Much ink is being spilled on when/if the Fed will move to the next iteration of its quantitative easing program. That’s the wrong question. The Fed and the world’s other major monetary authorities have effectively been captured by national treasuries running historically high budgetary deficits and their chief function has become the funding of governmental expenditures that cannot or will not be funded through taxes. Continued pressure to monetize the debt is a foregone conclusion so long as the deficits continue at their current levels.
A year ago we explored Chairman Bernanke’s position that "QE II (the purchase of long term Treasury Bonds by the Federal Reserve) is not inflationary and has not created an explosion of the money supply."
How could it be the case that rapid monetary expansion could be accomplished without an inflationary impact? Keynes, though much maligned and misused, provided a clear explanation for this one with his description of a “liquidity trap”. In normal credit environments new reserves added to the banking system are magically multiple through the working of fractional banking, creating a significant multiplier effect on business activity throughout the economy.
In a liquidity trap this no longer works; reserves just sit at the banks and the money multiplier sinks. That’s where we are today as recently outlined by Paul McCulley, Chairman of the Society of Fellows of the Global Interdependence Center and former PIMCO trader, in a recent CNBC interview. As a result the Fed has been able to create in excess of $1.5 Trillion of excess bank reserves since the 2008 crash
Looked at globally, the trend is even more dramatic.
Source: Zero Hedge
The size of the combined Federal Reserve, European Central Bank and Bank of Japan balance sheets has grown from a historical norm of approximately 12% of their respective GDPs to 24% of combined GDP since 2008 and now total in excess of $8 Trillion. Yet inflation is still relatively subdued globally and fear still abounds that we are headed for a round of deflation and severe recession.
In our last post on the subject we were inclined to give Bernanke the benefit of the doubt. He understood well the risks of the liquidity trap and was aggressively pursuing actions to prevent it from driving us deeper into a global depression. So what has happened since then? Certainly events to date have supported the view that the Fed’s actions in creating this massive amount of liquidity were necessary. Absent these actions the U. S. economy would almost certainly have fallen into a severe recession in 2011.
While we gave Bernanke a pass last year, we are less inclined to do so now. A new element has entered into the picture: the capture of the central banks by national treasuries desperate to fund unrelenting deficits throughout the world. The central banks are in effect printing massive amounts of currency to fund government deficits worldwide. They have enabled their governments to substitute debt monetization for taxation.
Looking at the recent course of U. S. deficit funding presented in the chart below, it is apparent that something very new occurred in 2011. From 2008 to 2010 the deficits were funded predominantly by U. S. households and overseas investors. This had the effect of neutralizing the inflationary impact of the deficits.
U. S. Deficit Funding (Source: Federal Reserve Flow of Funds Guide F.209 and Clear View Economics)
In 2011 the situation changed radically. During Q1, the Fed purchased treasury securities at twice the rate of new debt issuance while households liquidated their treasury holdings at a rapid rate. Q2 reflected a similar pattern, though not so extreme. The financial crisis in Europe provided a respite in Q3 as overseas investors flocked to dollar denominated assets, but the funding needs were so dramatic that the Fed continued to monetize debt even in a period of otherwise favorable flows.
A year ago, while defending quantitative easing as necessary to keep the economy on even keel, Bernanke assured the world that, were inflation to rear its ugly head, the Fed could raise interest rates “in fifteen minutes” if necessary. So far the dampening effect of the liquidity trap has made such action unnecessary.
Because of monetary capture it will become increasingly difficult for the Fed or its counterparts overseas to cut off the spigot when inflation threatens. With government debt levels in major nations worldwide at or approaching 100% of their domestic GDPs, a dramatic increase in interest rates would have a devastating impact on national budgets. In such an environment it is easy to imagine that the path of least resistance will be a tendency on the part of the central bankers to accept a higher level inflation as the smaller price to pay.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.