23 Jun A BRIEF EXPLANATION OF EXCESS BANK RESERVES AND MONETARY VELOCITY
Gold is at the highest level in almost 8 years. Oil is almost $41 barrel. The yield curve is the steepest in over five years. Many, me included, believe a reason for the above is the result of the exponential increase in the Fed’s balance sheet. In about three months its balance sheet has grown about $3 trillion to more than $7 trillion. It could conceivably exceed $10 trillion by year end based on some Fed forecasts.
Is the Federal Reserve monetizing the federal debt? Will runaway inflation be the inevitable consequence?
A possible answer to the above question is whether or not monetary velocity accelerates. Excess bank reserves are at an all-time record. If banks begin lending this money, monetary velocity will accelerate and inflation will rise.
The basic mechanism to encourage the lending of these reserves are interest rates paid on such money by the Federal Reserve. Until October 2008, the Fed did not have the authority to pay interest on excess bank reserves. In other words, the central bank had no real control over these funds. [Note: The Fed started paying an interest rate to recapitalize the banking system. Essentially the banks were making no risk loans to the Federal Reserve]
If the Fed ceases interest payments, banks would be forced to lend the money hence increasing monetary velocity. Conversely if the Fed increases the interest rate, banks would not be incentivized to inject the money into the real economy hence a curtailment in lending.
Currently the Fed is paying 0.1% on these excess reserves, down from 1.6% in February and 2.35% a year ago.
A major question at hand are there enough economically viable project to absorb these funds?
Some will correctly argue that some of these excess reserves have gravitated into the securities market hence the rise from March lows.
I can envision a scenario where the economy is expanding and volatility in the financial markets rises. As noted many times interest rates are around historical lows, M-2 or money supply is surging and government spending is exploding. It is conceivable government will inject $10 trillion into the economy by year end doubling the deficit from $20 trillion in March to $30 trillion in December.
Historically the above scenario causes inflationary growth, a declining currency and rising interest rates. Maybe gold does have it right?
Commenting about yesterday’s market activity, equities were nominally higher, emphasizing the reopening rather than the perceived increase in cases. Speaking of which, according to John Hopkins’ cases increased yesterday by 1.1%, slightly lower than the 7-day average of 1.2% and in line with the overall increases that has occurred for the past 45 days. There has been several regions where cases are spiking.
Testing is surging with well over 500,000 tests conducted daily. As a result, the positive rate actually went down over the past four days from 5.8% of those tested to 5.1%. Deaths are at the lowest figure since March 23 and hospitalizations are flat to down in a narrow range.
What will happen today?
Last night the foreign markets were up. London was up 1.29%, Paris up 1.61% and Frankfurt up 2.63%. China was up 0.18%, Japan up 0.50% and Hang Sang up 1.62%.
The Dow should open moderately higher as the President reassured the trade deal with China remains in place and economic data from the euro area pointed to further signs of a recovery. Oil is up about 2% to around $42/barrel. The 10-year off 6/32 to yield 0.74%.