Until the financial crisis started there were almost no excess reserves in the banking system. The excess reserves have exploded and now stand at more than a trillion dollars:
www.federalreserve.gov excess reserves
There has been a series of stories about this, how it potentially indicates money not is getting out to the people. That the unemployment now stands at between 10% to 20% possibly indicate that the money not is getting out there. But this could naturally also be related to other factors.
Several people have also claimed the massive excess reserves at some point down the road will cause considerable inflation. The idea is as long as the velocity of money stays low we will not see inflation, we could even see deflation. But when the economy stabilizes and lending activities picks up and the velocity of money picks up then the excess reserves now flowing into the system and working as a money multiplier could cause inflation:
Inflation is looming on America’s horizon
In an interesting report from FED July 2009 it is claimed that the excess reserves neither means the banks not are lending out their money and further that the massive excess reserves are unlikely to cause inflation down the road:
Why Are Banks Holding So Many Excess Reserves?
Thanks to a “new invention” FED claims things are different this time around. The new invention is to pay interest rates on excess reserves. Paying interest rates on excess reserves where introduced by the Emergency Economic Stabilization Act of 2008, and this is the new magic trick among central banks around the world.
FED now supposedly have much better control of when and how much of these excess reserves will go into the economy in form of increased lending.
FED’s report seems to be based on a series of hidden assumptions. They do not seem to take into account that FED has much less control over the long-term interest rates than the short rates. If the long-term interest rates went much higher than short rates and the economy at the same time picks up could it not happen that banks will start to lend out their excess reserves to long-term investments to get higher returns? And what about the equity markets and other markets, if the returns here should be great over an extended period of time would it then not be tempting for banks to increase lending to get considerably higher returns than on their excess reserve accounts?
Possibly I am completely wrong, I am far from an expert on excess reserves in the banking system. However to me there simply seems to be too many unknown factors that potentially could limit FED’s control over the excess reserves and thereby the money supply.
The central bank system also seems have very limited experience with how much extra control they actually gain over money supply and money multiplier by giving interest rates on the excess reserve accounts. FED mentions that The Reserve Bank of New Zealand has used this type of framework since 2006. But what is 4 or 5 years experience?
The record high gold price seems to tell a different story. People are normally moving towards gold when they start loosing their faith in the monetary systems ability to sustain stability in the value of legal tender. The high gold price is probably also a way for parts of the market to say they fear inflation coming down the road. What if FED is wrong in some of their assumptions, what if these massive excess reserves at some point down the road should cause massive turbulence and or inflation? It could naturally take many years before we know the answer to this question.
Last time the excess reserves where ballooning was under the great depression. Excess banking reserves in USA were just above 70 million dollars in 1929. In 1935 they had exploded to 1282 million dollars.
But this time everything is different; the central bankers have finally found the solution, the magic trick of giving interest rates on the excess reserves will be our savior this time around. I hope and wish it is this simple, but I am afraid not!
M1 is way up, M3 is flattish (or slightly down) likely due to the falling velocity of money.
When the velocity of money at some point picks up it will be interesting to see how well FED can control the total money supply of the economy.
But yes we can clearly get deflation before we get inflation. Well there has already been quite a lot of house price deflation around the world.