Fed Planning 15-Fold Increase In US Monetary Base
Friday, March 20, 2009
Fed Planning 15-Fold Increase In US Monetary Base
by Eric deCarbonnel
The fed is planning moves that would more than double its balance-sheet assets by September to $4.5 trillion from $1.9 trillion. Whether expressing approval or concern over the fed’s intentions, most commentators fail to understand the real magnitude of the projected expansion of the US monetary base because they don’t take into account the amount of dollars circulating abroad.
At least 70 percent of all US currency is held outside the country, and this means the US monetary base is considerably smaller than the fed’s overall balance sheet. Take, for example, the true US domestic money supply at the beginning of September 2008, before the fed started its quantitative easing. From the Federal Reserve’s website, we know that currency in circulation was 833 Billion. This translates as 583 Billion dollars circulating abroad (70 percent), and 250 Billion dollars circulating domestically (30 percent). Since the bank reserve balances held with Federal Reserve Banks were 12 billion, that gives us a 262 Billion domestic monetary base as of September 2008. Now compare that to the projected US domestic monetary base for September 2009 which is 3,818 billion (4,500 billion – 583 billion (dollars circulating abroad) – 99 billion (other fed liabilities not part of the money supply)). The fed’s planned balance sheet expansion results in a 15-fold increase in the base money supply.
262 Billion = US monetary base as of September 2008 (minus dollars held abroad)
3,818 Billion = projected US monetary base in September 2009 (minus dollars held abroad)
3,818 Billion / 262 Billion = 15-Fold Increase in US monetary base
This is a staggering devaluation of the US currency! It means that for every dollar in America in September 2008, the fed is going to created fourteen more of them! Below is a rough sketch of what this Increase in US monetary base would look like:
http://3.bp.blogspot.com/_EZMGVwURo3...2v2-782789.gif
This 15-Fold Increase will be impossible to reverse
Next September, when the fed realizes it has gone too far and tries to reverse its balance sheet expansion, it will be unable to do so. The realities which will hinder the fed’s control of the money supply are:
1) The toxic assets filling its balance sheet
Expanding the money supply is easy. All the fed has to do is print dollars and then use them to buy assets. There is no effective limit to how much the fed can print and spend.
Shrinking the money is much trickier. To shrink the base money supply, the fed sell assets and takes the dollars it receives for them out of circulation. The amount the fed can shrink the money supply is therefore effectively limited by the market value of assets on its balance sheets. Since the fed is in the process of loading up on toxic securities while trying to restore health to the financial sector, it is now sitting billions of unrealized losses. These unrealized losses means the fed has little ammunition available to bring the money supply under control.
Once September rolls around, If the fed wants to reverse the expansion of its balance sheet and shrink the monetary base back down from 3,818 billion to 262 billion, then it will need to sell 3,556 billion worth of assets. However, the market value of its assets will only be worth a fraction of that.
2) Political constrains on fed's actions
Even if the fed does try to shrink the money, it is likely to run into political constrains on its actions:
A) Selling toxic assets at a loss could become a crippling source of major embarrassment for the fed, undermining its authority. For example, last year when the fed took 29 billion toxic assets to help JPMorgan’s takeover of Bear Stearns, it assured Americans that by holding those securities till maturity, the cost to taxpayers would be minimal. If the fed sells those toxic Bearn Stearns assets at a catastrophic loss, it would cause fury and outrage from voters and lawmakers.
B) Selling assets at below book value will quickly cause the fed’s equity to turn negative. The Federal Reserve would then need to be recapitalized by new debt from the treasury, which would increase the national debt.
3) The benefits from of its balance sheet expansion would be lost if the fed starts selling assets
The fed is accumulating toxic mortgage backed securities, long term treasuries, and other assets to unfreeze the credit markets and spur economic growth. Turning around and selling those assets would result in the collapse of the credit markets and the financial system, which the fed has been desperately trying to prevent.
Upwards pressure on interest rates
On top of all the issues above, the fed’s woes are going to be compounded by upwards pressure on the yields of treasuries and other US debt. This upwards pressure will likely force the fed to monetize far more treasuries than the planned $300 billion purchases it has already announced, and will greatly complicate any efforts by the fed to control the money supply.
Below are the nine factors which will cause yields to move higher.
