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Grants Interest Rate Observer Summer E Issue

Grants Interest Rate Observer Summer E Issue

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Published by CanadianValue
Grants Interest Rate Observer Summer E-Issue
Grants Interest Rate Observer Summer E-Issue

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Published by: CanadianValue on Aug 22, 2013
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08/28/2013

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Vol. 31 Summer BreakAUGUST 23, 2013

(July 26, 2013) One day soon,banks will have on deposit at theFederal Reserve $2 trillion morethan the rules require them to hold,a mountain of excess reserves thatcould, at the outer limit of what istheoretically possible in money andbanking, support $20 trillion of newlending. Now under way is a specu-lation on the meaning of this immi-nent fact.All agree that $2 trillion is a large andcomplicating figure. Chairman Ber-nanke insists that it isn’t a troublingone. But unless we miss our mark, theFed will miss
its
mark. It will overstayits inflationary course until it can’t reelin the dollars it has so generously paidout. We think the die is already cast.For signs that the Fed will stay tooeasy for too long, look no further thanthe bond market. On talk of a mere “ta-pering” in asset purchases (never mindcessation, still less of outright sales),the yield on the 10-year Treasury notevaulted to 2.74% from 1.63% in thecourse of only 46 trading days. Worldmarkets shuddered, and the FOMCprobably shuddered along with them(
“Holy mackerel, we did that?”
). Buyingsecurities with newly issued dollars isnot only the path of least resistance, itis also, to many policymakers, the pathof prudence, conscience and duty. Itwill be hard for the Bernanke Fed toabandon it, and a Yellen Fed wouldfind it no easier.In modern central banking, thelearned practitioners do not justprint money (or withhold theirprinting). They also “communi-cate,” and the burden of what theyQE was tantamount to a rate cut:Such was the message two years ago.But in his Humphrey-Hawkins tes-timony last week, Bernanke tried toexplain why ending, or tapering, QEwould not be tantamount to a rate hike
.
“[E]ven after purchases end,” said thenew and revised version of the Ber-nanke text, “the Federal Reserve willbe holding its stock of Treasury andagency securities off the market andreinvesting the proceeds from matur-ing securities, which will continue toput downward pressure on longer-terminterest rates, support mortgage mar-kets and help to make broader finan-cial conditions more accommodative.”Possibly, the chairman means tocommunicate a yield-curve strata-gem. Other things being the same, thegreater the distance between fundsand 30s, the brighter the prospects foreconomic growth. By pledging to holdthe funds rate at zero while letting thelong-bond yield lift, the Fed might behoping to bring about the good thingsa steeper curve could help to deliver.Then, again, how would the Fed mus-cle down the funds rate except by theinflationary monetization of govern-ment securities? It’s a conundrum.Some would interject that even $2trillion of excess reserves present noinflationary threat if the apparatus of lending and borrowing is impaired.In that money and banking class youwish you had not slept through, theprofessor explained that banks maylend and relend these funds up tothe inverse of the reserve ratio. Thus,a 10% reserve ratio would providescope for $10 of new credit for eachcommunicate these days is usuallythe assurance that they will remainaccommodative. Thus, on Feb. 11,2011, Rep. Mick Mulvaney (R.,S.C.) asked Bernanke—the chair-man was then testifying before theHouse of Representatives—why theFed had decided to buy $600 billionof Treasurys in its second round of quantitative easing instead of, say,$500 billion or $750 billion? “We es-timate that the impact on the wholestructure of interest rates from $600billion is roughly equivalent to a 75basis-point cut [in interest rates],”Bernanke replied, the funds ratebeing zero. “So, on that criterion, itseemed that that was about enoughto be a significant boost, but not onethat was excessive.”
Demobilizing the reserves
“Where’s the 10-year?”
 
