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  • Fed To Raise Rates Next Year? Don't Worry! 41 comments
    Jun 21, 2014 9:54 AM

    There has been much breathless analysis and commentary on exactly when the Fed will start raising rates, the precise end-point (4% versus 3.75% etc), and too little attention paid to how they will raise rates. I hypothesize that in the post-QE era, "raising rates" may not have the same effects as it did in the pre- Bernanke era.

    Let us quickly revisit how the Fed used to tighten policy in the pre-Bernanke era. Bank reserves used to be an important constraint to bank lending and banks generally attempted to maintain reserves as close to required reserves as possible. When the economy overheated, the Fed would reign in exuberant bank lending by raising the target Fed Funds rate. The Fed would then extract reserves from the banking system until the FF rate rose up to the Fed's desired target. Since the banks were reserve constrained, all this would dampen bank lending and slow down the economy.

    How about now? With approximately $3 Trillion in excess reserves in the banking system, courtesy of QE, the Fed intends to take a different approach. The Fed can no longer withdraw sufficient reserves from the banking system to engender an increase in short term rates and constrain lending. Instead, the Fed intends to simply pay the banks a higher interest on reserves. Perhaps this will be accompanied by other techniques such as reverse-repos to enable non-banks , such as money market funds to also earn this new higher rate. This would have the effect of raising short term rates across the board. Current expectations are that the Fed will embark on this process sometime in 2015, with very gradual increases to something like 2% by the end of 2016.

    It is interesting to speculate on how this new approach may have effects quite different to previous Fed tightening cycles in the pre-Bernanke era. Now, banks are not reserve constrained; ie. banks don't worry about their reserves in deciding whether to lend more aggressively or not. On the other hand banks are highly sensitive to capital ratios - driven by their levels of capital and the riskiness of their assets. It is not at all clear that when the Fed starts paying banks a higher interest on reserves, it will act to dampen the banks' enthusiasm to lend. To the extent that bank profits are enhanced by the increase in interest earnings on what are now very high reserve balances ( approximating $3 Trillion) partially offset by whatever increased interest they pay on deposits, banks may in fact be more willing to lend. This may be the key thing to watch. Will interest on deposits increase in lock step with the increased interest on reserves? If not, banks may enjoy a period of significantly enhanced profitability and be more eager to take risk and lend .

    The Fed is apparently more concerned about the tepid economic growth than inflation at this time. They seem to be willing to err on the side of tolerating higher inflation rather than prematurely snuffing out the tenuous economic recovery. So, by the time they get around to actually paying banks a higher interest on reserves, its quite possible that inflation will be increasing smartly and the bond market will be demanding the Fed do something about it. It will be in this environment that the Fed's new experiment in policy tightening will play out. And, it may not actually work. Banks' willingness to lend may actually increase and demand for loans may also increase as investors clamor to borrow to acquire assets to protect themselves against the rapid inflation.

    If the new policy tightening approach fails to constrain exuberant bank lending and inflation it is likely the Dollar will decline and further exacerbate inflation. All this may take some time to play out, and we may be well into 2016-2017 by then. Then what ? Well, one possible technique to try out may be for the Fed to raise reserve requirements such that the actual reserves in the banking system become "required reserves". Then the Fed could actually go back to the old fashioned approach to policy tightening. But that is just wild speculation on my part.

    In summary, it is far from obvious that the new policy tightening approach of paying banks a higher interest on reserves will play out like previous Fed tightening cycles. The risks seem to lie in the direction of overheated markets, excessive speculation and inflation. Since most people have been heavily conditioned by the deflation scare form 2008, there is a natural tendency to believe that inflation and overheating will be a relatively easy problem to solve. It may not be.

