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Fed Exit Strategy? Preparing For Inflation: SPDR Gold Trust (GLD) et al.

By Brian Benton, Published: August 13th, 2009 9:53 AM CDT

Federal Reserve chairman Ben Bernanke used last week as an opportunity to address the Fed's exit strategy of removing the bank reserves that have been pumped into the banking system since September of last year. Of course, this will not happen until the Fed and our political leaders feel that both the banking system and the economy is on considerably sounder footing and tighter monetary policy is less likely to toss the economy back into the ditch. I say political leaders because the Fed has lost a considerable amount of its "independence" and pressure will be a tool wielded by our politicians (especially as elections near). Given the events of this week, it is a good opportunity to review the state of the Fed balance sheet, some if its recent operations, and a few key items in Bernanke's plan to drain reserves from the banking system at the "appropriate time". I will begin with a little background info that you can also find in previous articles, but presented a bit differently here.

Total reserves in the banking system now stand at $805 billion (seasonally adjusted as of 7/15), with $743 billion being excess reserves held by the banking system on deposit with the Federal Reserve. Remember that reserves are created when the Fed purchases assets. Each member bank has a reserve account with the Fed. When the Fed purchases assets, the aggregate reserves in these accounts rise (reserves are added to the banking system). When the Fed sells assets, the aggregate reserves in these accounts fall (reserves are drained from the banking system). This modification on the liability side of the Fed balance sheet is offset by an equal operation on the asset side of the Fed balance sheet.

Ex. 1
Fed action:
Fed purchases $100 billion of Treasuries
Asset side of the Fed balance sheet increases by $100 billion in the Treasuries category. Bank reserves on the liability side of the Fed balance sheet increases by $100 billion.

Ex. 2
Fed action:
Fed sells $100 billion of Treasuries
Asset side of the Fed balance sheet decreases by $100 billion in the Treasuries category. Bank reserves on the liability side of the Fed balance sheet decreases by $100 billion.

Thus, you can see how the Fed expands and contracts its balance sheet. The Fed has conducted a myriad of lending and purchase programs since the onset of the financial crisis. However, until September of last year, the Fed was sterilizing these injections by selling treasuries from its portfolio. These Fed asset sales drain reserves from the banking system, which in this case offset the other purchases that were made. So, the net effect was that the Fed was mostly swapping good debt (treasuries) for questionable debt (various securities held by the banks that were not receiving bids in the free market) ... with the amount of unsterilized injections exactly enough to achieve the falling federal funds rate target. The Fed ceased its reserve neutral policy last September and flooded the system with reserves over the next four months. Reserve levels have been mostly maintained since the end of last year (ranging between $700 billion and $932 billion with normal being between $10 and $20 billion).

Managing a balance sheet of this size and diversity is much more involved. Reserves have been fluctuating due to the cessation of certain programs (drains reserves), the introduction of new ones (injects or drains reserves depending on the program), increases or decreases in the amounts of assets purchased or currency swaps with foreign central banks (injects or drains reserves), and the maturing of Fed assets (drains reserves). Additionally, the average maturity of assets held by the Fed continues to rise, making an ultimate exit strategy even more interesting (interest rate risk). The principal measures introduced this year by the Fed include the outright purchase of longer dated treasuries, the purchase of mortgage-backed securities (MBSs) backed by Fannie Mae and Freddie Mac (Agency MBSs), and Agency debt itself. Thus far the Fed has purchased more than $213 billion of the $300 billion it may purchase under the current treasury purchase program. The Fed has purchased $545 billion in MBSs ($1.25 trillion max) and $102 billion in Agency debt ($200 billion max). The following link provides a nice graphical view of the asset side of the Fed balance sheet ... [See WSJ Blogs: Real time Economics] The Federal Reserve Bank of Cleveland also provides a nice detailed overview in graphical form [See Credit Easing Policy Tools]

What is so alarming about the level of excess reserves in the banking system? As stated many times in prior articles, quite simply the potential for serious inflation and a future boom/bust cycle worse than the one we are currently experiencing. The monetary base (outstanding currency in circulation + bank reserves) sits at about $1.673 trillion. This is approximately where it was at the end of last year, but double that of a year ago. However, narrow money supply growth remains tepid this year. The amount of lending in the system is mostly being offset by debt repayment (which is deflationary). As of the end of June, M1 has grown only 1.92% since the end of last year. M1 actually had negative growth from the end of last year through May. M2 growth since the end of last year has been tepid as well (2.31%). But the money supply will increase once the banks feel it is safe to ... 1) Lend these vastly increased reserves and/or 2) Invest these reserves in other securities (Ex. treasuries) ... and are less encouraged by the Fed to keep their reserves on deposit (via the payment of interest on required and excess reserves held by depository institutions). The key here is to watch the banks. They know the quality of their balance sheets and will engage once they are comfortable with their own capitalization levels, feel that the economy is turning, and the yield spreads are there. For the time being, they are comfortable with the slow recapitalization of the banking system being conducted by the Fed (it is all about buying time), at the ultimate expense of the taxpayer. Of course, a timely Fed exit is supposed to mitigate this potential future inflationary problem. Given the track record of the Fed (and more importantly, the difficulty of such timing), I am not optimistic in this regard.

