporations that are created by an act of Congress.) Treasuries as the asset purchase of choice is just a favor to the Feds that appoint the Federal Reserve Board itself, a favor arguably political in nature, and nothing more than that.
Back when there was no meaningful amount of excess reserves in the system, roughly from 1942 until 2008, bond buying would immediately increase the M2 supply because banks would stay "fully loaned up" and put the money in the system immediately, which was and has always been the primary purpose of Fed bond buying.
So while one could claim that bond prices are still partly under the Fed's sway and thus QE and tapering are not completely meaningless, insofar as all prices in the economy, including those of stocks and even bonds themselves are ultimately a function of the money supply, both QE and tapering are practically meaningless red herrings, especially when it comes to trading signals in the market.
Implication #2: The Fed has Effectively Lost Control over the Money Supply
The second implication stems from the first. If QE and tapering are practically meaningless given the current financial environment, then the Fed has effectively lost control over the money supply. Again let me preempt a possible challenge to this assertion. One may respond that the Fed still has quite a few options for affecting the money supply in circulation. It could, say, cut the interest it pays on excess reserves, thereby encouraging banks to loan. This, however, is problematic for a few reasons. First, with 95% of reserves stuck in excess, attempting to coax some of it out however conservatively could end up disturbing a very sensitive and deadly hornet's nest and bring the whole thing out in a torrent whose inflationary consequences would be ghastly. Or the Fed could theoretically raise reserve requirements, but this is highly unlikely with Yellen as Fed Chair, as this is exactly what the Fed did in 1936 fearing the excess reserves at the time, which set off the recession of 1937-38 according to mainstream economists like Yellen. She doesn't want to do that.
But the Fed is trying something to the end of draining excess reserves, something new. It admitted back in August 2013 in its published minutes that it was attempting to set up something called a "reverse repurchase facility" in order to soak up excess reserves in case this actually started happening and excess reserve started flowing into circulation too fast. A reverse repurchase agreement is the Fed's term for selling bonds (see footnote 30 at link), basically soaking up liquidity and preventing money from entering circulation. It is still unknown if the Fed has such a facility, or if it will even work, or what the economic consequences of a massive bond-selling reserve draining operation would be (see implication #3), but the fact that they are even planning such a facility shows us that the Fed is in totally uncharted territory and doesn't really know how to deal with the current situation.
I would encourage anyone who has not watched this video to take 50 minutes out of his or her day to do so. It is the 2012 Homer Jones Memorial Lecture given at the St. Louis Fed by former PIMCO CEO Mohamed El Erian. For those who want to skip to the relevant section, it is at the 10:28 mark, where El Erian explicitly says that the Federal Reserve is in uncharted territory:
"We have not been here before and we have to understand that we have not been here before and we cannot predict with any certainty as to what this will do to the economic system.
Basically, the Fed knows it has a serious excess reserves clog in the pipeline and doesn't yet know how to drain it, if that were even possible. So it is reasonable to assume that as of now, the Fed has zero direct control over the money supply as it once did before there were any excess reserves in the system.
Implication #3: The Bond Market is Going to get Crushed
This leads us to the third implication, and that is that bonds are in big trouble. Almost any way you look at it, interest rates are headed much higher long term. In one scenario, the Fed could actually taper and stop buying treasuries completely, which it will have to do eventually anyway. QE simply cannot go on indefinitely without a serious loss of confidence in the US Dollar (NYSEARCA:UUP), which is already at 52 week lows. A taper would severely impact the bond market. In a second scenario, when excess reserves start coming into the system, and they will eventually, the Fed may try to set up its reverse repurchase facility and start draining the excess by selling bonds, again severely impacting the bond market. Or if it doesn't try to drain the excess reserves, the $2.5T representing over 95% of current reserves will start flooding the economy causing severe price inflation, again severely impacting the bond market.
In one sentence, however the Fed decides to deal with those excess reserves, by ceasing to add to them, by draining them, or by ignoring them, the bond market will be severely and negatively affected. It seems Warren Buffett may agree with this, as he just lowered Berkshire Hathaway's bond holdings to their lowest proportions in a decade.
The only way bonds can benefit in the short term is if Yellen increases QE, which may yet happen in response to any instability created by what is going on in Crimea right now. The instability there may also cause traders to react impulsively in a "flight to safety" and move to treasuries in the short term. That said, traders intent on shorting the broader bond market (NYSEARCA:TLT) (NYSEARCA:BND) (NYSEARCA:LQD) may want to wait for the current situation to blow over before establishing short positions.
Implication #4: Stagflation Ahead
This takes us to one of the more paradoxical implications of excess reserves. That is, what very well may take them out of excess and into the economy is higher interest rates on loans. When bonds do start to accelerate down and interest rates rise significantly, this may be what banks are looking for to start loaning out the excess in order to obtain the higher interest rate return. Paradoxically, this would mean higher interest rates together with accelerating money supply, the perfect recipe for curtailing long term investment at the higher orders of production and encouraging consumption. In other words, lower capital prices and higher consumption prices. In one word, stagflation. The best way to protect against that is to buy real assets. Commodities have already had a significant run, and that will likely continue. Quick low volatility recommendations post Russian crisis include the DB Commodity Index Tracking Fund (NYSEARCA:DBC) and the Agriculture Fund (NYSEARCA:DBA).
As El Erian said, we are in uncharted territory. What effect these excess reserves will have once they hit the system is unknown. We have never been here before. But one thing that does seem a near certainty is that bonds will be crushed. As soon as the Russian situation blows over and the winds of war calm down, opening shorts in any of the more liquid bond funds like TLT, BND, or LQD may be a wise decision