Excess Reserves, One-Year Treasury Constant Maturity Rate,
Interest Rate on Excess Reserves

"The everyday tools of monetary policy are about to shift. The old standard tools of monetary policy taught in every intro econ class – open market operations, altering discount rates, and adjusting reserve requirements – all depend on banks that don't want to hold lots of excess reserves. When banks are holding a few trillion dollars in excess reserves, other policy tools are needed, and the Fed has already announced that monetary policy in the future will be conducted using the rate of interest that it chooses to pay on bank reserves as its primary tool for monetary policy, and secondarily by using its new reverse repo facility." – Timothy Taylor, Conversable Economics

As you can see in the chart above, the rules of the game changed in advance of the Fed's December, 2015 interest rate increase. The free market forces, unleashed by global selling of U.S. Treasuries, immediately began pushing rates higher. Most importantly, note in the chart that after 2015 the interest rates on one-year U.S. Treasuries – a proxy for interest rates in general – consistently traded above the static rate the Federal Reserve paid on excess reserves. The commercial banks now had strong incentive to begin converting excess reserves into new lending – an incentive that remains in play now.

Excess reserves and bank credit

Capital in the modern fiat money system is borrowed into existence. For monetary policy to induce growth, consumers and businesses must be willing to borrow and banks must be willing to lend. Then and only then can growth and economic recovery begin. This chart demonstrates that banks have been successful in placing loans and that consumers and businesses are in fact willing to borrow.

There are three features in this chart worth special emphasis:

- First, the commercial banks steadily reduced excess reserves from October, 2015 when the Fed first suggested that it was about to raise interest rates.

- Second, bank credit* accelerated from early 2014 just before excess reserves began to flow from the Fed's balance sheet and back to the commercial banks. It gained momentum after the Fed actually raised its target for interest rates by .25% in December, 2015 and again in December, 2016 – the second and third time in a decade it moved to push rates higher.

- Third, there is a clear divergence between excess reserves and bank credit demonstrating the direct connection between the two. As excess reserves were drawn down, bank credit went up.

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* Bank credit consists of the aggregate in loans extended system-wide by U.S. commercial banks to businesses, individuals and the federal government.

The redeployment of $700 billion in excess reserves has precipitated some interesting knock-on economic effects in other areas of the economy including a burgeoning money supply. Note the divergence in the chart above beginning in 2014. As excessive reserves are drawn down, money supply goes up – a clear indication of the correlation between excess reserves, bank credit, the money supply. . . .and ultimately, inflation. Famed monetary economist Milton Friedman stated that there was an average 23-month lag between the creation of money and when it showed up as monetary growth in M2. It is interesting to note that the commercial banks' first drawdowns in excess reserves occurred in early 2014 and, right on schedule, by late 2016 M2 had registered a 7.6% annualized gain.

Of course, the ultimate end result of monetary policy is the effect on employment and prices. As you can see in this chart, producer (or wholesale) prices noticeably have begun to move higher. Note the divergence between excess reserves and producer prices beginning in December, 2015 – a clear indication of the correlation between the two charted data sets. Inflation's return has not received a great deal of attention in media financial reports. Once it again becomes a regular topic in the business news, consumer spending habits and investment patterns are likely to change.

As pointed out in the previous newsletter on this subject (linked here), the price inflation that normally would have occurred as the result of the massive money printing scheme following the 2008-2009 financial crisis was sterilized and parked on deposit at the Federal Reserve in the form of excess reserves. As such, monetary inflation was quarantined for a time but not permanently sidelined. Now, as this series of charts demonstrates, that process has gone into reverse with quick and predictable results. Inflation has suddenly become an issue once again. The above chart shows the tight correlation since 2000 between gold and producer prices.

Looking to the future

"We had initially asked to pay interest [in 2006] on reserves for technical reasons. But in 2008, we needed the authority to solve an increasingly serious problem: the risk that our emergency lending, which had the side effect of increasing bank reserves, would lead short-term interest rates to fall below our federal funds target and thereby cause us to lose control of monetary policy. When banks have lots of reserves, they have less need to borrow from each other, which pushes down the interest rate on that borrowing — the federal funds rate." Ben Bernanke, The Courage to Act

Though it is too early to know with any certainty whether or not the tide has turned on the disinflationary economy, these changes in the monetary landscape are worth noting and monitoring. The telling part of the quote above is Ben Bernanke's concern about losing control of monetary policy. Since the crisis period he references, new threats to the Fed's preeminence have made their way into the monetary mix – the global liquidation of U.S. Treasuries which has had a direct effect on interest rates, and the commercial banks' drawdown of excess reserves which has had a direct effect on bank credit and the money supply.

As long as the Fed continues its policy of raising rates slowly and incrementally, the demand for U.S. Treasuries from overseas investors, including foreign central banks and governments, will remain subdued and, in fact, encourage liquidations. (China, for example, has liquidated roughly $1 trillion of its reserves over the past year.) Those liquidations, in turn, will continue to push rates higher in a kind of self-reinforcing feed-back loop. As for the future flow of excess reserves out of the central bank, the top commercial banks – all publicly owned – have as their primary mission the pursuit of profit in the best interest of their stockholders. As long as they are able to receive a consistently higher interest rate on their lending by drawing down their excess reserves, it is their responsibility to do so.

