The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

Frederick Sheehan is the co-author of Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve.

His next book, Panderer for Power: The True Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession, was published by McGraw-Hill in November 2009.

Fred was Director of Asset Allocation Services at John Hancock Financial Services in Boston. In this capacity, he set investment policy and asset allocation for institutional pension plans. He wrote the monthly Market Outlook and Quarterly Market Review for clients from 1990 to 2001. He has written several guest articles in Marc Faber’s Gloom, Boom & Doom Report. He has more recently contributed to Whiskey & Gunpowder and the Prudent Bear website, among others.

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Some quotes to start:

“Moreover, inflation has been declining and is currently quite low, with measures of underlying inflation running close to 1 percent….In this environment, the Federal Open Market Committee (FOMC) judged that additional monetary policy accommodation was needed to support the economic recovery and help ensure that inflation, over time, is at desired levels.”

-Federal Reserve Chairman Ben S. Bernanke, Sixth European Central Bank, Central Banking Conference; Frankfurt, Germany; November 19, 2010

“CORE U.S. INFLATION SLOWEST ON RECORD: Core consumer prices in the U.S are at their lowest pace since records began, bolstering the case for the Federal Reserve to complete its planned $600 bn in asset purchases and extend the programme to buy more….Excluding volatile food and energy prices, the consumer price index rose by only 0.6% on a year ago….”

-Financial Times – headline and lead story on page one, November 19, 2010

“A key gauge of U.S. inflation has fallen to its lowest level since record keeping began in 1957, underscoring continued weakness in the economy and bolstering the Fed’s case that it should continue its bond-buying program.”

-Wall Street Journal, first sentence, top of page one, November 19, 2010

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A BRIEF REVIEW: The Federal Reserve launched QE2 (a.k.a.: printing money) on November 3, 2010. Chairman Bernanke justified this laboratory experiment as a measure to prevent deflation. He wrote in the November 4, 2010, Washington Post: “Most measures of underlying inflation are running somewhat below 2 percent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth….” This “2 percent” hokum is an invention of Bernanke & Comrades, but the chairman pretends it is chiseled into the Federal Reserve charter. The contention is important since it is on this rock the Fed has built its justification for launching the $600 billion asset purchase, referred to in the Financial Times headline above.

The media, as represented by the newspapers above, not only accept the Consumer Price Index as released by the Bureau of Labor Statistics, but also: (1): accept the rationale that food and energy prices should not be included in the price index because of their excessive volatility, and, (2): notify readers that such low inflation “bolsters” the Fed’s case to continue pumping up asset prices. Note that both papers link the happy inflation news to the $600 billion purchase with the word “bolster.” This has the whiff of a press release delivered by the Fed to the media.

It went unnoticed how the Bureau of Labor Statistics (BLS) relieved the volatile food and energy prices of volatility. The BLS also relieved the CPI of “extreme values and/or sharp movements [of prices] which might distort the seasonal pattern [which] are estimated and [are] removed from the data.” So out went milk, cheese, oil, and cars from the CPI, if they did not meet the BLS volatility criteria. (The excisions also include non-edibles and non-combustibles, including cards, trucks and textbooks.)

Below are some monthly lists of items removed from the monthly Consumer Price Index Summary calculation and the excuses for doing so. (The lists were cut-and-pasted from the BLS website at the time. It looks as though the BLS only posts tables (no words) from the monthly CPI releases prior to May 2007.) There is nothing particular to the months shown. The reader may note the lists stop in 2006. This is because the BLS stopped releasing the list of items after December, 2006; possibly because the deception was so clear as to show the entire CPI calculation is a fraud. This is suggested without much conviction since there weren’t ten people outside of the BLS or Federal Reserve who knew it existed, possibly because critics of BLS methods had so many other fish to fry: hedonic adjustments, geometric averaging, substitution bias, owners’ equivalent rent, and on and on it goes.

To keep this short, the BLS methodology is not discussed. It is described in “Intervention Analysis Seasonal Adjustment,” a paper on the BLS website. The “procedure” referred to is the “X-12-ARIMA Seasonal Adjustment Method,” which may or may not apply to a particular item since (quoting the BLS) “components change their seasonal adjustment status from seasonally adjusted to not seasonally adjusted, not seasonally adjusted data will be used in the aggregation of the dependent series for the last 5 years, but the seasonally adjusted indexes will be used before that period.” Yeah, right.

This prescribed method of stupefying the public successfully deterred me from attempting to understand the changes to food and energy prices. And, as mentioned above, there are so many other distortions to the CPI that one is better off to assume the consumer price index is rising 5% to 10% a year and to adjust one’s life (and investments) accordingly. John Williams, author of the Shadow Government Statistics website, calculates that if the BLS used the same methodologies for compiling the CPI today that it employed in 1990, the government’s number would be 4.5%. If the BLS used the same methodologies as in 1980, the official CPI would be 8.5%.

