March 19, 2019

I had one of the strangest conversations with an investor this month regarding the Federal Reserve. He tried to convince me that the Fed does not know what it is doing by paying interest on excess reserves. When they pay interest on excess reserves, he said, they cause banks to hoard cash and not lend, which is why there are so many excess reverses in the system. “The Fed discourages lending with such policies.”

The silence between his statement and my answer may have seemed uncomfortably long. Here is why:

Excess reserves at depository institutions are a function of quantitative easing (QE). They were created on purpose by the Fed, and they are most definitely not a function of the Fed paying excess reserve interest rates. As the Fed bought bonds from primary dealers, they credited their accounts at the Federal Reserve Bank of New York (FRBNY) with electronic cash (excess reserves).

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary

FRBNY is a bank for commercial banks and all other open-market operations. FRBNY is to a bank what an average person’s neighborhood bank is to that person’s checking account. When the Fed rolled out QE, it bought the bonds and credited the primary dealer’s accounts at FRBNY with electronic credits, so when the inflationists say that “the Fed is printing money,” there is no actual ink used. It’s all electronic.

The reason why the Fed created those excess reserves was to stimulate lending, not to prevent it from happening. If they had not done that, the Great Recession of 2008 might have become the Second Great Depression, because the real estate bubble-related losses in the banking system were gargantuan. Such losses resulted from the oxymoronic AAA-rated subprime CDOs and other absurdities that made hedge fund managers like John Paulson of Paulson and Co. very rich by shorting these instruments.

With their QE monetarist maneuvers, the Fed succeeded in creating a very long economic recovery and record profits for the S&P 500 Index, which in turn pushed the S&P 500 Index to an all-time high in 2018. In July 2019, the present economic expansion will become the longest in U.S. history. Since I don’t believe there will be a recession in 2019 and maybe not in 2020– with fingers crossed for the Chinese trade deal and President Trump surviving the Mueller mess – we very well may see a fresh all-time high for the S&P 500 Index in 2019, too.

At the root of this massive bull market in U.S. stocks are those very excess reserves which were created with the help of Fed Chairman Ben Bernanke and his Ph.D. in monetary economics from MIT.

In addition to helping credit growth in the U.S. banking system recover from the monstrous real-estate bubble losses, QE is the largest carry trade in the world. The Fed buys bonds with electronic credits (excess reserves) and pockets the interest rate differential between the yields on the bonds they buy and the interest on excess reserves they pay the banks. The interest rate differential between the excess reserve rate and the yield on the Fed bond portfolio is remitted to the U.S. Treasury Department. One could characterize that enormous Fed-designed carry trade as a very profitable side effect of quantitative easing.

How the Fed Increases Liquidity Without Fueling Inflation

When large amounts of excess reserves are created, with the primary task being to stimulate lending in a financial system that is tending toward deflation, the Fed had to solve another big problem, and that is, how to prevent hyperinflation.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Without interest on excess reserves, the credit multiplier effect that is embedded in the fractional reserve banking system would have produced hyperinflation when those excess reserves enter the fed funds market. (The fed funds market is a place where banks can lend their excess reserves to each other with the supervision of fed funds traders employed by FRBNY that keep the interest rates on those loans within the band specified by the FOMC, presently at 2.25-2.50%.) The variability of the effective fed funds rate is obvious in the chart above as those transactions are being made throughout the day.

When the interest on excess reserves is higher than the fed funds rate, as has been the case for most of the last 10 years, the activity on the fed funds market grinds down. You could say that Ben Bernanke may have caused some of his own fed funds traders to look for other careers, as he was trying to prevent spiraling unemployment caused by the Great Recession. This, as they say, is where the plot thickens.

As the excess reserve interest rate is converging with the fed funds rate and excess reserves themselves are dropping due to the ongoing policy of quantitative tightening done by the Federal Reserve (evident in the Fed’s shrinking balance sheet), it appears to me that the Federal Reserve is trying to resuscitate the credit multiplier effect in the U.S. financial system and return the system back to more normal ways of operation. It’s too early to declare victory yet, but it would appear the Fed is hell-bent on succeeding.

If they succeed, it would appear that job advertisements will be more plentiful for fed funds traders in New York City and that Ben Bernanke will be at the top of the list for the Nobel Prize in Economics.

And the bottom line in the whole process is that the Fed is most certainly not stupid.

About The Author

Ivan Martchev

Ivan Martchev is an investment strategist with Navellier.  Previously, Ivan served as editorial director at InvestorPlace Media. Ivan was editor of Louis Rukeyser’s Mutual Funds and associate editor of Personal Finance. Ivan is also co-author of The Silk Road to Riches (Financial Times Press). The book provided analysis of geopolitical issues and investment strategy in natural resources and emerging markets with an emphasis on Asia. The book also correctly predicted the collapse in the U.S. real estate market, the rise of precious metals, and the resulting increased investor interest in emerging markets. Ivan’s commentaries have been published by MSNBC, The Motley Fool, MarketWatch, and others. *All content of “Global Mail” represents the opinion of Ivan Martchev*


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