From his Jan. 5th note, simply entitled: “I’ve got a problem.”
For the past 10 days, I have been attempting to write a comment on Money and Interest rates. This requires providing an analysis of the Federal Reserve’s balance sheet and its impact on both the financial system and the nation’s money supply. However, I am being stymied by three factors:
- Much of the data provided by the Fed contradicts other data provided by the same institution;
- Some of the numbers make no sense whatsoever; and
- Calls to the Fed in both Washington and New York have elicited no meaningful response (I have been told that the Fed may choose not to answer my questions at all, public spirited as it is).
His analysis of the “problem” starts with a cursory look at the fractional banking system then moves into a look at excess reserves — currently at something like $856.1bn — almost 15 times the amount actually required by Fed rules. Typical reserves, we would note, were something like $7bn two years ago.
The question, according to Bove, is why has there been “such a pronounced increase” ?
One answer, suggested by the Federal Reserve is that it is now paying interest on these reserves. This answer makes little sense, however, in that the interest rate is the Federal Funds rate which is effectively 10 basis points, at present. For example, banks have sold tens of billions of dollars in new preferreds to the Treasury with an effective pretax interest cost of 7%. The excess reserves number suggests that they are not lending this money to companies or individuals in the private sector; they are lending it to the Fed at 0.10%.
When the Fed is asked why this is being done, the answer was: “Ask the banks”. When I asked some banks the answer was basically: “I do not know why it is being done.” Clearly I am not getting to the right people because there must be some logic behind these actions that I am not getting to. Presumably, this is one of the issues that is bothering Congress also because it thinks that the TARP money is being deployed in loans to assist the economy and not at a loss in the Fed Funds market (reserves held at the Fed are also known as Fed Funds).
Not withstanding what Congress may or may not know, we would suggest the Fed is actively encouraging banks to build up their excess reserves — a policy similar to the one the Bank of Japan deployed during its own quantitative easing adventure. The policy was meant to do a couple of things, namely supplement zero per cent interest rates and encourage banks to start lending again via the certainty of their massive excess reserves. It’s kind of like forcing a three-year old to share by showering him with more sweets than he could possibly eat by himself.
Bove also touched on money supply issues:
The monetary base of the nation is basically its currency in the hands of the public and the reserves in the banking system. It is up sharply in recent months also due to above average growth in currency but mainly due to the growth in reserves. It is now approximately $1.7 trillion.
The question raised here is whether the increase in the monetary base suggests a loose monetary policy orchestrated by the Fed or whether it means that the Fed has no control of the money supply at all. If the monetary base is rising because banks have independently made the decision to put more funds on deposit at the Fed, then the Fed had very little to do with the increase in the monetary base.
Not quite. The Fed, as we’ve noted before, has basically admitted it’s divorcing monetary policy from money. The central bank is, rightly or wrongly, targeting asset prices — hence the massive increase in its balance sheet in recent months. The Fed needs to make non-money assets attractive to banks (at least more than sitting on a hoards of cash) to get them to lend once again. Monetary policy, beyond helping to inflate one’s way out of debt somewhat, isn’t really the Fed’s primary focus here.
In any case, Bove’s conclusion (of sorts) is this:
There are too many unanswered questions raised by the sizable amount of excess reserves at the Fed.
They include whether the Fed is relying on an unstable source of funds to provide illiquid loans to the private sector and whether this means that the Fed is vulnerable to a shock if these funds go away.
The other issue is whether monetary policy, which looks quite loose at the moment, may be changed rapidly without the Fed even knowing that it is happening.
At least this one observer would like some answers as to why the banks have so much on deposit with the Fed and why the Fed is not explaining the excess reserve dilemma.
While wrangling some home truths out of the Fed is an admirable cause (and Bove is not alone in that pursuit), we’re not sure it’s likely to yield much more than we already know. The notion that monetary policy might change rapidly is a good one, however. One of the things keeping rampant inflation in check at the moment is the fact that the money multiplier is not yet working. Should that kick in, expect a rather pronounced bout of inflation. Another good point is the potential instability of the Fed’s foray into non-traditional assets (i.e. things other than treasuries, like mortgage securities).
As Bove puts it:
This money, the excess reserves, are not being used by the Fed to buy traditional assets like Treasuries or gold or SDRs.
The reserves are being loaned to the private sector. If these private sector loans default, the Fed will have assets with no returns funded by liabilities with a small cost now, but what could be a very big cost later. Moreover, if the banks decide to reduce the excess reserves in the system, it will cause a problem.
The Fed would now hold relatively illiquid assets and it would be forced to either print money to fund them or borrow money in the open market to replace the lost reserves. If it borrowed money to do this it would push other borrowers out of the markets.
Not quite what it was going for then.
It’s not really a bad note from Bove per se, just, err, about two or three months too late.
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