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.
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).
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 and the labor market improves, we must be prepared to adjust policy appropriately.”
And finally, he said: “Our [current] challenge is subtly different. We have to restrain the pace at which banks lend those reserves out.” [Emphasis mine.] I’m quite surprised that he said this, but Reuters reported that this statement was part of his prepared remarks for his speech last Tuesday. So he meant to say it.
The question is: What did he mean by that? I thought a lot about that over the holiday weekend. As pointed out earlier, these excess reserves parked at the Fed can be removed whenever the banks so choose. Plosser’s statement above is potentially huge, but it has thus far received very little attention in the financial media.
Question: Is the Fed Paying Banks Not to Lend?
Here’s an unconventional thought. The Fed started paying banks 0.25% in interest at the height of the financial crisis in 2008. While the banks may have needed the money back then, they certainly don’t need it now. So one way to look at this is, the Fed is paying banks not to lend.
Could Mr. Plosser’s comment above about “restrain the pace” of bank lending mean that the Fed is considering increasing the amount of interest it will pay on reserves? I wouldn’t think so, but it’s impossible to know what he meant.
The minutes from the April 29-30 Fed Open Market Committee meeting were released last week. I read them carefully, and there was no mention of increasing the interest rate on reserves held at the Fed. So for now, we simply don’t know what Plosser meant when he said the Fed will have to “restrain the pace” of bank lending.
On a more general note, actions taken by the government often have unintended consequences. In this case, I doubt that Congress expected banks to park over $2.5 trillion in excess reserves at the Fed to earn a risk-free 25 basis-points, rather than lending that money in the economy. Yet that’s where we are.
Personally, I don’t think the Fed should pay interest on reserve deposits. Certainly not on excess reserves. If the Fed wants to reduce the $2.5 trillion in excess reserves, it could simply announce that it will phase-out such interest payments over time, and banks will get the message.
As noted earlier, Fed officials rarely make controversial statements in a vacuum. I don’t believe Plosser’s “ticking time bomb” statement last week was an accident or a rogue comment, even though it was reportedly made in the Q&A period after his prepared speech. What we don’t know is why he said it and what message it was supposed to send.
Finally, the ticking time bomb he warned about may not happen, especially if the economy continues to disappoint. Despite the much weaker than expected 1Q (only 0.1% growth), Plosser still believes the economy will grow by 3% for the year overall. For that to happen, growth must be well above 3% in the 2Q, 3Q and 4Q. I don’t believe that is very likely.
Most forecasters I read are now expecting growth of around 2% for this year. If that is the case, I don’t see banks ramping-up lending in a big way as Plosser suggests. Therefore, I don’t see a stampede of excess reserves out of the Fed. I could be wrong, of course.
Maybe Mr. Plosser will offer some clarification in one of his upcoming speeches.
I’ll stay on this and keep you posted.
Dinesh D’Souza to Prison, Jon Corzine Goes Scot-Free
Many of you will remember that I repeatedly urged clients and readers to see Dinesh D’Souza’s 2012 movie documentary 2016: Obama’s America. The film focused on President Obama’s upbringing, his past and the origins of his far-left political ideology. It was a fascinating documentary, regardless of your political persuasion.
Yet in January of this year, D’Souza was indicted by the Feds and charged with soliciting two illegal campaign contributions for Republican Senate candidate Wendy Long who ran for the Senate in New York in 2012.
Basically, D’Souza was charged with convincing two friends to donate $10,000 each to Ms. Long’s campaign and then reimbursing them both with personal money. Last Tuesday, D’Souza pled guilty to both charges of campaign finance violations, but he continues to maintain that he was targeted by the Feds over his film documentary that was highly critical of Obama.
While his formal sentencing will not be determined until September, it is very likely that D’Souza will be sentenced to prison for 10-16 months, plus a fine up to $250,000. Since D’Souza pled guilty to the charges, I will not defend him. However, I would like to compare D’Souza’s conviction and pending prison sentence to what happened last year in the case of Jon Corzine’s legal troubles in connection with the bankruptcy of MF Global in 2011.
Corzine, you may recall, was a United States Senator from New Jersey from 2001 to 2006 and was the 54th Governor of New Jersey from 2006 to 2010. He also worked as the CEO of Goldman Sachs during the 1990s. Most recently, he was the CEO of MF Global, a commodity futures clearing firm, from 2010 to 2011.
MF Global went bankrupt in 2011, and a reported $1.5 billion in customer funds went missing. It is widely believed that MF Global, on Corzine’s watch, used customer money to pay losses on its proprietary trading. When MF Global went down, Corzine was charged by the US Commodity Futures Trading Commission (CFTC) in connection with MF’s bankruptcy.
Yet despite the MF Global charges pending against him, Corzine was reportedly one of President Obama’s top fundraising “bundlers” in his 2012 re-election effort.
So how did Corzine’s case turn out? While D’Souza is almost certainly going to prison for $20,000 in illegal campaign contributions, Corzine who oversaw the loss of some $1.5 billion in customer funds at MF Global got off scot-free!
In an announcement last summer, the Justice Department said it was dropping all charges against Corzine. After 18 months of investigation, the criminal probe into Jon Corzine was completely abandoned. The Justice Department said it found no evidence of criminal wrongdoing, even though some $1.5 billion in customer funds were lost during the same period in which Corzine was the CEO.
It is strictly forbidden for clearing firms like MF Global to co-mingle customer segregated accounts with the company’s money, which many believe happened in this $1.5 billion bankruptcy. Customers of the bankrupt firm did not get all their money back.
When the Justice Department dropped the charges last year, there was surprisingly little coverage and certainly no outrage in the media – even in a political climate where members of the Democratic Party’s base were calling for the heads of big bankers and Goldman Sachs alumni, in particular. But Corzine is an “insiders’ insider.”
Perhaps because he has very close friends in the White House, the US Senate, New Jersey and Wall Street, Corzine got a pass for his oversight of the MF Global bankruptcy and the straight-up loss of $1.5 billion of customer money that was used to pay MF’s debts.
In D’Souza’s case, he had enemies in the White House and other corridors of power, so his $20,000 campaign finance crime makes him Public Enemy #1 and he will be going to prison later this year.
Has anyone gone to prison for “Fast & Furious,” the IRS scandal, the NSA spying, etc.?NO.
All I can say is, selective enforcement of the law is a dangerous thing.
Very best regards,
Gary D. Halbert