FORECASTS & TRENDS E-LETTER
by Gary D. Halbert

May 27, 2014

Fed Official: We’re Sitting On A “Ticking Time Bomb”

IN THIS ISSUE:

1. Warning: Fed Is Sitting On “Ticking Time Bomb”

2. Why Banks Hold Excess Reserves at the Fed

3. Back to the “Ticking Time Bomb” at the Fed

4. Question: Is the Fed Paying Banks Not to Lend?

5. Dinesh D’Souza to Prison, Jon Corzine Goes Scot-Free

Warning: Fed Is Sitting On “Ticking Time Bomb”

It is very rare for high-ranking Fed officials to issue dire warnings, but that’s exactly what Charles Plosser – the president of the Philadelphia Federal Reserve Bank – did last Tuesday. Mr. Plosser is very concerned about the $2.5 trillion in “excess reserves” that banks have on deposit with the Fed.

Mr. Plosser worries that if the economy strengthens as many expect, borrowing could surge and those excess reserves could pour out of the Fed and “that’s going to put [upward] pressure on inflation.” This is the “ticking time bomb” he warned about. More details to follow…

The Fed “reserve requirement” refers to the amount of cash funds that banks must have on hand each night. Banks can hold reserves either as cash in their vaults or as deposits with the Federal Reserve Bank. The amount (percentage) of the reserve requirement is set by the Fed.

If a bank doesn’t have enough cash on hand to meet its daily reserve requirement, it can borrow from other banks or at the Federal Reserve discount window. The money banks borrow or lend amongst each other to fulfill the reserve requirement is known as the Fed Funds market.

For decades, the Fed paid banks no interest on reserves held at the central bank; however, in late 2008 the Fed began paying banks 25 basis-points (0.25%) annually on deposits. Since then, excess reserves held at the Fed have exploded to a record above$2.5 trillion today.

Much of this money held at the Fed is owned by large banks and financial institutions which are designated as “primary dealers” from whom the Fed has purchased huge amounts of bonds as a part of its massive QE program. These entities have merely chosen to leave a large part of those bond proceeds on deposit with the Fed.

Fed Official

Excess reserves are money that banks hold over and above the reserve requirement set by the Fed. The main question is, why would banks hold sometimes huge amounts of excess reserves at the Fed for a measly 25 basis-points? You might answer that it’s because 0.25% is better than earning nothing if banks keep the reserves in their own vaults. While that’s true, there’s much more to it than that.

Why Banks Hold Excess Reserves at the Fed

Before we dig into that, let me briefly explain why the Fed decided to pay banks 0.25% interest on reserves held at the central bank. Over four decades ago, economist Milton Friedman recommended that the Fed pay interest to banks and other depository institutions on the reserves they are required to hold against their deposit liabilities.

In 2006, Congress finally granted the Fed authority to pay interest on reserve deposits, but it was not to go into effect until 2011. However, during the financial crisis, the effective date was moved up by three years through the Emergency Economic Stabilization Act of 2008.

On October 6, 2008, the Federal Reserve Board announced that it would begin paying interest on depository institutions’ reserve balances. In 2007 (pre-crisis) total required reserves held at the Fed averaged $43 billion, while excess reserves averaged only $1.9 billion.

Prior to the financial crisis, banks tried to keep excess reserves at the Fed to a minimum. This was typical for the prior 50 years when the Fed did not pay interest on reserves. Historically, banks kept excess reserves at the Fed as low as possible so that they had more money on hand to make profitable loans. The financial crisis changed all of that, and bank lending plunged!

Under normal circumstances, deposits and loans are more-or-less equal across the banking system as a whole. But since 2009 there has been a very significant change. There is a large and growing gap between loans and deposits. So what is causing this?

Banks, households and businesses have been deleveraging. That means they are paying off (or writing off) loans and not taking on more. Damaged banks don’t want to lend, struggling households don’t want to borrow and fearful businesses don’t want to invest. The combination of these three factors meant that both the supply of and the demand for loans were considerably below the levels prior to the financial crisis.

Back to the “Ticking Time Bomb” at the Fed

As I noted above, Charles Plosser, president of the Philadelphia Federal Reserve Bank recently went public with his serious concerns about the record-large $2.5 trillion in excess reserves sitting at the Fed. Mr. Plosser is also a current voting member of the Fed Open Market Committee (FOMC) which sets monetary policy. He is one of the more hawkish members of the Federal Reserve Board, meaning that he has not been a fan of the Fed’s massive QE bond buying or its zero interest rate policy (ZIRP).

ImageProxy

 

To understand why Mr. Plosser would go public with his concerns about the record $2.5 trillion in excess reserves at the Fed, and possibly ruffle feathers among his Fed colleagues, we have to take into consideration how easy it is for banks to remove that money from the Fed and plug it into the economy via loans.

For one, banks have no requirement to keep any excess reserves at the Fed. If they do, they can take it out at any time they wish. Mr. Plosser knows that the Fed has attracted these massive excess reserves in large part because it pays interest on such deposits. Banks would rather earn 0.25% in a risk-free account at the Fed as opposed to nothing if they hold this cash in their vaults.

Plosser points out that these unprecedented excess reserves are currently just sitting at the Fed, basically doing nothing. Part of the reason is that demand for loans has been unusually weak amid an economic recovery that’s the slowest on record since the Great Depression.

“These reserves are not inflationary right now,” Plosser said in a meeting last Tuesday with reporters in Washington. Yet he warned that if the economic recovery strengthens as many expect, borrowing could surge and those reserves could pour out of the Fed. Plosser worries that should this happen, “that’s going to put [upward] pressure on inflation.”

If inflation moves higher, the Fed could be forced to raise interest rates earlier and higher than it would like, which could slam the breaks on the economic recovery. This is the“ticking time bomb” Mr. Plosser is worried about.

Plosser knows that the Fed has often been late in responding to inflation threats in the past. He warned: “One thing I worry about is that if we are late, in this environment, with all these excess reserves, the consequences might be more dramatic than in previous times.”  With over $2.5 trillion in excess reserves parked at the Fed, he worries that a huge amount of money could be lent into the economy, which could drive inflation above the Fed’s 2% target.

And then he went on to say: “As we continue to move closer to our 2 percent inflation goal

1, 23  - View Full Page