Year-in and year-out, some items (e.g. motor fuels, new cars) are apparently a nuisance to stable prices, with the same stated rationale for not including them. How can the errant products forever be in need of adjustment (or banishment), since the selection is supposed to include temporary aberrant conditions? Of course, this whole procedure should not exist, if the CPI is a measure of the change in consumer prices. But that is not its purpose. Chairman Bernanke cannot stop reminding us that one of the Federal Reserve’s “mandates” from Congress is “stable inflation.” Thus, throw out prices that change. The wonder is after primping the inflation calculation he still has such difficulty keeping it stable.

June 2002 – BUREAU OF LABOR STATISTICS RELEASE: CONSUMER PRICE INDEX – A NOTE ON SEASONALLY ADJUSTED AND NONADJUSTED DATA

Extreme values and/or sharp movements which might distort the seasonal pattern are estimated and removed from the data prior to calculation of seasonal factors. Beginning with the calculation of seasonal factors for 1996, X-12-ARIMA software was used for Intervention Analysis Seasonal Adjustment. For the fuel oil, natural gas, motor fuels, and educational books and supplies indexes, this procedure was used to offset the effects that extreme price volatility would otherwise have had on the estimates ofseasonally adjusted data for those series. For the Nonalcoholic beverages index, the procedure was used to offset the effects of a large increase in coffee prices due to adverse weather. The procedure was usedto account for unusual butter fat supply reductions and decreases in milk supply affecting the Fats and oils series. For the Water and seweragemaintenance index, the procedure was used to account for a data collectionanomaly. It was used to offset an increase in summer demand in the Midwest and South for Electricity. For New vehicles, New cars, and New trucks, the procedure was used to offset the effects of a model changeover combined with financing incentives.

[My underlining. This preface introduced (until January 2007) each month's "Note on Seasonally Adjusted and Nonadjusted Data" in the BLS' Consumer Price Index. I left it out of the following examples.]

JUNE 2004 – BUREAU OF LABOR STATISTICS RELEASE: CONSUMER PRICE INDEX – A NOTE ON SEASONALLY ADJUSTED AND NONADJUSTED DATA

For the fuel oil, natural gas, motor fuels, and educational books and supplies indexes, this procedure was used to offset the effects that extreme price volatility would otherwise have had on the estimates of seasonally adjusted data for those series. For the Nonalcoholic beverages index, the procedure was used to offset the effects of labor and supply problems for coffee. The procedure was used to account for unusual butter fat supply reductions, decreases in milk supply, and large swings in soybean oil inventories affecting the Fats and oils series. For the Water and sewerage maintenance index, the procedure was used to account for a data collection anomaly and dry weather in California. For Dairy products, it mitigated the effects of significant changes in milk production levels and higher demand for cheese. For Electricity, it was used to offset an increase in demand due to warmer than expected weather, increased rates to conserve supplies, and declining natural gas inventories. For New vehicles, New cars, and New trucks, the procedure was used to offset the effects of a model changeover combined with financing incentives.

July 2005 – BUREAU OF LABOR STATISTICS RELEASE: CONSUMER PRICE INDEX – A NOTE ON SEASONALLY ADJUSTED AND NONADJUSTED DATA

For the Fuel oil, Utility (piped) gas, Motor fuels, and Educational books and supplies indexes, this procedure was used to offset the effects that extreme price volatility would otherwise have had on the estimates of seasonally adjusted data for those series. For the Nonalcoholic beverages index, the procedure was used to offset the effects of sharp rises in the price of coffee futures. The procedure was used to account for unusual butter fat supply reductions, changes in milk supply, and large swings in soybean oil inventories affecting the Fats and oils series. For Dairy products, it mitigated the effects of significant changes in milk, butter and cheese production levels. For Fresh vegetable series, the method was used to account for the effects of hurricane-related disruptions. For Electricity, it was used to offset an increase in demand due to warmer than expected weather, increased rates to conserve supplies, and declining natural gas inventories. For New vehicle series, the procedure was used to offset the effects of a model changeover combined with financing incentives.

December 2006 – BUREAU OF LABOR STATISTICS RELEASE: CONSUMER PRICE INDEX – A NOTE ON SEASONALLY ADJUSTED AND NONADJUSTED DATA

For the Fuel oil, Utility (piped) gas, Motor fuels, and Educational books and supplies indexes, this procedure was used to offset the effects that extreme price volatility would otherwise have had on the estimates of seasonally adjusted data for those series. For the Nonalcoholic beverages index, the procedure was used to offset the effects of sharp rises in the price of coffee futures. The procedure was used to account for unusual butter fat supply reductions, changes in milk supply, and large swings in soybean oil inventories affecting the Fats and oils series. For Dairy products, it mitigated the effects of significant changes in milk, butter and cheese production levels. For Fresh vegetable series, the method was used to account for the effects of hurricane- related disruptions. For Electricity, it was used to offset an increase in demand due to warmer than expected weather, increased rates to conserve supplies, and declining natural gas inventories. For New vehicle series, the procedure was used to offset the effects of a model changeover combined with financing incentives.

