Wednesday, May 25, 2011

Signs of Fed Desperation


Thanks to Ben Bernanke's new monetary "tools", the Federal Reserve continues to operate in panic mode. Specifically, because the Fed now pays interest on reserves held by banks at the Federal Reserve, excess reserves are piling up at the Fed at a remarkable rate.

There are now $1.5 trillion in excess reserves just sitting there that could explode and hit the economy at anytime and cause huge price inflation. There has never, ever, before Bernanke started paying interest on  reserves so much of an overhang in excess reserves. In the month before the Fed started paying interest on excess reserves, September 2008, excess reserves stood at only $27 billion.

Here's the difference between then and now:

THEN:      27,000,000,000

NOW:   1,500,000,000,000

Here's a graph of the situation:

Click on chart for larger view.

This is where most of the QE1 and QE2 money has been going. It hasn't even hit the economy, yet. The Fed has no idea what is going to happen with this $1.5 trillion once it does hit the system or how quickly it will flow into the system---and cause price inflation. Or how high they might have to raise interest rates to stop the flow.

An alternative the Fed is considering in draining the reserves by getting money market funds to conduct reverse-repos with the Fed. This gets a little technical, so just know that if the Fed does reverse-repos with money market funds, it will drain reserves from the system.

But the money market funds have nowhere near the cash on hand to do the sizable reverse-repos with the Fed that the Fed may need to do. The money markets have most of their funds in short-term paper that they would be required to sell (or certainly not roll-over) if the Fed came to them wanting to do sizable reverse-repos. Huge sales of short-term paper would panic the markets. It is a very dangerous scenario.

The Fed knows this. When they actually figured this out I am not sure. Trust me, they would have never started paying interest on reserves, if they understood the problem back then. So here we are with $1.5 trillion in excess reserves, with Bernanke not knowing when these might hit the system, and so the Fed desperately continues to add money market funds to the list of those they may in the future do reverse repos with. They are expanding the list hoping that with a larger list any reverse-repos conducted won't damage the economy. It's total desperation.