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  • RS055
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    Author’s reply » Additional thought:( in rough numbers)
    - bank Reserves: $3 T
    - Bank Deposits: $12 T
    - Bank Pofits; $150 B

     

    If Fed pays banks , say, 3% on reserves that would be $90 Bn. Will banks raise interest on deposits? that would be a huge hit and probably wipe out profits.
    How will this work? If the Fed just pays the banks an extra $90 Bn and nothing else happens that would hardly be a monetary tightening!!
    21 Jun 2014, 11:05 AM Reply Like
  • samuraitrader
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    I believe that the Fed will not raise rates for some time if at all until the whole dollar system unravels in a panic later this decade. The consistent lowering of rates for 30+ years has been to allow for the A) rolling over of debt and B) adding more debt. There are many reasons for this but the main one is the financing of the military empire.

     

    In the 70s, then the dollar last changed form, it took almost 10 years to play out and eventually required the double digit interest rates to cleanse the system and basically do a reset. I think that we will see that again but it will be worse.

     

    I agree that it is right to ask the question "how will the Fed raise rates?" I doubt they know.
    21 Jun 2014, 03:27 PM Reply Like
  • RS055
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    Author’s reply » Thanks Samurai - You may be right. However, it may become impossible for the Fed to ignore the increasing chorus from the gallery (CNBC commentators especially!) to do something. if we get another month of hot CPI readings, my instinct is the Fed may just pull the trigger and raise the interest on reserves all the way up to 0.5%. Even before they are done with QE.
    They may also be curious to see what happens when they pay the banks $15 Billion /yr more in interest.
    21 Jun 2014, 03:35 PM Reply Like
  • samuraitrader
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    it will not be the chorus from the gallery but the tsunami from the markets that will cause the Fed to act. by then we will be well into crisis mode and it will be global but worse in the US because of the dollar situation.
    21 Jun 2014, 05:27 PM Reply Like
  • RS055
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    Author’s reply » I wonder if the Fed gets any push back from Treasury. After all, the Fed sends all its earnings back to the Treasury, and paying the banks more , means less for the Treasury.
    21 Jun 2014, 03:37 PM Reply Like
  • samuraitrader
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    I am sure that the Fed is getting "feedback" from many places. But they have to put on this facade in public. "We are calm and in control of the situation. We know which lever to pull and when."
    21 Jun 2014, 05:28 PM Reply Like
  • TheMeyerGroup
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    I'd like to thank you for taking the time to share your thoughts on this. Your reasoning is impeccable and this is precisely the conversation that we need to be having. I've pondered how this anomalous Fed action will play out and any way I look at it we end up with 70's level inflation, or worse, and a weakened dollar.

     

