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The Alchemy of Printing Without Ink

Adjusting for excess reserves, the Fed has printed nothing


History tells us that one of the primary goals of alchemy was to turn base metals into precious metals. But one 21st century central banker has (so far) succeeded to do what alchemists for millennia could not accomplish: produce something out of nothing, using a controversial tool called quantitative easing.

“The process by which banks create money is so simple that the mind is repelled,” John Kenneth Galbraith famously said many years ago. His words are especially relevant today as the size of the constantly growing Federal Reserve balance sheet terrifies an increasing number of financial market observers, even though it has stimulated economic activity without (yet) any unfortunate inflationary effects.

Since quantitative easing is likely to continue for the time being, I thought it was important to try to clarify some points for those panicked investors.

I am not writing this to defend Fed Chairman Ben Bernanke or the practice of quantitative easing. In fact, I would rather have the U.S. operate on a “savings and investment” economic model — like many emerging markets — rather than resort to such gigantic financial maneuvers to perpetuate an economic model driven by rising financial leverage, which has already shown serious stress.

But I realize such wishes are unrealistic given the policies that have been in place since the creation of the Federal Reserve. The Federal Reserve has always been an institution of monetarists and Keynesians and any practitioners of Austrian economics are unlikely to ever lead it.

While the Federal Reserve controls and directs the U.S. financial system, it is the system itself that produces credit growth via the process of fractional reserve banking. In the classic model of fractional reserve banking, the Federal Reserve creates base money that then circulates in the banking system, multiplying itself until the level of required reserves naturally exhausts the process.

To save the system, the Fed intervened and indefinitely augmented the classic process of fractional reserve banking via the payment of interest on bank excess reserves.

By paying an interest rate on bank excess reserves, the Federal Reserve controls the cash it “alchemically” introduces into the system via quantitative easing, so it does not circulate and produce undesirable effects. The process of quantitative easing did help suppress long-term Treasury and mortgage rates, which in turn helped revive housing and the overall economy. However, QE also intentionally disrupted the money multiplier of the U.S. fractional reserve banking system and again intentionally affected the monetary velocity of the U.S. money supply, be it the M1, M2 or MZM kind. (Enterprising minds are urged to read this staff report by FRBNY, which tries to explain in the simplest possible terms how interest on excess reserves is designed to control this process.)

Many market observers know of the disturbing upward-sloping trajectory of the Fed’s balance sheet assets, but very few mention that bank excess reserves held at the Fed are also going up in a designed-to-be-similar fashion. The size of U.S. Federal Reserve balance sheet now stands at $3.354 trillion, while excess reserves of financial institutions held at the Fed now stand at $1.769 trillion. Since total excess reserves are designed to not circulate with the help of the interest the Fed pays on those balances, the balance sheet growth process has been remarkably well-controlled since 2008.

One could argue that the Fed has put on the largest carry trade in the world as its cost of funding is between 0%-0.25%, or exactly the level of the fed funds rate. (The interest rate paid on excess reserves is 0.25%, while electronic credits to bank accounts in the Federal Reserve system carry the “alchemical” cost of zero). Those balance sheet assets, on the other hand, yield way more than that, making the Fed a wildly profitable institution.

Since the Fed “arrests” the QE excess reserve cash with the process described above, one could, for the sake of the argument, subtract bank excess reserves from Fed balance sheet assets to see what actual printing has resulted since the great financial crisis erupted in 2008.

Subtracting excess reserves shows the Fed’s balance sheet is actually smaller on an excess-reserve-adjusted basis than it was in the darkest days of the crisis in 2008. In this great alchemy called quantitative easing, the Fed has literally printed nothing, but utilizing its balance sheet, it has imprisoned excess reserves while putting on a massive carry trade designed to help it control longer-term interest rates.

I believe this is only possible because the U.S. dollar is the world’s reserve currency, which holds hostage the holders of such U.S. dollar reserves. These reserve holders are terrified by the size of the quantitative easing operation — to the point where they are making it a political problem. They are looking for ways to bypass major international financial institutions to liberate themselves from their dependence on the dollar as a reserve currency and the de facto rule of the Federal Reserve over their hard-earned domestic forex reserves.

It is rather comical that as U.S. dollar reserve holders are looking for ways to decrease their dependence on the dollar, the Fed’s QE has improved U.S. economic performance to the point where it is resulting in a dollar rally as major alternatives such as the yen and the euro have even more serious issues.

I don’t know how long the easing maneuver can last or that it will ultimately end up being a success. Unwinding it might turn out to be a much longer process as the Federal Reserve lets bonds run off and adjusts interest paid on excess reserves to control the process.

But I am pretty certain that those looking for QE-driven inflation to become a problem in either 2013 or 2014 are going to be quite disappointed.

Ivan Martchev is a research consultant with institutional money manager Navellier & Associates. The opinions expressed are his own.

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