Fed Prez Spills the Beans on the Excess Reserve Inflation Time Bomb
by Robert Wenzel: The
For the second
time in two weeks, Philadelphia Fed President Charles Plosser is
warning about the time bomb that is excess reserves.
I first reported
on this last week, exclusively in the EPJ
Daily Alert. I wrote:
very big. There has been very little coverage in mainstream media
about the Fed super-money printing and how much of it is going
into excess reserves. But what if it doesn't go into excess reserves
and instead ends up in the system bidding up prices?
media is pointing at Bernanke's QE3 and not reporting beyond that,
the Fed knows it is all about where the money they print ends
of a very important interview Philadelphia Fed President
Charles Plosser gave yesterday to MNI News. It spills the beans:
Plosser also warned that QE3 "could be highly inflationary."
don't think it would occur immediately," he said. "Inflation
is going to occur when excess reserves of this huge balance sheet
begin to flow outside into the real economy. I can't tell you
when that's going to happen."
that does begin if we don't engage in a fairly aggressive and
effective policy of preventing that from happening, there's no
question in my mind that that will lead to lots of inflation."
and other Fed officials have often said that the Fed will be able
to contain the outflow of reserves into the economy and thereby
limit wage-price pressures by raising the rate of interest it
pays on excess reserves. But Plosser said the IOER and reserve
draining tools cannot be relied upon.
fast will we have to do that (raise the IOER)?" he asked.
"How rapid will it have to go up? We don't have a clue. Raising
the IOER where you have a trillion and half or two trillion dollars
reserves, we have absolutely zero experience with it."
have the tools to do it, but we don't know the consequences of
the tools," Plosser said.
the IOER doesn't work and we have to sell assets, MBS, how will
that affect housing?" he asked. "Will we be able to
unwind from this at a pace that doesn't disrupt the economy?"
Plosser's comments are about the core of the Fed's problem. If
those funds start to move out of excess reserves and into the
economy rapidly, the Fed will have to take counter measures, such
as boosting interest rates on excess reserves (IOER) or liquidating
some of their mortgage backed securities. Plosser is entirely
correct, no one knows how high interest rates will have to be
raised to stop the flow into the economy. It could very well end
up a tiger by the tail situation, the higher the Fed boosts rates,
the higher nominal rates climb (Sort of the reverse of what is
going on now). This is why it is very dangerous to hold long-term
bonds, when rates reverse and start heading higher, they could
move very rapidly, as the Fed could be forced to battle the very
inflationary flow of money out of excess reserves.
points out, there is approximately $1.5 trillion in excess reserves,
given that the multiplier for reserves and money supply (M2) is
now roughly 100, there is no way the Fed can allow that amount
of excess reserves to get into the system. It would mean an increase
in M2 of $150 trillion! On a current base of only $10 trillion.
The Fed would have to fight such an outflow very aggressively,
and that would mean much higher rates.
against the outflow of excess reserves will come, but the Fed
will likely be slow to act, so a lot of money will get into the
system which is why Plosser is also correct in that we are on
the edge of a very explosive inflationary situation.
key right now is to watch to see if the Fed's new money printing
of $40 billion per month ends up in the system or as excess reserves.
Further, excess reserves themselves have to be monitored to see
if any of those funds start to enter the system. In other words,
if any increases in required reserves occur, it could result in
an artificial boom to the stock market and economy, but also be
very price inflationary, very quickly.
is warning again about the excess reserves exploding into the system
and what it may mean for interest rates and the entire financial
CFA Society of Philadelphia/The Bond Club of Philadelphia, Plosser
today (my bold):
I have been
a student of monetary theory and policy for over 30 years. One
constant is that central banks tend to find it easier to lower
interest rates than to raise them. Moreover, identifying turning
points is difficult even in the best of times, so timing the change
in the direction of policy is always a challenge. But this time,
exit will be even more complicated and risky. With such a
large balance sheet, our transition from very accommodative policies
to less accommodative policies will involve using tools we have
not used before, such as the interest rate on reserves, term deposits,
and asset sales. Once the recovery takes off, long rates will
begin to rise and banks will begin lending the large volume of
excess reserves sitting in their accounts at the Fed. This loan
growth can be quite rapid, as was true after the banking crisis
in the 1930s, and there is some risk that the Fed will need to
withdraw accommodation very aggressively in order to contain inflation.
At this point, it is impossible to know whether such asset
sales will be disruptive to the market. A rapid tightening of
monetary policy may also entail political risks for the Fed. We
would likely be selling the longer maturity assets in our portfolio
at a loss, meaning that we may be unable to make any remittances
to the U.S. Treasury for some years. Yet, if we dont tighten
quickly enough, we could find ourselves far behind the curve in
risks are very hard to quantify, it is clear that the larger the
Feds portfolio becomes, the higher the risk and the potential
costs when it comes time to exit. And based on my economic
outlook, that time may come well before mid-2015. In my view,
to keep the funds rate at zero that long would risk destabilizing
inflation expectations and lead to an unwanted increase in inflation.
This is very
candid talk from a Fed insider, Plosser clearly sees the potential
for massive price inflation if those excess reserves hit the system,
even more striking is that Plosser knows that the Fed will likely
be very slow in hiking interest rates, thus fueling the inflation.
When the price
inflation hits, don't say you haven't been warned, Plosser is revealing
very clearly how it will hit.
with permission from Economic
Economic Policy Journal
Best of Robert Wenzel