    As investors interested in at least protecting our capital I don't see many good choices. What's your best bet as to surviving the Yellen era?
    22 Jun 2014, 02:28 PM Reply Like
  • RS055
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    Author’s reply » meyergroup- Thanks for reading. you might also enjoy this:
    http://bit.ly/1wj8hhG
    Its easier to write an analysis of the situation than figuring out how to invest! Iam inclined to inflation protection. TIPS seem to better than nominal bonds. A bit of gold seems appropriate especially after the huge smashup in the last couple of years. Some selected energy stocks - I like the ones with long lived assets in Canada. I am a bit skeptical about shale plays - i wonder if their business model is workable. It looks good initially, but the wells have very rapid depletion rates and so continually drilling new wells is necessary to just maintain production. Lots of dry powder. i am not at all sure how Yellen is going to react, so need to stay flexible.
    22 Jun 2014, 03:06 PM Reply Like
  • RS055
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    Author’s reply » I will add that my biggest fear is not the markets - I can handle just about any scenario. My biggest fear is increasing "administrative measures" ( as they call it in Asia). Brute force govt actions to manhandle markets to where they want them. For example; Stocks start selling off - make it illegal to short ( this actually happened in 2008 , if you recall). Bond funds getting redeemed - institute lock-ups. It easy to see how tax and regulatory measures can be used in a ham handed way as the Fed loses control. That is my fear.
    22 Jun 2014, 03:17 PM Reply Like
  • RS055
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    Author’s reply » The Fed is very "European" in its mindset, very central planner like. They dont trust markets. The fact that their models have missed massively in calling major events has not had any impact on what is essentially a priesthood . And we have a govt that is very interventionist - so any of the following types of things could be put in place if markets are not behaving well:
    - Capital controls
    - price controls
    - New rules and regs on trading
    - taxes on things they dislike ( like gold)
    - limited market closures - if they dont like what the markets are saying.
    - bank holidays - if the banks get in trouble all over again.
    Who knows? Will there be any political outcry? Maybe not - why would people protest actions that will be presented as necessary to hold up stock and bond prices and prevent a few "evildoers" ( shortsellers, goldbugs, foreign currency traders, people with foreign accounts etc etc) from undermining 'our way of life". This is the standard playbook now. It worked in the recent past, I would not be surprised to see it trotted out again.
    22 Jun 2014, 03:38 PM Reply Like
  • samuraitrader
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    if you are a US citizen, begin to have some assets outside the US. I agree with RS055, it is more than just the Yellen era. We will see capital controls in the US and more.
    22 Jun 2014, 03:49 PM Reply Like
  • RS055
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    Author’s reply » I actually don't agree. For most Americans, it is going to get increasingly uncomfortable and expensive to hold assets abroad. There is also a chance that you could get frozen out of your assets. Moreover they dont generate 1099s and such, so keeping track of interest income etc becomes cumbersome.
    With FATCA, a lot of foreign banks may not even want you as a customer.
    It is also not clear to me that any foreign jurisdictions are going to be any safer than the US. Europe is even more interventionist. And Asia, by and large does not have mature enough legal protections and you might be subject to all manner of ad-hoc laws and regulations and additional taxes.
    No - better to stay here and work within our political system to make sure property rights are not violated.
    22 Jun 2014, 04:03 PM Reply Like
  • RS055
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    Author’s reply » When push comes to shove, you are much more likely to get treated badly if you are a non-voting foreigner, especially a rich foreigner.
    Ultimately, its the political system that confers property rights. And the political system in each country is determined by the voting public. Foreigners will not get a seat at the table.
    22 Jun 2014, 04:07 PM Reply Like
  • samuraitrader
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    Here is an interesting blog post on how the Fed might raise rates.

     

    http://bit.ly/1pYVCA0

     

    I am reading this guys book too. Its good.
    22 Jun 2014, 05:00 PM Reply Like
  • RS055
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    Author’s reply » Thanks. here is a paper that discusses the reverse-repo technique in some detail.
    22 Jun 2014, 05:08 PM Reply Like
  • RS055
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    Author’s reply » http://bit.ly/1wj8hhG
    22 Jun 2014, 05:08 PM Reply Like
  • RS055
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    Author’s reply » OK , I actually read his essay. he needs to read my post on how banks work!! here is a quote from his essay:
    "rather than the alternative in which the banks lend out the $2T plus excess reserves that have been built up in the banking system or given back to the Fed in the case where the Fed Funds rate is increased."
    Banks do not "lend out reserves", It is not up to the banks to "give the reserves back to the Fed". Only the Fed and the Fed alone decides the total quantity of reserves in the banking system.
    22 Jun 2014, 05:29 PM Reply Like
  • RS055
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    Author’s reply » http://bit.ly/1nUQ0nf

     

    I would like as many people to read this short writeup as possible. The Fed in their "edutainment" videos do not explain banks this way. because it may disturb the peasants to realize that the banks can just make aloan - without having a box of cash in the backroom.
    22 Jun 2014, 05:39 PM Reply Like
  • samuraitrader
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    its a whole new world, completely uncharted. this will not be good for the dollar.
    22 Jun 2014, 05:23 PM Reply Like
  • samuraitrader
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    from page 11 "it appropriately ignores the quantity of money"