I first recommended GLD on Power lunch back in 2005. The Gold ETF was under $50, and the rec was greeted with widespread skepticism. The basis for the call was the 1% rate level that had set off a spiral of inflation in everything priced in US dollars or credit.

But I had no idea at the time of the history of how GLD came about. Today’s WSJ uncovers the tenuous beginning of the world’s largest private owner of bullion.

Here’s the WSJ:

“The innovation that opened gold investing to the masses and helped spur this year’s record-breaking bull market was hatched in an act of desperation by a little-known gold-mining trade group.

The World Gold Council, created to promote gold, was fighting for survival. Its members—global gold-mining companies—were frustrated with the council’s inability to stem two decades of depressed prices and find buyers for a growing glut of the yellow metal. Eight years ago, they were considering withdrawing funding from the trade group, a move that would have effectively shut it down…

What the council eventually managed to create in those dark days surpassed its wildest dreams: SPDR Gold Shares, the exchange-traded fund launched in November 2004. The fund, known by its ticker symbol GLD, has ballooned into a $56.7 billion behemoth.”

The Journal tells the history of how the Gold Council launched the fumd, and the problems they had to overcome. Its well worth reading.

The one thing that I’d like to know about the various gold funds is how much physical Gold they own relative to paper gold, i.e., futures. Some estimates are that the demands on Gold relative to paper is a high multiple on the order of 100X. Does that mean the price is artificially juiced, or that demand outstrips supply? I’ve seen interesting arguments on both sides of the debate.

Here are some more GLD tidbits:

• The gold council spent $14 million developing the fund;

• GLD is the fastest-growing major investment fund ever.

• Asset value: $56.7 billion making it the 14th largest ETF.

• Revenue is a percentage of net asset value, set at 0.15%

• Its the world’s largest private owner of bullion

• GLD buys $30 million of gold daily

• All of the ETF bullion is stored in vaults in London

• GLD has now locked up nearly 1,300 metric tons of the world’s gold supply

• Estimate are gold-backed ETFs have added about $100 to $150 an ounce to the price of gold.

• Between 60% and 80% of GLD investors had never bought gold before;

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click for larger graphic

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Source:
Behind Gold’s New Glister: Miners’ Big Bet on a Fund
LIAM PLEVEN and CAROLYN CUI
WSJ, NOVEMBER 25, 2010
http://online.wsj.com/article/SB10001424052748703628204575618602535514506.html

by Bob Lefsetz

Ringo’s a revelation!

Somehow, the Beatles coming to iTunes has become a business story, but that band was always about the music. The mania came after. The sheer joy of playing in a group, of living your life for music, not money, was the genesis. Watching this film you can see right through the images all the way to the U.K., where the sons of soldiers picked up instruments to fight their way out of drudgery and boredom. That’s the power of music. It can make you forget your circumstances. And if you’re really good, it can create a world you couldn’t even envision when you first started to play.

Beatles on iTunes? No big deal. Typical Fab Four. Leaders in their day, followers ever since.

Except that’s not the real story. The Beatles wanted to be on iTunes. It was an EMI problem. Castigate Guy Hands all you want, but by putting Roger Faxon in power, a deal could finally be made.

Is there a lot of money to be made?

Of course not. Just like when the Beatles first formed. They didn’t know they’d go on to be some of Britain’s richest citizens. Hell, you can’t get that rich playing music anymore. If you’re all about the bread go to Wall Street, be a banker, or go work for the corporation, being two-faced and conniving to ascend to a platform wherein you can rape and pillage and make double digit millions. But it won’t be fun. And each and every one of those so-called winners would trade everything they’ve got to be up on stage with these guys.

That’s what’s wrong with the mainstream media. They miss the story. So busy talking about Steve Jobs and EMI and Apple they didn’t focus on this Washington, D.C. concert that’s part of the hype. FOR FREE!

Don’t say Steve Jobs never did anything for you.

Go to iTunes. You’re confronted with a big black box that says “The Beatles”. And in the upper right-hand corner, you’re gonna see a little box that says “Watch The Concert”. Click on that RIGHT NOW!

Stay tuned through the voice-over. It’s lame. But the images are cool.

And then you get to the gig.

Security is not wearing yellow windbreakers, they don’t look like they’re on steroids and will beat you to a pulp. It’s a positively civilized affair, with the Beatles on a low riser in the middle of the hall.

