Several readers have ask me to comment on a King World interview of Michael Pento.
Before I offer my comments on Pento's thoughts, let me say upfront that Eric King is a world-class interviewer. King lets his interviewees have their say, no matter what it is.
It is up to listeners to decide whether the message makes any sense or not. King merely wants the position to be well stated.
Email Request From US
Hello Mish:Email From Down Under
Have you listened to Mike Pento's scenario where the FED will cease to pay interest on reserves held at the FED, as a result, forcing banks to loan out the money to seek some return. He believes that they will be encourage to purchase US treasuries:
Is this viable and/or probable?
Thanks for providing us with such a great blog.
All the best,
Dear MishPrimer on Bank Lending
I follow your work from Australia with great interest. I was impressed with your argument that the creation of new money will not lead to price increases because it is deposited with the Fed, and does not make it into the real economy.
You will no doubt be aware of recent comments by Michael Pento on King World News that the Fed is about to eliminate the incentives for the banks to deposit excess reserves with the Fed, and that this will force the banks to lend in the economy and cause significant inflation, and presumably a drop in the USD.
I would be greatly interested in your views on this, as a deflationist, because if Pento is right then the reason for deflation over inflation might be eliminated. Furthermore, the worsening in key stats such as auto sales and official unemployment might just be the trigger that forces the Fed to squeeze the money out into the economy.
The underlying premise of the first proposition is that bank reserves are needed for banks to make loans. An extreme version of this view is the text-book notion of a stable money multiplier.Lending Theory
In fact, the level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans.
The main exogenous constraint on the expansion of credit is minimum capital requirements.
A striking recent illustration of the tenuous link between excess reserves and bank lending is the experience during the Bank of Japan’s “quantitative easing” policy in 2001-2006.
Japan's Quantitative Easing Experiment
click on chart for sharper image
Despite significant expansions in excess reserve balances, and the associated increase in base money, during the zero-interest rate policy, lending in the Japanese banking system did not increase robustly (Figure 4).
Is financing with bank reserves uniquely inflationary?
If bank reserves do not contribute to additional lending and are close substitutes for short-term government debt, it is hard to see what the origin of the additional inflationary effects could be.
As I predicted as far back as June of 2010, the Fed will soon follow the strategy of ceasing to pay interest on excess reserves.Emphasis his.
Since October 2008, the Fed has been paying interest (25 bps) on commercial bank deposits held with the central bank. But because of Bernanke's fears of deflation, he will eventually opt to do whatever it takes to get the money supply to increase. With rates already at zero percent and the Fed's balance sheet already at an unprecedented and intractable level, the next logical step in Bernanke's mind is to remove the impetus on the part of banks to keep their excess reserves laying fallow at the Fed. Heck, he may even charge interest on these deposits in order to guarantee that banks will find a way to get that money out the door.
Commercial banks currently hold $1.42 trillion worth of excess reserves with the central bank. If that money were to be suddenly released, it could through the fractional reserve system, have the potential to increase the money supply by north of $15 trillion! As silly as that sounds, I still hear prominent economists like Jeremy Siegel call for just such action. If they get their wish, watch for the gold market to explode higher in price, as the U.S. dollar sinks into the abyss.
The cut in the interest rate was meant to convince banks to stop parking money, to lend more, to get more money into the system and make it more stable - in Wall Street parlance, to add "liquidity."JP Morgan alone pulled $29 billion in assets.
But the backlash from banks shows that they're willing to close money market funds rather than lose profits. The effect, ironically, is to reduce liquidity in the financial system.