 Summer Break
-GRANT’S/AUGUST 23, 2013
2
 SUBSCRIBE! 
- go to www.grantspub.com or call 212-809-7994
$1 of excess reserves—assuming anormally fluid banking situation. Butwhen borrowers aren’t borrowing, la-tent lending power goes unused. (Aslightly technical point: To the banksin whose Fed accounts the money isdeposited, “excess reserves” are cash,a perfectly suitable asset for use ascollateral in futures and derivativestransactions. So that $2 trillion maynot be entirely idle after all.)The chairman, a scholar in his pre-vious life, values punctilious accu-racy in speech and writing (the Feddoes “not literally” print money, hehelpfully pointed out last week; theBureau of Engraving and Printing isthe one with ink on its fingers). So,in support of the cause of accuracy,we note that the Fed has retired the
datum
excess reserves; under a newrule, banks keep reserves within arange above and below the requiredlevel. But the concept of excess re-serves lives on, and so—in a do-it-yourself fashion—does the calcula-tion of the now-retired figure. Thus,as of July 10, such balances amount-ed to $1.983 trillion, within shoutingdistance of $2 trillion. As recently asyear-end 2007, they totaled a mere$1.8 billion (with a “b”).“As a percentage of GDP,” relatescolleague Evan Lorenz, “excess re-serves stand at a never-before-seen12.4%. Total domestic nonfinancialcredit amounts to 254% of GDP, whichmeans that banks are sitting on the po-tential to increase total credit in Amer-ica by half. Between 1929 and 2007,excess reserves averaged just 0.5% of GDP (as a rule, of course, bankers pre-fer not to sit on idle balances, but tomake their money sweat). As a percent-age of GDP during the unprosperous1930s, excess reserves peaked in 1935at 3.4%. They spiked to 6.2% of GDPin 1940, the year Paris fell to Hitler.” Just as noteworthy as the level of excess reserves today is their com-position. Of that almost $2 trillion,$738 billion, or 37% of the total, iscredited to American branches of for-eign banks. Interest-rate arbitrage isone reason for this striking fact. De-sire by the managements of foreignbanks to accumulate reservoirs of dollars with which to stock the homeoffice in times of need is another rea-son. Suffice it to say that if the Fedfinds it necessary to jack up the in-terest it pays on reserve balances—today’s rate is 25 basis points—Con-gress will surely demand to knowwhy the taxpayers are enriching thestockholders of non-American finan-cial institutions.There is another item of backgroundinformation that bears on the curiousdistribution of excess reserves. Eversince 2011, the FDIC has dunned itsmember banks not on the size of theirinsured deposits but on the differencebetween their assets and tangible eq-uity. In the case of Bank of AmericaCorp., for instance, the change raisedthe assessed base to $1,968 billion(that being the difference between as-sets and tangible equity) from $1,006.8billion (those being the bank’s Ameri-can deposits). The BofA’s assessablebase was effectively doubled. Thoughall banks, foreign and domestic, earnone-quarter of one percent on theirdeposits at the Fed, American bankswind up paying the FDIC betweenfive and 45 basis points on those samedeposits (the exact levy depends onthe regulators’ assessment of a particu-lar bank’s safety and soundness). Formany of these institutional depositors,it’s a break-even proposition, at best.Because the American branches of foreign banks are not so inclined ashomegrown institutions to lend in the50 states, the excess reserves that theforeign banks control are less likely tofind their way into the American finan-cial bloodstream than are the Ameri-can banks’ balances at the Fed. So letus set aside the foreign banks’ share of that nearly $2 trillion figure. Still, thatleaves $1.2 trillion in excess balancesin the accounts of American-charteredbanks, equivalent to 7.8% of GDP.That, too, is a record-high reading.Anyway, apologists for the Fed ar-gue, there is no realistic risk of theseimmense sums doing inflationary mis-chief. With the power to pay intereston excess reserves (granted by an actof Congress in October 2008), the cen-tral bank is the master of the dollars itconjured. If it chooses to bottle themup inside the Federal Reserve Sys-tem, it can simply pay the banks not towithdraw them. Problem solved, or sothe argument runs.Yet the banks, as noted—the Amer-ican ones—are earning little to noth-ing on those balances at the current,25 basis-point deposit rate. How littlebecomes clear when one comparesone-quarter of 1% with the 4.61% thatthe banks are earning today on jum-bo mortgage loans to prime borrow-ers (see
Grant’s
, July 12). If the Fedwould manipulate the banks with highdeposit rates, the very same Fed hascommitted to medicate the labor mar-ket with low deposit rates.“Besides,” Lorenz observes, “theFederal Reserve is earning the samerock-bottom interest rates that Ber-nanke et al. have stuck the rest of us with. In 2012, the system’s earn-ing assets delivered a return of 2.9%,down from 3.3% in 2011 and 3.7% in2010. Maybe the yield is on its way to2.5% (no disclosure on this point till
6/133/123/113/103/09
Foreign banks’ share booms...
quarterly total bank reserves (left scale)vs. foreign reserves as percent of total (right scale)
source: Federal Reserve
  r  e  s  e  r  v  e  s   i  n    b   i   l   l   i  o  n  s
f   o ei   gn  b  an  e s  e v e s 
015304560%5001,0001,5002,000$2,500total reserves:$1,982 billionforeign banks:37%

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