     

    frightening.
    22 Jun 2014, 05:25 PM Reply Like
  • RS055
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    Author’s reply » yeah! Econ PhDs are a strange lot. They have all these theories, multiple competing theories for some very basic things in the economy. They get all hung up on various theories on "quantity of money" and "velocity" and other esoterica. Many of them seem to not even understand how banking and money actually works. Very strange discipline - if I may call it that. Best compared to astrology or palmistry.
    That's why I think we best understand the financial world by understanding the actual plumbing as it actually exists today.
    22 Jun 2014, 05:53 PM Reply Like
  • samuraitrader
    , contributor
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    they are too left-brain data driven and cannot see the forest for the trees. in other words they cannot think about or accept some very basic fundamentals.
    22 Jun 2014, 07:45 PM Reply Like
  • TheMeyerGroup
    , contributor
    Comments (135) | Send Message
     
    This may well be the most relevant and interesting conversation I've read on SA and "the room is almost empty." Sad.

     

    From an Austrian Economics perspective (Mises.org), this is the most egregious "mal-investment" in human history and if their theories are even half correct, the reckoning when this mega bubble bursts should be quite unprecedented.

     

    On the other hand, who'd a thunk the Fed and their brethren central banks could have gotten this far without igniting massive inflation and currency meltdown already. I've been saying the EU was headed for a meltdown for the last decade and it hasn't happened. I dumped stocks and bought a big position in gold in 2008 on the theory that TARP & QE signaled imminent 1970's style inflation, but it still hasn't happened. Happily the gold did just fine.

     

    Maybe the Empress Dove at our Fed just holds all those bonds to maturity and the banks dribble out the loans so the velocity of money bends up rather than spikes into hyper-inflation. Maybe we end up with a long slow recovery rather than a bubble after all. Maybe America is the prettiest horse in the glue factory when it all comes down and we all do just fine.

     

    I can't bring myself to believe in that scenario but, as my wife is fond of pointing out, I've been predicting Armageddon since Obama was elected so whadda I know?

     

    Can you conjure up a good outcome if you try?
    23 Jun 2014, 04:24 PM Reply Like
  • RS055
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    Author’s reply » "who'd a thunk the Fed and their brethren central banks could have gotten this far without igniting massive inflation and currency meltdown already"
    I remember having this debate back in 2009 with a friend about whether QE would unleash massive inflation. Surely such a bizarre monetary experiment had to have some very bad consequences right?
    Well, my view was that the "very bad consequence" would not be inflation , necessarily ( see my little blogpost on how banks work), but rather something even worse. TARP/QE and what not were nothing less than a coup by very powerful money players who now completely and utterly control our economy, our politics and our police/military forces. They are too big to fail, too big to jail, so big they should be worshipped as gods. This is as un-American a set of policies that have ever been promulgated. Inflation ... hah .. we can deal with that. A complete takeover of the levers of power ... is a different matter.
    Who's going to reign in the Fed? What if they create another crisis and roll out ever more egregious policies? Most in congress dont even understand the basics of how banks work - you can always tell when someone says " the banks are not lending out all that money the Fed gave them" - they need to read my half-page explanation of how banks work! They are not in a position to argue with the Fed.
    23 Jun 2014, 04:43 PM Reply Like
  • financeminister
    , contributor
    Comments (1218) | Send Message
     
    Thanks for the write up. Very insightful. Am I wrong to feel that those in the ivory towers of finance prefer to encourage bubbles to have the economy stay afloat? The bubble continues until they eventually pop. They are not good at predicting when it will pop but they are good at creating conditions to continue the bubble until the first signs of weakness overwhelm momentum. To stimulate the economy again, they have to start a different bubble - from dot coms to real estate to financial markets.

     

    I'm trying to prepare for a continued bull or bear scenario. Currently I'm 80% allocated in dividend growth stocks. 20% is in cash to buy a house in 2016 and that also acts as an emergency fund until then. We have around 30 years for retirement so we can afford to dollar cost average the stock market until then. If the market goes downward by 2016, the excess cash comes in handy and hopefully real estate is also cheaper. If the bull market continues, the equities perform finely and keep paying cash and I will continue with my plans to buy a home.
    9 Jul 2014, 02:47 PM Reply Like
  • RS055
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    Author’s reply » " Am I wrong to feel that those in the ivory towers of finance prefer to encourage bubbles to have the economy stay afloat?"
    No , I think that is exactly correct and Yellen , in a speech a couple of days go said exactly that.
    The bigger issue is what if anything the Fed is able or willing to do when the stock market drops , say, 20-30%? Not clear at all.
    9 Jul 2014, 02:55 PM Reply Like
  • T-time
    , contributor
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    "The bigger issue is what if anything the Fed is able or willing to do when the stock market drops , say, 20-30%?"