And that’s when you see them move their own equipment. You can call it humble. I’ll just tell you this is what a musician does. He SCHLEPPS! Talk to anybody who plays live for a living. Sure, if you’re a household name you’ve got roadies, but everybody below that level is lifting amps into a van or a trailer, or if you’re just starting out, a car. And you set up your gear at the gig yourself. And until you truly make it, you have no monitors. You play by your wits.

The fact that these cats can get it so right, barely able to hear themselves, is amazing.

But what’s really amazing is their ability to play. George picking out the leads. Paul on the bass. Our dear departed John bouncing up and down with his legs spread. If you didn’t imitate that look, you weren’t alive, or you were blind.

McCartney shvitzing. Music, when done right, is a workout.

And speaking of workouts… This film should put to rest any guff about Ringo’s ability to play the drums. He’s the anchor, he’s the powerhouse, and he’s railing and flailing and pounding that big bass drum. You can have a lot more equipment, but you’ve only got two hands and two feet.

And when they bring the mic up to him and he sings “I Wanna Be Your Man”…

Or how about George singing “Roll Over Beethoven”?

But stay until the very end. When Paul rips apart “Long Tall Sally” to such a degree he trumps Little Richard. Not that either he or Richard would agree, but watch with your own two eyes.

This was the beginning. This was the genesis. This was where it all began.

In America.

But for the Beatles it started years before. They had a dream. They played shitholes. They didn’t have rich parents. They didn’t expect to make a record a week after they formed and have it be a hit. They just played and played and played until ability was not a question and they could focus on showmanship.

And what’s truly amazing in this movie is the audience is irrelevant. This is a gang, having a blast. They’re not playing for the media, they’re having a lark. A serious one. They don’t want to mess up. But it’s truly shocking that they’re so on at what many today would consider a secondary gig. I mean who’s paying attention in D.C?

But we were all paying attention. Because nothing we ever heard before came out of the speakers like “I Want To Hold Your Hand”. There was an energy and a confidence and when these guys do the “oos” and all the other initial Beatle tricks/trademarks/cliches your head will explode. Just watch the audience… Oprah never got this reaction.

Everybody’s sitting there, with their Brownie cameras and programs. They’ve spun the LP at home. They know all the words.

Not that Paul is aware of this. He’s got no context. He’s explaining.

But we already knew.

That our lives would never be the same.

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Visit the archive: http://lefsetz.com/wordpress/

The FT Deutschland is reporting that the EU is pressuring Portugal to be the next to walk the plank and quickly accept a bailout package in order to head off the spreading of credit worries. This story however was denied by a German government spokesman and Portugal said they are not being asked. Either way, 5 yr CDS in Portugal, Ireland and Spain are rising to new record highs at 500, 600 and 320 bps respectively. To put these sovereign levels into perspective, California trades at 300, El Salvador at 310, Lebanon at 295, Hungary at 360, Coca Cola at 38, McDonalds at 39, Cablevision at 360 and the USA at 42. Following up Axel Weber’s comments on Wed that the EU/IMF could always expand the side of the EFSF, the German Govt immediately told him to shush up and Merkel said the existing facility is enough. While euro LIBOR has remained stable over the past few weeks, US$ LIBOR is at the highest since Sept 2nd.

Today’s info porn comes to us from der Spiegel:

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With Thanksgiving behind us, we move into the period of mass consumption of useless baubles and silly/unwanted gifts. CNBC interviewed various retailer reps (Toys-R-Us, Brookstone, etc.) in malls, with lots of people shown out and about shopping. (I’ll be site-seeing in Chicago, steering clear away from the retail areas).

Despite the potential upside surprise from the retail sector, markets are under pressure yet again (see below). Tensions in Korea continues to rise, while concern over Europe’s debt continues to deepen. Portugal and Spain spreads widenend.

Bloomberg reported that “More than $1.8 trillion has been wiped off the value of global equities in the past three weeks as traders speculated Ireland’s debt crisis will spread to other European Union countries.”

Stock markets close at 1pm, this is usually a low volume day, with rookies manning the terminals . . .

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click for updated futures

Emerging-market equity prices as measured by the MSCI Emerging Markets Free Index are primarily driven by commodity prices and in particular by metal prices as measured by the Economist Metals Price Index. Currently emerging-market equities are approximately 8 – 10% overpriced given the level of metal prices.

Sources: I-Net Bridge; Plexus Asset Management.

The ratio of the MSCI Emerging Market Free Index and MSCI Global Index is also driven by commodity prices and specifically metal prices. On a relative basis emerging-market equities tend to bottom earlier than mature markets and the ratio therefore acts as a leading indicator of metal prices. At this stage the still-rising and elevated level of the ratio suggests that metal prices are likely to hold up well despite the recent sell-off.

Sources: I-Net Bridge; Plexus Asset Management.

