In all the recent hoopla over Excess Reserves and spurious rumors over whether or not they should generate any form of interest (readers will recall a key catalyst for a surge in the market two weeks ago was the expectedly false rumor that Bernanke would announce the elimination of any IOR (Interest Paid On Reserves) rather than keeping the even current minimal 0.25% rate), everyone seems to have forgotten that old staple: the Discount Window. And probably logically so: while the Excess Reserve issue is one that deals with excess liquidity in the banking system (by definition: otherwise it would be lent out to consumers), Discount Window-related concerns deal with the opposite, or a liquidity deficiency. Logically, the two are mutually exclusive: near record excess reserves held with Federal Reserve Banks simply means that banks are not in any want for money (of any term, but most specifically ultra-short term).Looking at the Fed's H.4.1 statement confirms that for the week ended July 29, the Fed's Primary Credit facility (aka the current version of the Discount Window, together with the Secondary Credit and the Seasonal Credit Facility) usage has plummeted to just $11 million: a negligible number for a "rescue facility" that at the peak of the crisis saw more than $100 billion in overnight borrowings. The finding is not surprising, when considering that the rate on the Primary Credit Facility is 0.75%. As this is higher than the rate on the 2 Year Treasury, there is very little banks can do in reinvesting capital that is more expensive than even long-term funding sources. In other words, with well over a trillion in Excess Reserves, banks are becoming increasingly self-funding, at least in the medium term, and seek to disintermediate themselves from the Fed. In looking at the same problem, but from the perspective of the IOR, the Atlanta Fed concludes: "One broad justification for an IOR policy is precisely
that it induces banks to hold quantities of excess reserves that are
large enough to mitigate the need for central banks to extend the
credit necessary to keep the payments system running efficiently. And,
of course, mitigating those needs also means mitigating the attendant
risks." An environment in which banks are increasingly leery of relying on the Fed for funding, irrespective of whether IOR at 0.00% or 0.25%, is not one in which consumer should expect to see any incremental lending any time soon.
The chart below shows discount window borrowings since 2007, combing the Primary and Seconady Credit facilities.
A glance at the other side, or the Fed's "excess liquidity" liabilities, reveals that while Excess Reserves have declined by almost $200 billion since their peak of $1.227 trillion on February 24, to the current $1.045 trillion, the balance has been more than made up by the Deposits with FR Banks other than Reserves, which during the same period has more than offset the Excess Reserve decline, climbing from $45 billion to $250 billion. Indeed, as the chart below demonstrates, banks continue basking in the glow of the Fed liquidity excess, whether they collect 0.25% on this capital or not. While the $205 billion increase in the latter category deserves an analysis of its own, we will put that off to a future date.
Combining the two charts yields the following observation: there are three distinct regimes visible: the first one pre Bear Stearns, was one in which the ratio of Primary Credit Borrowings to Excess Reserves was negligible. Then, at the collapse of Bear (blue shaded area), the ratio of Discount Window Borrowing to Excess Reserves surged to over 100%, at its peak hitting 250%: this was Regime 2. However, Regime 2 promptly ended when Lehman also failed, pushing the ratio back to historical levels, as Excess Reserves took off to offset for the massive surge in Fed "assets" as part of QE 1.0. With the most recent reading, the ratio of the two is back to 0.0%.
So what happens next?
If, as Bullard expects, QE 2 is imminent, then the assets imminently purchased by the Fed will result in yet another massive offset of Excess Reserves: in other words, should QE 2.0 prove to be about $2-3 trillion, all of a sudden banks will find themselves depositing instead of $1 trillion in cash with the Fed, anywhere between $3 and $4 trillion. When one considers the FRNs in circulation are less than $1 trillion (as the other main Fed liability), and this relationships starts to get problematic. If the Fed has difficulty explaining why banks are unwilling to lend to consumers when there is over $1 trillion in cash sitting and collecting dust, or 0.25% as it is technically known, the problem gets even thornier when Bernanke (and Jamie Dimon) have to defend 4 times this number. Surely, the US consumer will demand that banks open up the spigot and provide cash to everyone no matter what their creditworthiness, simply as a result of all the excess money floating around. Will lowering the IOR to 0% at that point help? Not at all due to massive problems such a move would create in the shadow banking system. Very much contrary to expectations of lowering the IOR to 0%, Bernanke in fact provided reasons for why such a move would make no sense:
"… Lowering the interest rate it pays on excess reserve—now at 0.25%—could create trouble in money markets, he said.
" 'The rationale for not going all the way to zero has been that we want the short-term money markets, like the federal funds market, to continue to function in a reasonable way,' he said.
" 'Because if rates go to zero, there will be no incentive for buying and selling federal funds—overnight money in the banking system—and if that market shuts down … it'll be more difficult to manage short-term interest rates when the Federal Reserve begins to tighten policy at some point in the future.' "
In other words, all those who say QE2.0 will do nothing to stimulate the economy are correct, as all such a greenlighted action would encourage is the warehousing of yet more cash by banks. And since banks have no incremental incentives to lend it out, it doesn't matter if the Fed's liabilities are $2.5 trillion or $2.5 quadrillion. Instead of stimulating inflation, which is the end goal, all such an action would do is to create further doubts about the stability of the dollar, which in turn, as Ambrose Evans-Pritchard discussed, is a sure way to go to hyperinflation without first passing either Go, or inflation. Hyperinflation: not in the sense of a pull-driven rise in prices from cheap consumer credit, but a complete collapse of faith in the monetary unit of exchange, likely predicated by a rush to physical commodities and a collapse in the paper system supporting the forced shorting of commodities such as gold. And with Treasuries yielding next to zero courtesy of the expectation of the Fed becoming the end buyer for all paper, and stocks surging to infinity, on the assumption that the Fed will not allow the failure of any risk assets, the end result will be the most divergent market in history, in which both inflation and deflation are priced at the very margins with no gray area inbetween (a theme we have been observing increasingly more often on the pages of Zero Hedge). While that may be good in the short-term for long-only holders of any asset classes, in the medium run (not to mention long), it means the end of the financial system, as the Fed will be caught in a Catch 22 whereby it needs to sustain the perception that it will print into infinity to maintain the divergence, or else the convergence will be one of catastrophic proportions. Of course, even the continued decoupling between inflation and deflation will ultimately eat away at the core of the monetary system, resulting in the complete destruction of the dollar. And with both inflation and deflation priced in at the extreme margin, the only sure alternative will be non-paper based forms of exchange. And unless someone can come up with a substitute to the 2,000 year old legacy cash alternative of gold, it is obvious what real asset class will benefit at the end, as society once again reverts from a monetary system to something far simpler, and far less encumbered by the scourge of any society that are Central Banks.