Now that we have discussed the size of the Fed balance sheet, we should address quality. It is important to note that the asset side of the Fed balance sheet is what underpins the outstanding currency in our system, the bank reserves, and ultimately our money supply. Thus, the quality of these assets (and as you will see later, the current value of these assets) is of real importance. It would be an understatement to say that the quality of assets held by the Fed has declined since the onset of the financial crisis. What was once principally treasuries backing our money is now of considerably lesser quality. These currently held assets include Agency MBSs, Agency debt, various loan programs where the Fed takes similar assets as collateral, foreign currency swaps, and of course treasuries. The Fed also holds Gold as an asset, but this only amounts to about $250 billion at current prices (it is represented at $42.22/oz. on the Fed balance sheet). It will not be long until the amount of MBSs surpass the amount of treasuries held by the Fed. So, keep this in mind as we review Bernanke's exit strategy.

Exit Strategy?

Bernanke wrote an Op-Ed in the Tuesday (7/21) edition of the Wall Street Journal. The purpose of this editorial was to assuage investors that the Fed in fact does have a plan to withdraw the immense amount of reserves injected by the Fed during this crisis. The editorial can be found here ...

Candidate tools outlined in Bernanke's exit strategy:

  • Supplementing interest paid by the Federal Reserve on bank reserves on deposit with the Federal Reserve
  • Execution of large scale reverse-repurchase agreements 
  • Issuance of new Treasury debt with the proceeds deposited at the Federal Reserve
  • Offering interest bearing term deposits to banks
  • Asset sales from Federal Reserve holdings

All of these options drain reserves from the banking system. However, most are more temporary in nature. The only new option outlined by Bernanke is the Federal Reserve offering term deposits to banks (#4 above). As discussed, the Fed already pays interest on required and excess reserves held by depository institutions, which is essentially the Fed borrowing from the public. Since a market for lending/borrowing federal funds is offered daily, the banks can choose to leave their reserves on deposit with the Fed and earn interest (currently 0.25%) or lend in the federal funds market (typically paying less than 0.25%). Offering term deposits would simply lock up these reserves for a longer period of time, allowing some of the planning variables in the Fed equations to become more constant. But this option is still only temporary and it is one that costs the taxpayers (via smaller Fed payments to the Treasury). Raising the interest rate paid on reserves (term and non-term) will provide more aid to the banks, but determining the correct rate of interest that will sterilize these reserves (without going overboard) will be very difficult and bias will likely be to the inflationary side (lower rate of interest). This rate will put somewhat of a floor under the federal funds rate. The exception to this floor is that there are non-depository institutions (Ex. Fannie Mae, Freddie Mac, non-bank primary dealers) that participate in the federal funds market, but are not eligible to receive interest on reserves. Hence, they may undercut the rate paid on reserves which results in a nice arbitrage opportunity for the banks.

Executing large scale reverse-repurchase agreements are certainly temporary (#2 above). When the Fed closes this transaction, it will inject reserves (actually, slightly more than originally drained) back into the system. The Fed is already engaged with the Treasury in the Treasury Supplemental Financing Program (TSFP) (an implementation of #3 above). Here, the Treasury auctions debt and deposits the proceeds with the Fed in a special Treasury account (represented as a Fed liability). This drains reserves from the banking system as the Treasury is not a depository institution and is in effect the Treasury borrowing on behalf of the Fed. However, the reserves flow back into the system when these auctioned securities mature. This program reached a peak of about $559 billion last year. But these auctions have ceased and the maturation of these securities has left a balance of about $200 billion. Operating this facility again will only add to the amount of debt the Treasury will need to auction in the coming quarters. You also have the issue of losing even more Fed independence from the government (Treasury) as it depends on the Treasury to execute such a program.

But I want to focus more on the last item above (#5) as it is not being discussed in terms of the quality of assets being held by the Fed. The assumption has been that the Fed will be able to drain all (or most) of the reserves it originally created. But since the Fed is going further out on the yield curve with treasuries, it is more susceptible to interest rate risk. If the Fed were to drain reserves by selling these longer term treasury assets (which would also put upward pressure on interest rates), the price that these assets would fetch would quite likely not be enough to drain the amount of reserves originally created when it purchased them.  Also as I have previously discussed, the composition of the balance sheet is getting shakier. I think that this may ultimately be the larger problem, as opposed to the sheer size. This may become a serious problem as MBSs, longer term treasuries, and other assets held by the Fed decline in value relative to their inflated purchase price (especially as the Fed commences the selling of these assets and interest rates rise). In other words, simply the Fed saying that it will execute a proper exit strategy (draining the reserves it created) is not enough with the prices of their assets falling.  Meanwhile, much more debt remains to be auctioned (both domestically and globally). There will be much competition for scarce funds globally, which will place upward pressure on interest rates. Thus, the Fed will likely find itself in a position where the assets it holds are falling in price while it needs to assist the Treasury market by purchasing treasury debt ... which will add reserves to the banking system making a successful execution of the Fed exit strategy even more difficult. I think that eventually, another option may surface, but will require congressional approval. I have discussed it in prior missives ... the issuance of Federal Reserve interest bearing debt (which would compete with Treasury debt).

Even if all of the above works nicely in favor of the Federal Reserve (quite unlikely), there is always the issue of timing. If the Fed is late in draining these massive reserves (and "late" probably needs to happen if we are to have an economic rebound ... albeit false and temporary), the banks will already have expanded the money supply (maybe considerably) and we will experience an unhealthy dose of inflation which could lead to serious price inflation and another asset bubble - See: SPDR Gold Trust (GLD). Can anyone cite a time when the Fed timing has been correct? I cannot.

Related: GLD, TBT

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