The yield on the JP Morgan Emerging Market Bond Index is at its lowest on record. Sentiment regarding emerging-market bonds is also significantly influenced by metal prices. The JP Morgan Emerging Market Bond Index yield (please note the reverse axis) has dropped significantly more than what metal prices suggested and therefore points to increased risk in emerging-market bonds.

Sources: I-Net Bridge; Plexus Asset Management.

Emerging-market bond yields took their cue from mature-market bonds, though, as the yield spread narrowly tracks that of the Metals Index. However, the yield spread (please note reverse axis) is currently 50 basis points lower than what it should have been given the current levels of the Metals Index. It therefore also indicates that emerging-market bonds are expensive relative to mature-market bonds.

Sources: I-Net Bridge; Plexus Asset Management.

The yield spread between the JP Morgan Emerging Market Bond Index and the calculated mature-market bond index is even lower than the range that existed before the economic malaise started in 2008. It will need a big push in metal prices to reduce the spread further.

My equally-weighted commodity currency index − consisting of the Australian dollar, Turkish lira, Brazilian real, Czech koruna, Thai baht, Hungarian forint, Russian rouble and SA rand – is driven by the same forces behind investments in emerging markets, namely metal prices. For some unknown reason the commodity currency index lagged and opened a gap with metal prices towards the end of last year. The gap closed only recently.

Sources: I-Net Bridge; Plexus Asset Management.

The commodity currency index has an inverse relationship with the yield spread of emerging-market bonds to U.S. treasuries, thereby indicating that commodity currencies rise when the risk of investing in emerging markets − as measured by the yield spread – declines and vice versa.

With the emerging-market bond yield spread expected to widen somewhat in the short term, commodity currencies can be expected to follow suit and weaken.

Sources: I-Net Bridge; Plexus Asset Management.

My country’s currency, the South African rand, is currently slightly (5%) overvalued against the commodity currency index.

Sources: I-Net Bridge; Plexus Asset Management.

Bar the current situation where emerging-market equities and bonds are somewhat overpriced and a healthy market correction is needed to pull them back to realistic levels compared to mature markets, the longer-term outlook for investment markets in emerging economies is cloudy and becoming increasingly uncertain. Despite QE2 I see no quick fix to substantially boost consumer sentiment in the U.S., especially in light of the absence of new fixed investment given the significantly surplus capacity, severe problems in the house market and the inelasticity of job creation to stimulatory measures.

Furthermore, global demand is likely to remain under pressure. I expect demand in the Eurozone to be lethargic, especially in light of the fiscal crisis in the PIIGS, Japan running the risk of returning to a recession, and emerging economies and China in particular reigning in their economies by hiking interest rates.

I do not see emerging-market economies tanking, though, but in my opinion the short-term risk of investing in emerging markets has increased significantly.

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Charles Hugh Smith
November 23, 2010
Of Two Minds

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Santa, please, please, please strangle the idiotic fantasy that Americans buying a bunch of junk (or gift cards for after-Christmas purchases of junk) will “save” the imploding U.S. economy. My Christmas wish to Santa: please let this be the last Christmas in America that is dominated by the propaganda that holiday retail sales have any more impact on the $14.7 trillion U.S. economy than a moldy, half-eaten fruitcake left over from 2007.

Fact: the 2010 GDP of the U.S. is projected to be about $14.7 trillion. (CBO estimate) The Federal Budget Primer.

Components of Government spending within U.S. GDP.

Fact: total holiday retail sales were $504 billion in 2009. Holiday sales–National Retail Federation.

That means holiday retail sales are a mere 3.4% of the U.S. GDP.

Despite the Financial and Mainstream Media’s pathological obsession with holiday retail sales numbers as proxies for the “health” of the entire U.S. economy, holiday sales don’t really change much:

2007: (pre-recession) Holiday sales: $516 billion
Holiday sales as percentage of annual retail sales: 19.5%

2008: Holiday sales: $495.5 billion
Holiday sales as percentage of annual retail sales: 18.6%

2009: Holiday sales: $504.8 billion
Holiday sales as percentage of annual retail sales: 19.4%

So the start of the 2008-09 recession saw a drop of $21 billion in holiday sales: statistical noise in a $14.7 trillion economy and a modest 4% decline from pre-recession levels. 2009 saw sales rise by about $10 billon (about 2%), so a rise of 2% from 2009 would return holiday sales to pre-recession levels.

Now the propaganda machine is cranking up to announce that a 2% increase in holiday retail sales means the U.S. economy is off and running. Santa, please, please, please order your reindeer to stomp the life out of the idiotic fantasy that Americans buying a few billion dollars more needless junk from China is any sort of evidence that the U.S. economy is “growing at a healthy clip.”

The entire retail sector is 7.9% of the GDP compared to a 21.4% share for the FIRE tranch (finance, insurance and real estate) of the economy.

Does anyone seriously believe that 3.4% of the economy can possibly leverage up the entire GDP with a razor-thin increase of $10 billion in holiday sales?

