An Inflationary Contraction II

Fed Balance Sheet Analysis

Analyzing the Fed’s April 30 H.4.1 $6.6 trillion balance sheet requires more nuance than just observing its rapid, unprecedented increase since the start of the government imposed Covid-19 economic contraction.  

Change in Fed balance sheet from Jan 02, 2020 to Apr 30, 2020

 

Jan 02

Reserve Bank credit

4,121,396       + 1,034       + 92,386       4,134,215

 

Apr 30

Reserve Bank credit

6,597,655       + 146,446       +2,725,889       6,616,131

The Fed increases its balance sheet by the purchase of assets with money created out of thin air. These purchases result in base money creation. The Fed’s creation of the supply of base money relative to its global demand is what determines the dollar price of gold (POG). The spot POG signals error in base money supply relative to demand. An increase in the spot POG above the optimum POG indicates a decrease in the value of the dollar. The gold signal warns of monetary error. 

The Fed does not inject base money into the economy, an important point to understand. Base money is cash and reserves. Cash is on demand. The amount of cash in circulation rises or falls based on demand. Cash demanded comes from base money reserves, and cash returned to the banking system goes back into base money reserves. The Fed provides cash demanded through base money creation.  

The other component of base money is reserves. These are bank reserves held as deposits with the Fed. One can think of reserves as the required monetary lubricant necessary for depository institutions to support the economy. An expanding economy requires more cash and reserves to support increased economic activity while theoretically maintaining a constant value of the dollar.  

Normally, the Fed requires depository institutions to maintain required reserves to protect against the risk of bank insolvency. The Fed has suspended the rule to maintain required reserves in response to the Covid-19 economic shutdown.  

Excess reserves (ER) are reserves above required reserves. Prior to 2008 and before the Fed began paying interest on excess reserves (IOER), excess reserves were nominal (they were a cost to banks and banks had little incentive to hold them), required reserves were minimal by regulation, and most base money was cash in circulation. Now, excess reserves exceed cash in circulation. Currency in circulation remains fairly constant regardless of other Fed actions. The recent increase in base money has gone into excess reserves, Fed lending facilities, and central bank swap lines.

Change in currency in circulation from Jan 02, 2020 to Apr 30, 2020

 

Jan 02

Currency in circulation (11)

1,805,947      + 6,784      + 86,908      1,807,740 

 

Apr 30 

Currency in circulation (11)

1,903,433      + 12,518      + 175,001      1,910,511 

Base money always remains 100 percent in the Fed’s control. Cash and reserves are liabilities of Fed assets. Provided the Fed makes risk free asset purchases, which are historically T-Bills, the Fed can extinguish on dollar for dollar basis any cash and reserves that it creates.  

Looking at the H.4.1, it is the last balance sheet line, reserve balances, that is important to observe and understand relative to current inflationary expectations. The rest of the H.4.1 is important for context or to observe more granular data. The last line, reserve balances, are excess reserves. How depository institutions use them in the context of Fed policy and regulation reflects inflation expectations. 

Here’s the change from January 02 to April 30

 

January 02

Reserve balances with Federal Reserve Banks

1,615,846      – 36,081      – 6,010      1,548,849 

 

Apr 30  

Reserve balances with Federal Reserve Banks

3,159,142      + 55,638      +1,697,723      3,163,512 

The Fed has increased base money excess reserves by $1.615 trillion since the start of the year.

What happens with this increased $1.615 trillion? We can assume that the $1.55 trillion of ER as of Jan 02 was somewhat in balance with regulatory capital requirements, required reserves, and excess reserves held by banks that receive interest (IOER). The POG was $1527 on Jan 02. The increase in the POG to $1700 indicates inflationary expectations from a doubling in excess reserves.

CARES Act Impact on Fed Balance Sheet

The government imposed Covid-19 shutdown cratered the economy.  Congress then appropriated funding through the CARES Act to attempt to put a temporary bandaid on the economic femoral artery the federal government slashed with its shutdown of the economy.

