Update and Analysis on Fed Policy: It's Different This Time
The Federal Reserve embarked on its new policy of buying securities in the open market in March - following January's pseudo deflation shock, which saw it drain some $200 billion in (excess) reserves from the banking system by liquidating currency swaps, repos and a few of the other loan facilities.
Its balance sheet shrank even more, thanks to the Treasury's withdrawal of some $150 billion - which, incidentally, added to the stock of deposit money in subsequent months. The statistic that describes the Fed's influence on reserve creation and destruction is the one in the graph to the right: reserve balances, or the net/difference between the factors supplying and absorbing federal reserve funds (release H.4.1, "Factors Affecting Reserve Balances of Depository Institutions").
The relevance of this statistic peaked back in the early nineties, as the banks relied increasingly on other means of multiplying deposits. Today, however, it has gained in importance like never before.
Just this past two months, since January, the Fed has re-inflated those reserves through the open market purchase of about $235 billion in mortgage backed securities, and about $55 billion in US Treasury and Federal agency debt, as part of its new plan to buy US$1 trillion in securities this year.
Those are whopping figures for a factor that accounted for changes of less than $5 billion month to month through most of its history - both ways - prior to last September. Almost all of those reserves you see in the graph above ($800 billion plus) were created in the last four months of 2008, as we all know. However, critics aren't happy that the banks aren't tapping into those reserves to their potential.
If you ask us, the truth is that interest rates are too low.
But many believe the bank "multiplier" is crippled by exploded balance sheets and a weak consumer, and that the Fed must lean on alternative modes of transmitting its inflation policy - if it wants to avoid Armageddon, that is! -as if money and credit expansion were synonymous with economic growth.
Theoretically, those reserves should already be sufficient to fuel the creation of more than five trillion dollars, easily doubling the money supply (the Austrian School definition) within a couple years.
Furthermore, it should be recognized that money supply growth is in no way anemic.
As you can see, even the most conservative measure of money supply is growing at 10 percent year over year, and the slope of this intertemporal relationship is on the rise. A lot of people are focused on the overall level of debt and expect it to contract despite what the central bank is doing. Putting aside the debate over the many contradicting doctrines, at least today, the obvious fact is that this has not yet happened. Although we don't expect it to happen while central banks have their collective metal to the pedal, if you will, that is not to say that deflationary headwinds don't exist, or cannot increase.
In fact, on the Fed's balance sheet, these head winds manifest more or less as increases in deposits held at the Fed, or as currency in circulation (i.e., currency leaving the banking system). This latter statistic has been growing at twice its historic rate since October, implying a continued drop in confidence in the banking system. The drain is neutral with regard to the question of overall inflation because currency in circulation is part of the total money supply; it is only deflationary in the sense that it is working against the Fed's intent to inflate bank reserves.
There are other deflationary forces working throughout the economy. But what is important to understand is that the agitation for a new policy course, like quantitative easing, or heli-money, is based on the fear of deflation, and the idea that pouring more money onto the problem will solve it.
Indeed, we think the policy is hasty, which is why we believe in gold and the commodity complex.
Regardless, the new policy was kicked off in March, and we are likely to see its effects manifest soon as an acceleration in the growth of deposit liabilities. The Fed is ¼ of the way to its $1 trillion stimulus plan - and so far this has all been monetized, which means paid for by pure money (reserve) creation.
Of course, whether you operate within a neoclassical framework or the Austrian School's business cycle theory, the big question is what will the Fed to these reserves and inflation going forward.
In order to answer that, however, it might be helpful to understand the difference between this policy and the others, since 2007, when the Federal Reserve began to ease money and credit conditions.
Its policy has evolved through three distinct phases.