     

    Yes, well, obviously - the idea is to not let that happen to begin with...! And they are doing pretty good job so far...

     

    How do you solve problems in the fed? Throw some money at it...
    9 Jul 2014, 04:53 PM Reply Like
  • RS055
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    Author’s reply » If you believe the Fed has magical powers to stop a stock market decline - what were they doing in 2001, 2008?
    Earnings are likely to start disappointing badly ( IMHO). Folks who think stocks at 20X earnings are fairly priced may be in for a shock. Also folks who buy into non-GAAP, operating earnings Ex Items may discover that they are only fooling themselves.
    9 Jul 2014, 04:59 PM Reply Like
  • T-time
    , contributor
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    it is not what they were doing in 01 and 08, it is what they were NOT doing... that was my point. They pumped billions a month for all of 1 and 2Q 2014 - they did not do that in 2001 and 2008
    10 Jul 2014, 03:36 PM Reply Like
  • RS055
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    Author’s reply » Its hard to know exactly what the Fed is up to and what the backroom discussion are , but this is my opinion:
    - The Fed primarily cares about the banking system. They have moved heaven and earth to make sure the banks make money and are protected.
    - The Fed also cares about making sure the Federal Govt is able to easily finance its deficits.
    - they kinda sorta care about unemployment and inflation. But the numbers are highly unreliable and subject to tinkering, and the Fed is smart enough to know they cannot really do much about employment. or much about rising oil prices, rents or food prices.

     

    Note in my list above, no mention of small cap stocks! i really dont think the Fed particularly cares about the stock market. The huge run up in small cap stocks in the past year was driven by speculators, not the Fed. If these stocks go down 30-50%, the fed is not going to drop everything else and attempt to help out the speculators. Its a popular superstition and a fantasy held by stock speculators that the Fed somehow has their back.
    10 Jul 2014, 03:49 PM Reply Like
  • samuraitrader
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    agree with your opinion. The Fed is there to A) finance fed govt debt and protect the banks. Although I think the first priority is to finance the debt.
    10 Jul 2014, 06:00 PM Reply Like
  • GoGowadof100s
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    nice writeup RS and commentary
    10 Jul 2014, 06:23 AM Reply Like
  • RS055
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    Author’s reply » "In recent weeks, the Fed has neared consensus that its workhorse tool will be the interest it pays banks on excess reserves on deposit at the Fed - giving the central bank a direct way to encourage banks to either take money out of circulation and leave it at the Fed, or lend it elsewhere." Reuters 7/12/2014
    This seems to be the common perception, and the Fed is doing nothing to discourage it. This is exactly why I wrote my blogpost. It seems a lot of people continue to labor under the belief that banks "lend out reserves". It does'nt make any sense. but that has never prevented popular beliefs from lingering on.
    12 Jul 2014, 02:37 AM Reply Like
  • samuraitrader
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    the Fed, and all the central banks playing these games, are going to get caught in their underwear. not a pretty visual is it? :-)
    12 Jul 2014, 07:36 AM Reply Like
  • RS055
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    Author’s reply » No , but more likely hte Fed will get caught in Our underwear! Thats even uglier!
    12 Jul 2014, 04:48 PM Reply Like
  • PendragonY
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    The first problem I see with this is that you failed to mention that the banks don't have $3 trillion in excess reserves. They might have this much under the old rules, but not under Bessel III rules. Those rules now in the process of being phased in, require a much higher rate of reserves than the older rules.

     

    Second, how you have described QE and increased excess reserves isn't quite right.