Treasury issued debt to raise the $2 trillion appropriations, and the Fed bought it through its primary dealers. It shows up as an increase in the Fed’s balance sheet. The $2 trillion increase in the Fed’s balance sheet matches closely with the $2 trillion CARES Act appropriation.  

Treasury makes direct payment injections through the CARES Act to qualifying individuals, the unemployed, businesses, hospitals, state and local governments, and others stipulated in the Act.

This is similar to other previous Congressional stimulus appropriations, whether shovel ready money or cash for clunkers, except the scale of the CARES Act is much larger, was acted on outside of the normal budgetary process, and the Fed immediately monetized it.

One can argue about the benefit of the CARES Act outlays, but they are not necessarily inflationary. It is no different than funding LBJ’s Great Society or another useless war. It is just more debt created and fobbed off onto future generations to deal with. Stable money and growth would solve the debt issue while tax hikes, austerity, inflation, and a slowing economy will make it worse.

The Fed’s monetization is critical to the value of the dollar. Any excess base money supply beyond demand—that banks do not withhold for reserve requirements, capital regulations, IOER, or individual institutional needs—gets reflected by a rise in the POG.   

As the economy opens up and we get to the other side of the government imposed contraction, to maintain the value of the dollar relative to gold, the Fed will have to contain ER in some matter. It will need to mop up ER either by OMO asset sales, increased capital requirements, increased IOER, increased reserve requirements, or some combination of all of the above. Presently, IOER and reserve requirements are at zero, and the Fed has relaxed capital requirements. The Fed ended OMO assets sales when it threw in the towel on its normalization experiment in December 2018. The Fed is attempting to force credit creation to support the contracted economy. While the Fed has 100% control over the value of the dollar, it has no direct control over credit creation. The idea that the Fed has the power to direct economic activity is the great Fed fallacy.

The Federal Reserve Act prevents the Fed from direct lending. To get around its statutory requirements, the Fed created a special purpose vehicle (SPV). Treasury backs the SPV with taxpayer money from its Exchange Stabilization Fund (ESF). The Fed makes loans through the SPV, and the Treasury (nee taxpayers) take any losses.

The CARES Act provides $500 billion to Treasury’s Exchange Stabilization Fund (ESF), of which $454 billion is available for Federal Reserve loans, loan guarantees, and investments to eligible businesses, states, and municipalities.

There is potential for $4.4 trillion in Fed loans through the SPV lending facilities. The May 07 balance sheet shows that the Fed has only lent $113 billion through the SPV—2.5% of the potential total.

May 07

Loans

118,730       – 2,654       + 118,686       113,342  

The current Fed lending programs are:

TALF – Term Asset-backed Securities Loan Facility – Treasury provides $10 billion in equity investment to back $100 billion in loans

PMCCF – SMCCR – Primary Market Corporate Credit Facility – Secondary Market Corporate Credit Facility (Corporate bond loans) – Treasury equity of $75 billion for $750 billion of loans

MLF – Municipal Lending Facility – Treasury equity of $35 billion for $500 billion of Eligible Notes

MSLP – Main Street Lending Program – Treasury equity of $75 billion for $600 billion of loans 

PPPLF – Paycheck Protection Program Liquidity Facility – Fed provides funds to lender who are eligible to make PPP loans. The loans are backed by collateral issued by the small businesses that take the loans. The Fed maintains the collateral that supports the loans.

A Return to 1970s Monetary Chaos

The Fed’s previous monetary experiment in excess base money supply resulted in the 1970s global stagflation and decline in standards of living. With the 1971 end of the Bretton Woods dollar link to gold, the POG went from $35/oz to $850/oz before settling at $350/oz. The electorate wisely chose Reagan and his policy mix of stable money and low taxes to end the inflationary chaos. Reagan established a gold commission, and though it unwisely rejected a return to a gold standard, stable money was a core component of Reagan’s monetary policy.  

Gold began its climb from the relative stability of the optimum $350/oz in 2006. Today, spot is at $1700/oz with a massive supply of excess reserves that, if not contained, signals a new 1970s-like inflationary episode. As always, gold will signal the error.

 

Next:  An Inflationary Contraction III defines the reference for stable money and a guide to understanding the current monetary environment.   

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