The first phase, lasting from September 2007 to August 2008, saw the central bank cut the Federal Funds rate from over 5% to 2%. The distinguishing mark of this phase was that the Fed expanded reserve bank credit by just $10 billion, and it created virtually no new money in the process, despite the interest rate cuts. Although it began to create and extend new facilities early in 2008, it drew that firepower from the sales of Treasuries. That is, its policy was aimed at specific areas within the credit market, and it was sterilized. It worked well enough to bring down interest rates and offer a temporary lifeline to the weak players. But, according to the Austrian School theory of the business cycle, the Fed's attempt to reign in the previous inflation during its tightening campaign (2004-07) is what undermined the boom in the first place. The boom requires inflation rates to grow in order to sustain, even though such "booms" really aren't sustainable indefinitely. Thus, this policy, while effective at obliterating inflation expectations, also contributed to the continued spreading of the financial crisis.
The policy at this stage could therefore be viewed as a failure, by most any measure.
The second phase began with the nationalization of the dominant GSE's, and AIG, as well as the ball drop on Lehman, this past September. With inflation expectations all but dead and buried, the Federal Reserve started creating reserves with abandon, and it stopped selling Treasuries - having practically depleted its holdings (this is no longer true as about $200 billion of Treasuries initially loaned out have been returned - but as of November it had less than ½ the Treasuries fully collateralized on its books).
In any case, the distinguishing characteristic of this second phase was the massive expansion in the balance sheet of the Federal Reserve System, and the unprecedented level of bank reserve creation.
Remember, in the first phase, there was little to no money creation.
Furthermore, the policy tools used for this expansion were themselves unconventional. And while it was no longer sterilizing expansions, it wasn't really going out into the open market and buying either.
Most of these reserves were provided by way of term auction credit and other specialized facilities.
These assets may be idle. In all likelihood, these funds are a lifeline for patients that aren't able to pyramid new deposits on top of them, or so it would appear by the static nature of "excess reserves."
At least that explains why the Fed is breaking out the current phase, which involves more conventional means of transmitting the "stimulus" of money creation, except that the object of its affection is higher risk mortgage backed securities today. This is not to say the Fed is being completely conventional with regard to its methods. The ideas of "quantitative easing" and buying long term treasuries, while not all that revolutionary, are nonetheless being carried out quite differently than at any other time in its 95 year history. However, what marks this third phase is that it is buying securities in the open market.
In phase one, the Fed created new facilities but tried to sterilize its activities, which failed. The second phase involved the unsterilized creation of many more specialized facilities. The third phase involves the monetization of these loans by ultimately replacing them with general open market purchases.
In this phase, ideally, the Fed would want to collapse those specialized facilities at some point.
There is already talk about that.
But talk is just that.
Until the Fed begins to liquidate its newly created term facilities and other special loans, based on its history, we have to assume that they are going to be permanent fixtures of the Fed's balance sheet.
Meanwhile, moreover, the current phase involves a highly inflationary policy that is likely to overshoot on the inflation side. The Fed is planning to buy roughly another $700 billion in securities this year.
It is not clear how much of that will be pure money creation, but even if it just replaces the current $700 billion or so in idle excess reserves, it could still accelerate the growth of actual money supply.
Our expectation is that the Fed will pump reserve balances up to about $1 trillion and allow the money supply to practically double before it begins to actually drain any reserves or tighten money conditions.
We'll have to wait and see.
But, in no way is the growth in money or credit impaired as so widely believed.
And as long as this is true, its value will invariably decline - whether we're talking about dollars or rubles. Money is not immune to the laws of supply and demand. Barring a miracle of productivity, or an outsized increase in the demand for holding cash balances, this means prices must ultimately rise.
Economic growth in the future is likely to consist in short bursts of enthusiasm interrupted by price and interest rate shocks. Warren Buffett likes to think in terms of the 10 year outlook. Certainly, the last 10 years have not been kind to equities. The trouble is that the cause of that ailment is widely considered to be the best solution to today's problems, but in bigger dosage. The reasons for this mis-diagnosis are all too familiar to repeat. But, if the thinking on market policy does not change, the next decade is bound to be even less kind... it is bound to be another lost decade for stocks as a favored asset class.
Turns out, however, such an environment is fundamentally bullish for the precious metals, and miners.