In a lead op-ed editorial in the Wall Street Journal on July 21, 2009, Federal Reserve Chairman Ben Bernanke revealed the Fed’s exit strategy with regards to the inflationary effects of the Obama “spending is stimulus” packages and other government measure to contain the current crisis. This article is mandatory reading for anyone interested in the future of the US economy.

First of all, the Federal Reserve Bank does not foresee inflation as a problem in the immediate future:

As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period.

This seems to reflect the Carter-era mistake of confusing economic recovery (measured in terms of employment and business activity) with inflation.

Flawed dependence on “managing” depository reserve balances

The most powerful tool that a central bank has to sop up money created by excessive government spending is to increase mandatory, non-interest-bearing reserve requirements of depository institutions. This method has the potential of effectively “sterilizing” money that the government deposits in bank accounts in payment of imprudent Congressional spending, while reducing interest charges on government deficits.

In the United States, however, in response to lobbying of the banking industry, plus regulatory confusion between banking and the securities market, the Federal Reserve’s powers in this area have been dramatically reduced.

1. Most “bank deposits” are now with money market funds, rather than banks, thereby escaping Federal Reserve control. (See: Money Market Funds will tell us when inflation is here. )
2. Since the early 1990s, mandatory bank reserves have fallen sharply. In 1990, reserve requirements on large time deposits were eliminated. In 1992, reserve requirements on transaction accounts were reduced. Banks have introduced “sweep accounts” which automatically transfer funds from regular deposit accounts to time deposits or money market funds, both exempt from reserve requirements.
3. The largest portion of mandatory reserve requirements that now remain are relative to vault cash or purely operational needs of banks, having little effect on the money supply.

For the Federal Reserve to effect changes that would restore its powers to neutralized excess government spending, it would need to go before Congress and obtain such authority. There are four formidable barriers to restoring such powers:

1. Opposition from the powerful banking lobby.
2. Opposition from factions seeking to reduce Federal Reserve power in general.
3. Opposition from undeclared factions favoring “easy money” and currency devaluation as a means of reducing debt burdens on a profligate population.
4. Opposition from the securities industry and securities regulators who will fight to keep money market funds away from the powers of the Federal Reserve.

Perhaps recognizing the impracticality of having anti-inflationary powers restored by Congress, Chairman Bernanke has focused on using the newly granted powers of paying interest on bank reserve requirements as a means of controlling the money supply.

In other words, Bernanke has effectively taken “The Nuclear Option” off the table as a tool to fight inflation. (See: How the US may avoid inflation: The Nuclear Option. )

Bernanke’s false hope: fiddling interest rates on bank reserves

According to Chairman Bernanke’s WSJ article, the primary inflationary threat comes from excess bank deposit with the Federal Reserve resulting from government actions taken to stimulate the economy in the early stages of the crisis.

These emergency reserve-producing actions consist of such things as the Fed acquiring securities and loans from banks to provide liquidity support in the immediate crisis. Such amounts on the Fed balance sheet are now more than $800 billion above “normal” levels. Of course, these balances must be worked off.

However, most of the Obama “spending is stimulus” measures have not yet reached the stage where funds have been disbursed. As this happens, money will enter the banking system and will be swept into money market funds and time deposits, exempt from Fed banking reserve requirements. Money market funds in particular are a parallel banking system outside of Fed control. With no reserve requirements, while presenting all the features of demand deposits, these funds have the potential to be highly inflationary due to the “multiplier effect”.

Chairman Bernanke’s plan is to use the newly granted power of paying interest on bank reserve requirements as a sort of free market enticement that will attract bank reserves to federal control. This, of course, has an obvious, glaring disadvantage compared to traditional mandatory non-interest bearing reserve deposits — the interest paid by the government will add to the government debt burden at a compound rate.

Increasing the interest rate on federal reserve deposits will contribute to higher interest rates throughout the economy — a typical effect of inflation, while increasing the cost of doing business — a measure to reduce economic activity. In other words, a recipe for stagflation.

Another problem with Bernanke’s formula is that unless the Fed takes decisive, believable actions against inflation, primary buyers of government securities — holders of debt representing the accumulated trade deficit — will shun government securities and move into non-financial assets. (See: How long will it take to work off the US trade deficit?)

Finally, the Bernanke formula seems to ignore the fact that interest rates are not the sole, or even primary determinant of money flows in an inflationary environment. In an open, global economy, funds will flow out of the United States to economies with stronger currencies.

Of course, before we get to the point that inflation begins to kick in, management of the Federal Reserve may change — for better or worse. Furthermore, with the popularity of the Obama administration teetering over reactions to the “spending is stimulus”, “cap and trade”, and Obamacare packages, there is no assurance that current policies, for better or worse, will persist.

These are trying times.

We won’t have to consult the Consumer Price Index to know when the much feared Obama-inflation monster has finally arrived to devour what savings we have left. All that will be necessary will be to look at the average yield on short-term money-market funds.

In the 21st Century, money market funds are now the center of the short-term banking system — and are largely unregulated by the US monetary authorities.

In Q1 2009, total assets of money market mutual funds, according to Fed flow of funds table L.206, were $3.7 trillion, 5.6 times the $666.6 billion in checkable demand deposits with commercial banks. Demand deposits are now only 5.1% of commercial bank liabilities.

The MMF: the non-bank bank

Although money market funds are classified as securities and regulated by the SEC, rather than by the banking authorities, they are, in fact, a banking operation. They take money from “depositors”, with the understanding that it may be withdrawn at any time, on demand, by checks that are cleared along with drafts on commercial banks.