Santa, you have my deep gratitude if you could jam the propaganda machine so that this is the last Christmas in America where trivial retail sales are hyped as the bellwether for the $14.7 trillion U.S. economy.

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Originally published at Of Two Minds

Washington’s Blog strives to provide real-time, well-researched and actionable information.  George – the head writer at Washington’s Blog – is a busy professional and a former adjunct professor.

For those of you who cannot spend a holiday without digesting some wonky goodness, this post is for you . . .

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Ben Bernanke has said that the Fed is trying to promote inflation, increase lending, reduce unemployment, and stimulate the economy.

However, the Fed has arguably – to some extent – been working against all of these goals.

For example, as I reported in March, the Fed has been paying the big banks high enough interest on the funds which they deposit at the Fed to discourage banks from making loans. Indeed, the Fed has explicitly stated that – in order to prevent inflation – it wants to ensure that the banks don’t loan out money into the economy, but instead deposit it at the Fed:

Why is M1 crashing? [the M1 money multiplier basically measures how much the money supply increases for each $1 increase in the monetary base, and it gives an indication of the "velocity" of money, i.e. how quickly money is circulating through the system]

Because the banks continue to build up their excess reserves, instead of lending out money:

(Click for full image)

These excess reserves, of course, are deposited at the Fed:

(Click for full image)

Why are banks building up their excess reserves?

As the Fed notes:

The Federal Reserve Banks pay interest on required reserve balances–balances held at Reserve Banks to satisfy reserve requirements–and on excess balances–balances held in excess of required reserve balances and contractual clearing balances.

The New York Fed itself said in a July 2009 staff report that the excess reserves are almost entirely due to Fed policy:

Since September 2008, the quantity of reserves in the U.S. banking system has grown dramatically, as shown in Figure 1.1 Prior to the onset of the financial crisis, required reserves were about $40 billion and excess reserves were roughly $1.5 billion. Excess reserves spiked to around $9 billion in August 2007, but then quickly returned to pre-crisis levels and remained there until the middle of September 2008. Following the collapse of Lehman Brothers, however, total reserves began to grow rapidly, climbing above $900 billion by January 2009. As the figure shows, almost all of the increase was in excess reserves. While required reserves rose from $44 billion to $60 billion over this period, this change was dwarfed by the large and unprecedented rise in excess reserves.

[Figure 1 is here]

Why are banks holding so many excess reserves? What do the data in Figure 1 tell us about current economic conditions and about bank lending behavior? Some observers claim that the large increase in excess reserves implies that many of the policies introduced by the Federal Reserve in response to the financial crisis have been ineffective. Rather than promoting the flow of credit to firms and households, it is argued, the data shown in Figure 1 indicate that the money lent to banks and other intermediaries by the Federal Reserve since September 2008 is simply sitting idle in banks’ reserve accounts. Edlin and Jaffee (2009), for example, identify the high level of excess reserves as either the “problem” behind the continuing credit crunch or “if not the problem, one heckuva symptom” (p.2). Commentators have asked why banks are choosing to hold so many reserves instead of lending them out, and some claim that inducing banks to lend their excess reserves is crucial for resolving the credit crisis.

This view has lead to proposals aimed at discouraging banks from holding excess reserves, such as placing a tax on excess reserves (Sumner, 2009) or setting a cap on the amount of excess reserves each bank is allowed to hold (Dasgupta, 2009). Mankiw (2009) discusses historical concerns about people hoarding money during times of financial stress and mentions proposals that were made to tax money holdings in order to encourage lending. He relates these historical episodes to the current situation by noting that “[w]ith banks now holding substantial excess reserves, [this historical] concern about cash hoarding suddenly seems very modern.”

[In fact, however,] the total level of reserves in the banking system is determined almost entirely by the actions of the central bank and is not affected by private banks’ lending decisions.

The liquidity facilities introduced by the Federal Reserve in response to the crisis have created a large quantity of reserves. While changes in bank lending behavior may lead to small changes in the level of required reserves, the vast majority of the newly-created reserves will end up being held as excess reserves almost no matter how banks react. In other words, the quantity of excess reserves depicted in Figure 1 reflects the size of the Federal Reserve’s policy initiatives, but says little or nothing about their effects on bank lending or on the economy more broadly.

This conclusion may seem strange, at first glance, to readers familiar with textbook presentations of the money multiplier.

Why Is The Fed Locking Up Excess Reserves?

Why is the Fed locking up excess reserves?
As Fed Vice Chairman Donald Kohn said in a speech on April 18, 2009:

We are paying interest on excess reserves, which we can use to help provide a floor for the federal funds rate, as it does for other central banks, even if declines in lending or open market operations are not sufficient to bring reserves down to the desired level.

