HOT: Fed Prez Spills the Beans on the Excess Reserve Inflation Time Bomb

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For the second time in two weeks, Philadelphia Fed President Charles Plosser is warning about the time bomb that is excess reserves.

I first reported on this last week, exclusively in the EPJ Daily Alert. I wrote:

Here’s something very big. There has been very little coverage in mainstream media about the Fed super-money printing and how much of it is going into excess reserves. But what if it doesn’t go into excess reserves and instead ends up in the system bidding up prices?

While mainstream media is pointing at Bernanke’s QE3 and not reporting beyond that, the Fed knows it is all about where the money they print ends up.

Here’s part of a very important interview Philadelphia Fed President Charles Plosser gave yesterday to MNI News. It spills the beans:

—– Plosser also warned that QE3 "could be highly inflationary."

"I don’t think it would occur immediately," he said. "Inflation is going to occur when excess reserves of this huge balance sheet begin to flow outside into the real economy. I can’t tell you when that’s going to happen."

"When that does begin if we don’t engage in a fairly aggressive and effective policy of preventing that from happening, there’s no question in my mind that that will lead to lots of inflation."

Bernanke and other Fed officials have often said that the Fed will be able to contain the outflow of reserves into the economy and thereby limit wage-price pressures by raising the rate of interest it pays on excess reserves. But Plosser said the IOER and reserve draining tools cannot be relied upon.

"How fast will we have to do that (raise the IOER)?" he asked. "How rapid will it have to go up? We don’t have a clue. Raising the IOER where you have a trillion and half or two trillion dollars in reserves, we have absolutely zero experience with it."

"We have the tools to do it, but we don’t know the consequences of the tools," Plosser said.

"If the IOER doesn’t work and we have to sell assets, MBS, how will that affect housing?" he asked. "Will we be able to unwind from this at a pace that doesn’t disrupt the economy?" —– Plosser’s comments are about the core of the Fed’s problem. If those funds start to move out of excess reserves and into the economy rapidly, the Fed will have to take counter measures, such as boosting interest rates on excess reserves (IOER) or liquidating some of their mortgage backed securities. Plosser is entirely correct, no one knows how high interest rates will have to be raised to stop the flow into the economy. It could very well end up a tiger by the tail situation, the higher the Fed boosts rates, the higher nominal rates climb (Sort of the reverse of what is going on now). This is why it is very dangerous to hold long-term bonds, when rates reverse and start heading higher, they could move very rapidly, as the Fed could be forced to battle the very inflationary flow of money out of excess reserves.

As Plosser points out, there is approximately $1.5 trillion in excess reserves, given that the multiplier for reserves and money supply (M2) is now roughly 100, there is no way the Fed can allow that amount of excess reserves to get into the system. It would mean an increase in M2 of $150 trillion! On a current base of only $10 trillion. The Fed would have to fight such an outflow very aggressively, and that would mean much higher rates.

The fight against the outflow of excess reserves will come, but the Fed will likely be slow to act, so a lot of money will get into the system which is why Plosser is also correct in that we are on the edge of a very explosive inflationary situation.

Thus, the key right now is to watch to see if the Fed’s new money printing of $40 billion per month ends up in the system or as excess reserves. Further, excess reserves themselves have to be monitored to see if any of those funds start to enter the system. In other words, if any increases in required reserves occur, it could result in an artificial boom to the stock market and economy, but also be very price inflationary, very quickly.

Now, Plosser is warning again about the excess reserves exploding into the system and what it may mean for interest rates and the entire financial system.

Before the CFA Society of Philadelphia/The Bond Club of Philadelphia, Plosser said today (my bold):

I have been a student of monetary theory and policy for over 30 years. One constant is that central banks tend to find it easier to lower interest rates than to raise them. Moreover, identifying turning points is difficult even in the best of times, so timing the change in the direction of policy is always a challenge. But this time, exit will be even more complicated and risky. With such a large balance sheet, our transition from very accommodative policies to less accommodative policies will involve using tools we have not used before, such as the interest rate on reserves, term deposits, and asset sales. Once the recovery takes off, long rates will begin to rise and banks will begin lending the large volume of excess reserves sitting in their accounts at the Fed. This loan growth can be quite rapid, as was true after the banking crisis in the 1930s, and there is some risk that the Fed will need to withdraw accommodation very aggressively in order to contain inflation. At this point, it is impossible to know whether such asset sales will be disruptive to the market. A rapid tightening of monetary policy may also entail political risks for the Fed. We would likely be selling the longer maturity assets in our portfolio at a loss, meaning that we may be unable to make any remittances to the U.S. Treasury for some years. Yet, if we don’t tighten quickly enough, we could find ourselves far behind the curve in restraining inflation.

While these risks are very hard to quantify, it is clear that the larger the Fed’s portfolio becomes, the higher the risk and the potential costs when it comes time to exit. And based on my economic outlook, that time may come well before mid-2015. In my view, to keep the funds rate at zero that long would risk destabilizing inflation expectations and lead to an unwanted increase in inflation.

This is very candid talk from a Fed insider, Plosser clearly sees the potential for massive price inflation if those excess reserves hit the system, even more striking is that Plosser knows that the Fed will likely be very slow in hiking interest rates, thus fueling the inflation.

When the price inflation hits, don’t say you haven’t been warned, Plosser is revealing very clearly how it will hit.

Reprinted with permission from Economic Policy Journal.

2012 Economic Policy Journal

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