1) Massive supply of treasuries in the pipeline
The biggest force pressuring treasury yield upward is without a doubt the trillions of debt the treasury has to sell to finance the enormous 2009 budget deficit. There is nowhere near enough buyers to absorb this supply. The graph below demonstrates the challenge facing the treasury in funding this year’s budget.
http://3.bp.blogspot.com/_EZMGVwURo3...%5D-783305.jpg
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There is the mistaken belief that the role of treasuries as a safe haven is bullish for treasury bonds. It is not. This logic ignores the reality that reserve assets, such as treasuries, are accumulate in good times and sold in bad times:
Federal and state agencies will be selling treasury reserves. For example, the Deposit Insurance Fund (a.k.a. FDIC) will be selling treasuries to pay back depositors of failed banks, and the Unemployment Trust Fund will be selling treasuries to make payments to the unemployed.
State and local governments will be selling treasury reserves. As an example, states have already begun drawing down reserves as their budget troubles worsen. The bulk of those reserve remain, and they will be sold over the course of this year.
Banks and insurers will be selling off their treasury loan-loss reserves. Financial institutions have been building their treasury loan-loss reserve for the last year in anticipation of growing defaults. In 2009, this process will reverse as loans go bad and insurers make good on claims.
Foreign central banks will be selling off their treasury foreign reserves. Saudi Arabia, for example, is projecting a 2009 Budget Deficit, which it intends to finance by selling off its US holdings. Russia, meanwhile, has already sold over 20% of its $598.1 billion reserves, and India's central bank has been forced to sell off its US holdings to curb its currency's decline, and its total reserves have decreased by $62.2 billion. Japan, which is now running a record current account deficit, can also be expected to sell treasuries.
Even China could become a seller of treasuries as it mobilizes its dollar reserves. The Chinese government has sent clear signals that it is shifting from passive to active management of its reserve and is exploring more efficient ways to use its reserves to boost its domestic economy.
3) Retirement inflows into treasuries are over
The steady accumulation of treasuries by government retirement funds has helped absorb the supply of treasury bonds for over three decades. This accumulation of government debt to secure the retirement of baby boomers helped drive down treasury yields and fund deficit spending. As of September 2008, the four biggest of these funds held 3.3 trillion treasuries:
2150 billion (Federal old-age and survivors insurance trust fund)
615 billion (Federal employees retirement fund)
318 billion (federal hospital insurance trust fund)
217 billion (federal disability insurance trust fund) (for more on these four funds, see where social security tax amounts are deposited)
3300 billion total
Today, the accumulation of treasuries by government retirement funds is over. Baby boomers are beginning to retire, increasing outflows, and unemployment is rising, cutting inflows. More importantly, the 3.3 trillion already accumulated in these funds provides an enormous political incentive to prevent treasury prices from collapsing. Faced with a run on treasuries, politicians, rather than explaining to baby boomers that their retirement savings are gone, will instruct the fed to monetize treasury bonds. This alone will prevent the fed from reversing its current balance sheet expansion.
4) Deleveraging in credit-default swap market will drive up risk premiums
If you have been following the credit crisis in any detail, you might have heard that the 53 trillion credit-default swap market threatening the solvency of the financial system. What you might not have heard is the other dire threat posed by the CDS market: drastically higher risk premiums on all forms of debt.
These higher risk premiums are the result of reversing the process by which credit-default swaps were leveraged up and packaged into investment vehicles. Some examples of these horrors are:
Synthetic CDOs
As opposed to regular CDOs (which contain actual bonds), synthetic CDOs provide income to investors by selling credit-default swaps on hundreds bonds from companies and governments.
To juice returns, these synthetic CDOs disproportionally insured the riskiest AAA rated debt, such as Lehman’s bonds. Synthetic CDOs are estimated to have sold insurance on between $1.25 trillion to $6 trillion worth of bonds.
Constant-Proportion Debt Obligations
CPDOs are specialized funds which work exactly like synthetic CDOs but with one major difference: they used leverage to boost returns. These CPDO funds typically borrowed about $15 for every dollar invested with them. They also contain safety triggers that force the liquidation of their investments if losses reach a predetermined level, and most CPDO funds have begun to hit these triggers. For example, Three CPDO funds launched in 2006 by Dutch bank ABN Amro Holding NV have already been forced to liquidate as credit insurance costs spiked and their credit ratings were downgraded.
Credit Derivative Product Companies
CDPPs are another group of specialized funds which work exactly like synthetic CDOs and CPDO funds, except for one key difference: they used an insane amount of leverage, as much as $80 for every dollar invested. CDPP funds together with subprime CDOs squared are finalists for the title of “most idiotic financial instrument ever createdâ€