The only way for the Fed to interfere in both processes would be to get ahead of the interest rate curve by consistently pushing the fed funds rate above the rate established in the free market. To do so at this juncture, however, would send the wrong signal to the financial markets and would kill any semblance of recovery already set in motion. In addition, it would thwart the Fed's own attempt to counter disinflationary/deflationary trends at work in the U.S. economy.

In short, the baton has clearly passed, at least for the time being, to the commercial banks and global sellers of U.S. debt. The former will be a key determinant in money creation and the latter a key determinant in setting interest rates. When seen in this context, Mr. Bernanke's concerns about the Fed losing control of monetary policy appear to have been warranted.

At the moment investors are focused on the political aspects of the "reflation trade" as it is dubbed by the mainstream media, i.e. the fiscal and tax policies proposed by the Trump administration. These policies though come with a long fuse. It will take many months for the Trump administration to push its agenda through Congress (if at all). After that, it will take many more months for any resulting legislation to be implemented (particularly in the case of fiscal spending), and more time still before it actually takes effect in the economy.

In the meantime, as the sequence of charts above demonstrates, the excess reserves situation and related activity of the Federal Reserve System present a more immediate and direct avenue to reflation of the economy. In fact, the effects of that effort are already being felt.

Gold's role in all of this – "No one questions its value."

In a recent World Gold Council interview, Alan Greenspan made the following comments on gold's portfolio role under an inflationary/stagflationary economic scenario:

"Significant increases in inflation will ultimately increase the price of gold. Investment in gold now is insurance. It’s not for short-term gain, but for long-term protection. I view gold as the primary global currency. It is the only currency, along with silver, that does not require a counter-party signature. Gold, however, has always been far more valuable per ounce than silver.

No one refuses gold as payment to discharge an obligation. Credit instruments and fiat currency depend on the credit worthiness of a counter-party. Gold, along with silver, is one of the only currencies that has an intrinsic value. It has always been that way. No one questions its value, and it has always been a valuable commodity, first coined in Asia Minor in 600 BC."

Gold is not like other assets that depend upon another individual or an institution’s performance for value.  It  stands alone, and as Greenspan states without mincing words:  “No one questions its value.”  It is for those reasons that gold protects wealth no matter the economic malady visited upon the economy – inflation, hyperinflation, disinflation, stagflation, runaway stagflation and deflation.  It is the ultimate armchair investment – the one asset you can rely upon no matter what happens politically or economically.

That said, Greenspan believes stagflation and runaway inflation to be the two primary portfolio menaces that need to be hedged for the future. Here is what he said in that same World Gold Council interview:

"As productivity growth slows down, the whole economic system slows down. That has provoked despair and a consequent rise in economic populism from Brexit to Trump. Populism is not a philosophy or a concept, like socialism or capitalism, for example. Rather it is a cry of pain, where people are saying: Do something. Help!

At the same time, the risk of inflation is beginning to rise. In the United States, the unemployment rate is below 5%, which has put upward pressure on wages and unit costs generally. Demand is picking up, as manifested by the recent marked, broad increase in the money supply, which is stoking inflationary pressures. To date, wage increases have largely been absorbed by employers, but, if costs are moving up, prices ultimately have to follow suit. If you impose inflation on stagnation, you get stagflation."

Investors last tangled with these twin dangers in the 1970s. Here is one last chart, and an important one, that shows gold's performance superimposed over the producer price index during that period.  As you can see, while producer prices increased 2.5 times, gold rose by nearly 21 times.  This chart tells, at a glance, the value of diversifying with gold and goes to the heart of the point Dr. Greenspan is making. (The Dow Jones Industrial Average over the same period gained only about 16%.) I might add as a final caution that runaway inflations rarely come in like a lamb, but more like a lion – suddenly and with a full-throated roar. In that respect, the near double-digit 8% annual gain in wholesale prices this past January might have been a clear warning shot across the bow.

(Pictured above: Lydia gold stater, King Croesus, 561-541 BC, electrum (blend of silver and gold), ‘heavy’ stater specimens bring upwards of $30,000 in top grades. This specimen is from the British Museum collection and reproduced with permission.)

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Michael J. Kosares is the founder of USAGOLD and the author of "The ABCs of Gold Investing - How To Protect and Build Your Wealth With Gold." He has over forty years experience in the physical gold business. He is also the editor of News & Views, the firm's newsletter which is offered free of charge and specializes in issues and opinions of importance to owners of gold coins and bullion. If you would like to register for an e-mail alert when the next issue is published, please visit this link.

Disclaimer - Opinions expressed on the USAGOLD.com website do not constitute an offer to buy or sell, or the solicitation of an offer to buy or sell any precious metals product, nor should they be viewed in any way as investment advice or advice to buy, sell or hold. USAGOLD, Inc. recommends the purchase of physical precious metals for asset preservation purposes, not speculation. Utilization of these opinions for speculative purposes is neither suggested nor advised. Commentary is strictly for educational purposes, and as such USAGOLD does not warrant or guarantee the accuracy, timeliness or completeness of the information found here.