     

    http://onforb.es/1i59Wh3

     

    "QE involves buying assets held by the private sector, both banks and investors. When the Fed buys from banks, the bank simply exchanges one asset (UST or MBS) for another (new reserves), and there is no change in deposits. But when the Fed buys assets from private sector investors, the purchases are intermediated through banks, and the newly-created dollars that investors receive in return for their assets are credited to their bank deposit accounts. Consequently bank deposits rise."

     

    12 Jul 2014, 08:21 AM Reply Like
  • RS055
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    Author’s reply » I have not seen where Basel 3 increases reserve requirements. The main focus of Basel 3 has been to raise capital requirements.
    I you look at the loan growth against deposit growth ( its in that Forbes article) , it sure looks like the gap is almost exactly made up by the amount of QE.
    "When the Fed buys from banks, the bank simply exchanges one asset (UST or MBS) for another (new reserves), and there is no change in deposits."
    Sure that is strictly speaking true as the last step in the transaction which usually proceeded as follows:
    Bank buys Treasuries from the US treasury ( and creates a deposit in favor of the US Treasury), Fed buys Treasuries from the bank a few hours later ( replacing the Treasuries with Reserves).
    12 Jul 2014, 04:54 PM Reply Like
  • PendragonY
    , contributor
    Comments (11265) | Send Message
     
    Given the requirements for liquid assets and what Tier 1 capital is, this is effectively an increase in reserve requirements.
    13 Jul 2014, 09:36 AM Reply Like
  • RS055
    , contributor
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    Author’s reply » Ahh.. there may be a bit of that going on, but look at the magnitudes. The reserves in the banking system are approaching 30% of deposits.
    Iam by no means an expert on Basel3, but it appears it plans to impose something like an additional 2.55% capital buffer.
    But, i take you point that if the Fed desired they could simply raise reserve requirements to 30% of deposits and eliminate the "excess" reserves with the stroke of a pen. i dont think Basel 3 does anything like that.
    13 Jul 2014, 02:20 PM Reply Like
  • RS055
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    Author’s reply » Also, the existence of excess reserves, does not in any way imply high capital ratios. ie. banks may still need to raise equity capital even with very high level of excess reserves.
    we need to be careful not to confuse loan Loss Reserves ( a contra-asset , which effectively functions as equity) and Reserves On Deposit with the Fed( an asset).
    13 Jul 2014, 02:29 PM Reply Like
  • Dbest1
    , contributor
    Comments (328) | Send Message
     
    Credit(debt) needs to be included in the money supply. If money supply is growing, but the credit extended is shrinking faster than money supply is expanding, well, you would not have a situation of inflationary pressures. That is what we have here.
    Money velocity is the key to understanding why inflation is not a issue. Sure the fed is creating money....but it is going into very few hands, and is not being released to the average wage earner. Whether this is through non credit worthiness, or the average wage earner not wishing to take on more debt is a good question to ponder. The results are where we are now.
    Deflation is more likely scenario in my opinion. It is easy really..Deflation is money going away. When debt gets unwound, money goes away. Either through default or through paying off of debt, the results are the same; less money in circulation. You ask....what about inflation? Well, if the debt burden is at the top of what the system can handle( I would say that is where we are at now), then any raising of monthly rates would have a exponential curve of insolvency. Defaults go up when inflation raises the amounts to service debt. This happens on all levels, consumer, local gov, and fed gov. So the result is deflation for either case.....
    It only needs time to play out. Just wait for more risk. No large players have defaulted, yet, that all changes in the not too distant future. As soon as several "safe" institutions are shown as a high risk of defaulting, the whole house of cards starts tumbling in short order. Risk gets priced in, and the higher interest rates have consumers, corporations, local governments, and federal governments in default.
    The whole process gets uglier as more players go down. That is how the last depression went. This coming insolvency will be worse in my opinion. We are already in worse shape, in many ways, than we were in the depression. With one exception, there is welfare.
    18 Jul 2014, 09:31 AM Reply Like
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