I missed this story on the Wall Street Journal website yesterday. Thanks to my lovely wife for pointing it out. “Overheard: Banks Shift From Treasurys to Loans” says that banks are chasing yields by starting to make loans again. Watch for interest rates to rise soon.
There’s one comment on this article by Frank Anderson: “This is scary.” I don’t know who Mr. Anderson is, but he’s absolutely correct. Banks have stashed about $2.5 trillion in excess reserves. When I last wrote about this, excess reserves were fairly stable at about 95% of total reserves.
But over the last 15 months that percentage has begun to fall slightly.
If we look at the year-over-year change in excess reserves, the pattern becomes clear. (I used year-over-year changes because the data is not seasonally adjusted.)
What’s It Mean?
What can cause excess reserves to decrease? The standard textbook answer is the Fed engaging in open market sales. But that would cause interest rates to rise (at least in principle — we’re in uncharted territory here). Although deciphering the Fed’s Table H.4.1[1] bears a close resemblance to reading tea leaves, it doesn’t look like the Fed has materially reduced its holdings of U.S. government securities.
That leaves us with the Wall Street Journal’s idea. Bank lending is picking up. There’s just a hint right now. But if this trend continues you can expect one (or possibly both) of these events:
- inflation will rise rapidly,
- interest rates will rise rapidly.
I’ve been writing about this for at least five years. The Fed’s attempt to rescue the economy using monetary policy alone has been a fool’s errand. Now they face a Sophie’s choice:
- The FOMC can do nothing, allowing those banks to continue to increase lending. This will increase the growth rate of M1, M2, and (eventually) lead to inflation. Right now M1 is about $3 trillion and M2 around $12 trillion. Even a relatively small value for the money supply multiplier (say 2.0), $2.5 trillion in excess reserves translates to a $5 trillion increase in M1.
- The FOMC can engage in open-market sales and take other actions to eliminate the excess reserves. The FOMC will have to act quickly. And this will cause interest rates to rise once the growth rate of M1 begins to slow. Among other effects will be a sharp increase in the Federal government budget deficit as interest payments on the $16 trillion debt begin to rise. (A 10 basis point increase in the average interest rate on the government debt will increase interest payments on the debt by a cool $16 billion. Even by government standards that’s not just spare change.
Note that either way interest rates rise. If the Fed does nothing, inflation expectations will increase nominal interest rates. If the Fed tightens, the reduced growth rate of the money supply will increase nominal (and perhaps real) interest rates.
Unsolicited Advice
My highly unprofessional advice: head for TIPS[2] funds. But remember: you get what you pay for. How much did you pay for this advice?
(Disclaimer: my wife and I own shares in TIPS funds. However, this is irrelevant because (a) we are not buying or selling, therefore we don’t affect the market price; and (b) I’m pretty sure our holdings are a miniscule percentage of total TIPS securities held by the public.)
Transparency note: click here to download the usual Excel workbook.
[1] “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks” current release available at http://www.federalreserve.gov/releases/h41/Current/
[2] Treasury Inflation Protected Securities.
