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Quantitative Uneasing

banks excess reserves

For the past six years, many people have asked me why we don’t have runaway inflation in this country. They tell me how the Fed has printed trillions of dollars and that it is only a matter of time before we see the dollar collapse and prices spiral. Here is my opinion on why this hasn’t happened.

When the U.S. economy gets sluggish, the Federal Reserve lowers interest rates. When the U.S. economy is nearly dead, they lower interest rates and then leave them low for many years. Part of the plan the Fed has used to stimulate economic growth has been labelled “quantitative easing” (QE).

Because our economy relies heavily on consumer spending for economic growth, the Fed has been encouraging people to spend money for the past six years. How better to do this than to just print a lot of it? The Fed and Treasury prefer to describe this process as “expanding the balance sheet.” QE is another phrase of choice. Both of these sound better than “print a lot of money.”

What is QE in simple terms? The Fed expands its balance sheet by buying bonds. The Economist magazine (Jan. 14, 2014) described the process like this: “To carry out QE, central banks create money by buying securities, such as government bonds, from banks with electronic cash that did not exist before.”

I love to think of the magic in that statement: to buy bonds with electronic cash that did not exist before.

The idea behind QE is that when the Fed buys bonds, it drives the prices for the bonds higher and the interest rates lower. The bond sellers suddenly have cash in their hands that is no longer earning interest. In theory, these people will then aggressively start to make loans or investments or spend the money. All these actions tend to create jobs in America. The Fed bond-buying spree also causes mortgage rates to go down and house prices to rise. QE also has caused stocks and commercial real estate to move back to record highs. So asset prices have skyrocketed, but the U.S. economy continues to grow at a sluggish pace.

Here is what QE looks like in a picture. It’s a chart of the total assets of the Federal Reserve. Notice how the Fed had about $870 billion assets on Aug. 1, 2007. Then the credit crisis began, and the financial pillars of global capitalism began to crack in September 2008. The Fed began to ease quantitatively. It began electronically creating money and bought Treasury bonds and mortgages with the new money. In just two months, bonds owned by the Fed had doubled. By the end of 2008, its balance sheet was $2.2 trillion. Today, after six years of QE, the Fed’s balance sheet is around $4.4 trillion. That’s a lot of bonds!

So the Fed has electronically created about $3.5 trillion since the fall 2008. Why isn’t the economy on fire? Why aren’t we experiencing the high inflation that so many gold vendors have been screaming about for years?

The money has been created, but it’s not being spent. A fancy way to say this is that the velocity of money is really low. Where is all this newly created money going? The short answer is: nowhere.

The chart below shows the amount of “excess reserves” in the banking system. Going back to 1985, you can see that banks don’t like to have excess reserves. They would much rather have their funds loaned out to qualified borrowers to run businesses, take vacations and buy things. But this changed dramatically when QE was initiated in 2008. Since then, excess reserves have ballooned from virtually zero to over $2.6 trillion.

So the Fed conceptually created $3.5 trillion in fresh cash since 2008, but about $2.6 trillion of that is buried in the largest banks in the country earning .25 percent interest from the Fed. Essentially, money is not really “printed” until a bank loans the money to someone to buy something. As long as the money stays in excess reserves, it’s not really printed.

Here is how Ben Bernanke described this phenomenon in a speech in 2009:

“However, banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed. Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base. At this point, with global economic activity weak and commodity prices at low levels, we see little risk of inflation in the near term. . . . ”

Hence, the Fed technically hasn’t printed trillions of dollars. It has expanded its balance sheet and purchased bonds from banks. This purchase of bonds has created massive excess reserves but not a massive increase in the money supply. As long as the money created stays buried in the reserves of the banking system, the threat of inflation stays in abeyance.

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