I had one of the strangest conversations with a wealthy 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 it pays interest on excess reserves, he said, it causes banks to hoard cash and not lend, which is why there are so many excess reserves 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, it credited their accounts at the Federal Reserve Bank of New York (FRBNY) with electronic cash (excess reserves).
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 dealers’ 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 (See chart.)
Read: Text of FOMC March statement
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 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 those instruments.
Excess reserves also push up risk asset prices, including those of stocks and junk bonds. By pressuring risk asset prices higher, the Fed was actually pulling the whole economy out of the depressionary hole that it was in at the beginning of 2009. Allowing risky borrowers to borrow at lower rates and preventing more bank failures from happening is also how those QE policies saved the economy in the 2008-2009 crisis.
With their QE monetarist maneuvers, the Fed succeeded in creating a very long economic recovery and record profits for the S&P 500 Index SPX, -0.29% which in turn propelled the benchmark 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 this year.
At the root of this massive bull market in U.S. stocks are those very excess reserves that were created with the help of former 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 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 were 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.
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 federal funds market. (The fed funds market is a place where banks can lend their excess reserves to each other with the supervision of 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 as those transactions are being made throughout the day. (See chart.)
When the interest on excess reserves is higher than the fed funds rate, as has been the case for most of the past 10 years, the activity in the fed funds market grinds down. You could say that 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 is where the plot thickens.
As the excess reserve interest rate is converging with the fed funds rate and excess reserves themselves are dropping because of the ongoing policy of quantitative tightening, it appears 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. The problem is that removing excess reserves too quickly can cause problems with risk asset prices, as we saw in the fourth quarter.
If the Fed succeeds, it would appear that job advertisements will be more plentiful for fed funds traders in New York City and that Bernanke will be at the top of the list for the Nobel Prize in Economics.
And the bottom line is that the Fed is most certainly not stupid.
Ivan Martchev is an investment strategist with institutional money manager Navellier and Associates.