Kohn said in a speech on January 3, 2010:

Because we can now pay interest on excess reserves, we can raise short-term interest rates even with an extraordinarily large volume of reserves in the banking system. Increasing the rate we offer to banks on deposits at the Federal Reserve will put upward pressure on all short-term interest rates.

As the Minneapolis Fed’s research consultant, V. V. Chari, wrote this month:

Currently, U.S. banks hold more than $1.1 trillion of reserves with the Federal Reserve System. To restrict excessive flow of reserves back into the economy, the Fed could increase the interest rate it pays on these reserves. Doing so would not only discourage banks from draining their reserve holdings, but would also exert upward pressure on broader market interest rates, since only rates higher than the overnight reserve rate would attract bank funds. In addition, paying interest on reserves is supported by economic theory as a means of reducing monetary inefficiencies, a concept referred to as “the Friedman rule.”

And the conclusion to the above-linked New York Fed article states:

We also discussed the importance of paying interest on reserves when the level of excess reserves is unusually high, as the Federal Reserve began to do in October 2008. Paying interest on reserves allows a central bank to maintain its influence over market interest rates independent of the quantity of reserves created by its liquidity facilities. The central bank can then let the size of these facilities be determined by conditions in the financial sector, while setting its target for the short-term interest rate based on macroeconomic conditions. This ability to separate monetary policy from the quantity of bank reserves is particularly important during the recovery from a financial crisis. If inflationary pressures begin to appear while the liquidity facilities are still in use, the central bank can use its interest-on-reserves policy to raise interest rates without necessarily removing all of the reserves created by the facilities.

As the NY Fed explains in more detail:

The central bank paid interest on reserves to prevent the increase in reserves from driving market interest rates below the level it deemed appropriate given macroeconomic conditions. In such a situation, the absence of a money-multiplier effect should be neither surprising nor troubling.

Is the large quantity of reserves inflationary?

Some observers have expressed concern that the large quantity of reserves will lead to an increase in the inflation rate unless the Federal Reserve acts to remove them quickly once the economy begins to recover. Meltzer (2009), for example, worries that “the enormous increase in bank reserves — caused by the Fed’s purchases of bonds and mortgages — will surely bring on severe inflation if allowed to remain.” Feldstein (2009) expresses similar concern that “when the economy begins to recover, these reserves can be converted into new loans and faster money growth” that will eventually prove inflationary. Under a traditional operational framework, where the central bank influences interest rates and the level of economic activity by changing the quantity of reserves, this concern would be well justified. Now that the Federal Reserve is paying interest on reserves, however, matters are different.

When the economy begins to recover, firms will have more profitable opportunities to invest, increasing their demands for bank loans. Consequently, banks will be presented with more lending opportunities that are profitable at the current level of interest rates. As banks lend more, new deposits will be created and the general level of economic activity will increase. Left unchecked, this growth in lending and economic activity may generate inflationary pressures. Under a traditional operating framework, where no interest is paid on reserves, the central bank must remove nearly all of the excess reserves from the banking system in order to arrest this process. Only by removing these excess reserves can the central bank limit banks’ willingness to lend to firms and households and cause short-term interest rates to rise.

Paying interest on reserves breaks this link between the quantity of reserves and banks’ willingness to lend. By raising the interest rate paid on reserves, the central bank can increase market interest rates and slow the growth of bank lending and economic activity without changing the quantity of reserves. In other words, paying interest on reserves allows the central bank to follow a path for short-term interest rates that is independent of the level of reserves. By choosing this path appropriately, the central bank can guard against inflationary pressures even if financial conditions lead it to maintain a high level of excess reserves.

This logic applies equally well when financial conditions are normal. A central bank may choose to maintain a high level of reserve balances in normal times because doing so offers some important advantages, particularly regarding the operation of the payments system. For example, when banks hold more reserves they tend to rely less on daylight credit from the central bank for payments purposes. They also tend to send payments earlier in the day, on average, which reduces the likelihood of a significant operational disruption or of gridlock in the payments system. To capture these benefits, a central bank may choose to create a high level of reserves as a part of its normal operations, again using the interest rate it pays on reserves to influence market interest rates.

Because financial conditions are not “normal”, it appears that preventing inflation seems to be the Fed’s overriding purpose in creating conditions ensuring high levels of excess reserves.

***
As Barron’s notes:

The multiplier’s decline “corresponds so exactly to the expansion of the Fed’s balance sheet,” says Constance Hunter, economist at hedge-fund firm Galtere. “It hits at the core of the problem in a credit crisis. Until [the multiplier] expands, we can’t get sustainable growth of credit, jobs, consumption, housing. When the multiplier starts to go back up toward 1.8, then we know the psychological logjam has begun to break.”

***

It’s not just the Fed. The NY Fed report notes:

Most central banks now pay interest on reserves.

