More Twists And Turns By Bernanke Or Something More Powerful?

by: Yee Ong, CFA

Fed Chairman Ben Bernanke has been talking about more tools that the Fed has at its disposal to stimulate our economy. After QE1, QE2, Operation Twists, and lowering of the federal funds rate to near zero level, does the Fed really have other feasible tools available or is it just all talk?

I actually believe that Bernanke has more things to twist and turn, but it is not Operation Twists that I am referring to. Rather, it is the lowering of the interest rate on excess reserve. Before we go deeper into why this can be an extremely potent tool for the Fed to unleash at desperate moments, let's just step back and understand more about this interest rate on excess reserve and what the Fed had been really twisting and turning in the past few years.

Whenever I talk to bankers, many would tell me that most banks are simply not lending as loan underwriters are instructed to find every reason not to lend. That's why despite the massive amounts of money being printed by the Fed, we don't see the same volume flooding our economy and thus our inflation rate is at a mere 1.7% level.

The Fed fills the reservoir with water but the banks are the real faucet that regulates the flow of money into the economy. While the Fed has been pumping an excessive amount of water into the reservoir, the banks are not letting the faucet loose and thus people and businesses are not getting the much needed water.

But why are the banks not lending? Well, the real secret is that the Fed actually does not want them to lend. The Fed is paying banks to deposit money with the Fed (called excess reserve) at 0.25%. In other words, if Bank A deposits $100M at the Fed it will receive $250k. This is risk free and profitable for banks as they are paying 0% interests to depositors like you and me. So the more we deposit the more the bank makes because it just turns around to lend it to the Fed. Prior to the financial crisis, the Fed actually was not authorized to pay an interest on excess reserves. But that changed on October 8, 2008, when the Emergency Economic Stabilization Act allowed it to begin paying interest on excess and required reserves.

Excess reserve deposited at the Fed was negligible prior to 2009. It totaled merely $1.7 billion in early 2008. Then it mushroomed to $800 billion in January of 2009 and currently stands at about $1.5 trillion.

Don't get me wrong, banks will still lend if you are a high quality borrower. Lending to a high quality borrower at say 3.5% is definitely more profitable than depositing with the Fed. After all, lending has always been the business of a bank. But this interest on excess reserves allows banks to essentially make money while not having to lend to mediocre high risk borrowers. So this is in essence the strategy that the Fed uses to discourage bad debts from forming in the books of the banks again. It is simply asking the banks not to lend unless there is a high quality borrower and paying them to execute such a practice.

Printing money and using interests on excess reserve to soak it back up simultaneously is actually a clever way for the Fed to inject steroid into the economy without causing inflation. It is really trying to achieve a placebo effect. What the Fed is trying to accomplish is to brain wash people to believing that an excessive amount of money is being pumped into the economy such as through QE1 and QE2 and that can jump start the economy and cause excessive inflation. But what it is really trying to do is just to make consumers think that way because people are more likely to spend when they are more optimistic with the economy and expect inflation to skyrocket.

When people think that the Fed will do everything possible to save the economy, they will feel more secure about their job prospects. Also, if high inflation is going to hit consumers, that means you better use up the $100 that you have in your pocket now because you can buy more goods with it today than tomorrow (the same thing will cost more tomorrow). Consumer spending will cycle back into the economy and jump start its engine. When consumers spend and companies become confident, hiring will start and unemployment will drop.

Again, the Fed is actually trying to jump start the economy not by printing money - because it prints with the left hand and takes a substantial of it back with the right hand - but by creating such a certain mindset in consumers so that they will spend. This is why we are able to maintain a low inflation rate amid the "excessive money printing".

The complication is that Bernanke cannot say that or it will not work, and the money printing part causes criticism from politicians and people, especially savers and retirees. That's why you need the Fed to be independent of politicians in Washington. But the downside of it is you may be giving too much power to the Fed and that can also spell disaster if it becomes unscrupulous.

Now, let's return to the core of our conversation where I had mentioned that lowering this interest on excess reserve is actually what the Fed Chairman Bernanke has always been implying about "other monetary tools" that it has under its sleeves that got many economists scratching their heads on.

But it is really not "other monetary tools." It is simply finally feeding the patient the real drug. It is about loosening the valve that releases water from the reservoir that has been overflowed with QE1 and QE2. As you can now see, taking this step can really have a material impact on flooding our economy with money - the excessive money printing that many people have been talking about in the past few years!

As a matter of fact, this is going to be more powerful than just another round of quantitative easing. As you can now understand, another round of QE is simply a placebo effect if the interest on excess reserve remains, as the Fed prints with one hand and mobs up the printed money with another.

Lowering this rate, instead of another round of quantitative easing, is also going to get less criticism from people and politicians who failed to understand what the Fed has been doing all along.

But taking this step also shows a desperate move by the Fed because doing it means changing the placebo into the real drug!!! With real drug comes the side effect, which means inflation!!!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.