The “depositors” in money market funds do so with the understanding that they will be able to withdraw the amount deposited, plus a variable rate of interest, whenever they feel like it.

Of course, technically, “deposits” in a money market fund are not a liability of the fund, but rather equity in the form of shares, usually with a net asset value adjusted daily to a one dollar benchmark by issuing additional fractional shares in the amount of the interest earned in one day.

Like commercial banks, money market funds invest “depositors’” money in short-term loans, usually commercial paper.

However, unlike commercial banks, money market funds do not have to maintain reserves with the central bank, nor do they normally set up reserves for doubtful receivables. Furthermore, unlike commercial banks, their “deposits” are not guaranteed by the government (until the Crash of 2008).

For practical purposes, a money market fund is the same as a bank. A fund borrows short and lends long and promises to pay depositors on demand, principal plus interest.

An unfair advantage

Because money market funds do not maintain reserves with the central bank, they are able to pay substantially higher interest than available on demand deposits at commercial banks. Nor do money market funds normally offer drive-in tellers, night depositories, or the myriad other services that regular banks offer depositors.

In 1968, when the first money market fund was set up in Brazil, during the years of the economic miracle, the Minister of Finance quickly realized the dangers of this new instrument and slapped strict restraints on marketing.

However, three years later, when money market funds were introduced in the United States, the authorities did not perceive any potential problems, mainly because the instrument seemed to fall under the jurisdiction of the SEC, rather than the banking authorities.

In order to see systemic risk in a new product or operation, regulators must have multiple jurisdictional understanding, reponsibility, and authority. Because the SEC saw only the risks of investors losing money, they could not perceive the larger threat to the banking system.

The problem was, however, that banks, particularly savings banks, had legal limits imposed as to interest that could be paid on deposits. As the Jimmy Carter stagflation grew during the 1970s, and as asset-backed securities were invented to provide a virtually unlimited supply of short-term debt securities to the new money market fund industry, the position of savings banks became untenable.

Since savings bank assets consisted of long term mortgages with fixed interest rates, they were not able to raise rates on deposits to match the rise in short-term interest spurred by the inflation.

The result was the “great sucking sound” (as Ross Perot might put it) of savings bank deposits being transferred to money market funds.

Because American officials were not as smart as their Brazilian counterparts and were hog-tied in a tangle of conflicting regulatory jurisdictions, the savings banks were ultimately destroyed by unfair competition from money market funds, leading the savings and loan crisis of the 1980s and 1990s.

Short-term interest rates and inflation

When the first money market fund was set up in Brazil in 1968, the internal rate of inflation was about 25%. Six month to one year commercial paper, in retail denominations, yielded rates of from 28% to 32%. Interest on bank deposits were limited by usury laws.

As a result, the first money market fund was able to offer rates on what essentially were demand deposits, of about 24% — double commercial bank rates — and still charge an annual “administration” fee of 4% on fund assets! Because there are no capital requirements to manage a money market fund, the potential return on the equity of a money fund manager is virtually limitless. The only limit is marketing ability.

In these extreme circumstances, it is no wonder that the Brazilian authorities saw the dangers posed by the money market fund instrument and drastically reduced marketing options.

Years later, after the prudent ministers of the Brazilian miracle were gone, and as money funds had become popular in the US, the Brazilians copied the American example and allowed money market funds to flourish.

After the Crash of 2008 and the 2009 budgetary madness of the Obama-Pelosi-Reid team, we now look forward to the possibility of inflation rates in the United States to which most Americans have never been exposed. In this context, the regulatory status of money market funds becomes extremely relevant.

With inflation of 25% a year, or more, and with money market funds not subject to bank reserve requirements, the Federal Reserve will be unable to control the money supply.

The reason is simple:

1. At 25% a year inflation, long term bonds become worthless. To cover deficit spending, the Treasury will only be able to sell short term bonds. This will push short-term rates to extreme levels.
2. As the Treasury issues checks to pay for the Obama “spending is stimulus” plan, the money will leave commercial banks to be deposited in money market funds, which will have no reserve requirements and therefore will be able to pay much higher rates of interest than commercial banks.
3. As interest rates rise on short-term paper soar, money market funds will be able to charge higher and higher “administration” fees. With the demise of Glass-Steagall, banks will place depositors money directly in money market funds they control.
4. Without the control of reserve requirements on money market funds, the “multiplier effect” of these virtual banks will kick in, as the public moves money from one fund to another, and inflation will get really serious.

What this means is that unless the government cracks down on money market funds, placing them under virtually the same regulatory regime as commercial banks, including the ability to set reserve requirements that can be adjusted upwards as needed, the United States will be at risk of much higher inflation than many can imagine today.

So, what we must watch is the regulatory moves made on money market funds. So far, from the anti-inflationary point of view, noises made by the administration are not encouraging.

For the first year since 2001, investors moved back into money market mutual funds in 2005, with net sales of $127 billion. (See: Federal Reserve flow of funds account F206.)

The largest flows into money market funds came from U.S. households ($47.7 billion) and funding corporations ($58.4 billion).

The return of investors to money market funds was clearly the result of the Federal Reserve policy of increasing short-term interest rates, combined with the flattening of the yield curve due to buying pressure on longer-term fixed income securities resulting from the trade deficit.

Investment by funding corporations picked up in the last quarter of 2005 to an annual rate of $168.6 billion. Much of the money of funding corporations is connected to cash collateral held on short-sales of securities.

Presumably, collateral put up by speculators against long-bonds (gambling that long-bond prices would fall) was being channeled through funding corporations into money market funds, thereby helping to keep short-term rates down.

(See: “Just What Are Funding Corporations?“)