Robert D. Auerbach – an economist with the U.S. House of Representatives Financial Services Committee for eleven years, assisting with oversight of the Federal Reserve, and subsequently Professor of Public Affairs at the Lyndon B. Johnson School of Public Affairs at the University of Texas at Austin – argues that the Fed should slowly reduce the interest paid on reserves so as to stimulate the economy.

Last week, Auerbach wrote:

In September, Auerbach explained:

Immediately after the recession took a dramatic dive in September 2008, the Bernanke Fed implemented a policy that continues to further damage the incentive for banks to lend to businesses. On October 6, 2008 the Fed’s Board of Governors, chaired by Ben Bernanke, announced it would begin paying interest on the reserve balances of the nation’s banks, major lenders to medium and small size businesses.

You don’t need a Ph.D. economist to know that if you pay banks ¼ percent risk free interest to hold reserves that they can obtain at near zero interest, that would be an incentive to hold the reserves. The Fed pumped out huge amounts of money, with the base of the money supply more than doubling from August 2008 to August 2010, reaching $1.99 trillion. Guess who has over half of this money parked in cold storage? The banks have $1.085 trillion on reserves drawing interest, The Fed records show they were paid $2.18 billion interest on these reserves in 2009.

A number of people spoke about the disincentive for bank lending embedded in this policy including Chairman Bernanke.

***
Jim McTague, Washington Editor of Barrons, wrote in his February 2, 2009 column, “Where’s the Stimulus:” “Increasing the supply of credit might help pump up spending, too. University of Texas Professor Robert Auerbach an economist who studied under the late Milton Friedman, thinks he has the makings of a malpractice suit against Federal Reserve Chairman Ben Bernanke, as the Fed is holding a record number of reserves: $901 billion in January as opposed to $44 billion in September, when the Fed began paying interest on money commercial banks parked at the central bank. The banks prefer the sure rate of return they get by sitting in cash, not making loans. Fed, stop paying, he says.”

Shortly after this article appeared Fed Chairman Bernanke explained: “Because banks should be unwilling to lend reserves at a rate lower than they can receive from the Fed, the interest rate the Fed pays on bank reserves should help to set a floor on the overnight interest rate.” (National Press Club, February 18, 2009) That was an admission that the Fed’s payment of interest on reserves did impair bank lending. Bernanke’s rationale for interest payments on reserves included preventing banks from lending at lower interest rates. That is illogical at a time when the Fed’s target interest rate for federal funds, the small market for interbank loans, was zero to a quarter of one percent. The banks would be unlikely to lend at negative rates of interest — paying people to take their money — even without the Fed paying the banks to hold reserves.

The next month William T. Gavin, an excellent economist at the St. Louis Federal Reserve, wrote in its March\April 2009 publication: “first, for the individual bank, the risk-free rate of ¼ percent must be the bank’s perception of its best investment opportunity.”The Bernanke Fed’s policy was a repetition of what the Fed did in 1936 and 1937 which helped drive the country into a second depression. Why does Chairman Bernanke, who has studied the Great Depression of the 1930′s and has surely read the classic 1963 account of improper actions by the Fed on bank reserves described by Milton Friedman and Anna Schwartz, repeat the mistaken policy?

As the economy pulled out of the deep recession in 1936 the Fed Board thought the U.S. banks had too much excess reserves, so they began to raise the reserves banks were required to hold. In three steps from August 1936 to May 1937 they doubled the reserve requirements for the large banks (13 percent to 26 percent of checkable deposits) and the country banks (7 percent to 14 percent of checkable deposits).

Friedman and Schwartz ask: “why seek to immobilize reserves at that time?” The economy went back into a deep depression. The Bernanke Fed’s 2008 to 2010 policy also immobilizes the banking system’s reserves reducing the banks’ incentive to make loans.

This is a bad policy even if the banks approve. The correct policy now should be to slowly reduce the interest paid on bank reserves to zero and simultaneously maintain a moderate increase in the money supply by slowly raising the short term market interest rate targeted by the Fed. Keeping the short term target interest rate at zero causes many problems, not the least of which is allowing banks to borrow at a zero interest rate and sit on their reserves so they can receive billions in interest from the taxpayers via the Fed. Business loans from banks are vital to the nations’ recovery.

The fact that the Fed is suppressing lending and inflation at a time when it says it is trying to encourage both shows that the Fed is saying one thing and doing something else entirely.

I have previously pointed out numerous other ways in which the Fed is working against its stated goals, such as:

• Reinforcing cyclical trends (when one of the Fed’s main justifications is providing a counter-cyclical balance);

• Increasing unemployment (when the Fed is mandated by law to maximize employment); and

• Encouraging financial companies to make even riskier gambles in the future (when it is supposed to stabilize the financial system).

And see this.

Postscript: If the Fed really wants to stimulate the economy, it should try Steve Keen’s idea.