St Louis Fed Explains Why The Fed Has Cornered Itself Between Deflation And (Hyper) Inflation

Tyler Durden's picture

In its September Monetary Trends letter titled "The Monetary Base and Bank Lending: You Can Lead a Horse to Water…" the St Louis Fed analyzes the phenomenon that has all monetarists up in arms, namely the surge in the monetary base and the very muted increase (and outright alleged drop in the case of the M3) of monetary stock, going back to the core topic at every debate over hyperinflation/deflation: the money multiplier, and its current reading of well below 1. What is the reason for this discrepancy: as the St Louis Fed explains: "The answer centers on the willingness of depository institutions (banks) to lend and the perceived creditworthiness of potential borrowers. A deposit is created when a bank makes a loan. Ordinarily, bank loans—and hence deposits—increase when the Fed adds reserves to the banking system. How ever, despite an increase in reserves of over $1 trillion, total commercial bank loans were some $200 billion lower in May 2010 than in September 2008. Banks added to their holdings of securities, which resulted in a modest increase in deposits and the money stock, but many banks were reluctant to make new loans." And herein lies the rub: if and when the economy ever picks up, and at this point that looks like an event that may well never happen, "Many economists worry that bank lending and monetary growth will eventually surge and, ultimately, cause higher inflation." The backstops offered by the Fed looks increasingly more brittle: reverse repos and IOER. The longer ZIRP continues, the more aggressive the Fed will have to become if and when the money multiplier finally shoots higher. If prior examples of hyperinflation are any indication, this will not be a seamless or smooth process, which is why aside from the traditional calls for hyperinflation as a result of a collapse in the faith of the monetary system as a whole, many are also calling for this outcome should the Fed, paradoxically, stabilize the economy. And it is about to get worse: the Fed's balance sheet is likely about to grow by another $2 trillion as soon as QE 2 is announced. Which means that by the time the economy needs to remove excess liquidity, the Fed will need to find a way to remove not $2Bn, but probably double that number. The simple conclusion is that the longer the Fed fights deflation, the greater the likelihood for (hyper) inflation as the final outcome once it ultimately rights the economy. We tend to think that Odysseus was faced with an easier choice.

From the St. Louis Fed:

The Monetary Base and Bank Lending: You Can Lead a Horse to Water…

In its response to the worsening financial crisis during the fall of 2008, the Federal Reserve took actions that dramatically increased the size of the monetary base (the sum of currency in circulation and depository institution deposits with the Fed) (see chart). Subsequently, the Fed purchased some $1.7 trillion of securities issued by the U.S. Treasury and federally sponsored housing agencies, which expanded the monetary base further. The base more than doubled in size between September 2008 and May 2010. Yet measures of the money stock, such as MZM, M1, and M2, increased far less. For example, M1 increased about 17 percent over these months; consequently, the ratio of M1 to the monetary base (measured by the St. Louis Adjusted Monetary Base), commonly referred to as the “M1 money multiplier,” fell from about 1.6 to 0.84.

Why was the increase in the money stock so small when the increase in the monetary base was so large? The answer centers on the willingness of depository institutions (banks) to lend and the perceived creditworthiness of potential borrowers. A deposit is created when a bank makes a loan. Ordi -
narily, bank loans—and hence deposits—increase when the Fed adds reserves to the banking system. How ever, despite an increase in reserves of
over $1 trillion, total commercial bank loans were some $200 billion lower in May 2010 than in September 2008. Banks added to their holdings of securities, which resulted in a modest increase in deposits and the money stock, but many banks were reluctant to make new loans. Partly this reflected weak loan demand, but it also indicated a diminished appetite for risk on the part of bankers. Further, a lack of equity capital (and a high cost of obtaining additional capital) constrained the lending of many banks (banks are subject to minimum capital requirements based on their outstanding loans and other assets).

Many economists worry that bank lending and monetary growth will eventually surge and, ultimately, cause higher inflation. Minutes of Federal Open Market Committee meetings indicate that Fed officials have discussed possible measures to discourage excessive growth in lending and the money  stock. One option is to sell securities outright or under repurchase agreements, which would shrink the monetary base. Recent experience illustrates, however, that large changes in the base may be necessary to effect the desired changes in bank lending. Another option is to raise the interest rate paid to banks on their reserve deposits, which would raise the opportunity cost of lending and thereby tend to exert upward pressure on market rates generally and slow the growth of loans and the money stock. However, because the Fed has little experience with paying interest on reserves,
it is difficult to predict how much bank loans would change in response to an increase in the interest rate paid on reserve deposits. Hence, the Fed may resort to both options if monetary growth threatens to become excessive.

—David C. Wheelock


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hedgeless_horseman's picture

Why so small when the President's Stimulus Package is so Huge? CNBC personnel have been quietly asking themselves this same question for some time.

SheepDog-One's picture

LMAO that must be Cramers boyfriend.

Thomas's picture

Bunch of liars. They set up a Fed-to-Fed carry trade and then claim to be oblivious to the fact that their money is being deposited at the Fed for a profit? Hooey. Take away interest bearing deposits at the Fed and you will see change.

Hephasteus's picture

The whole things carry trade. The corporations are cash rich becuase the fed owes them money. The FED is rich because the corporations owe them money. It's the fractional reserve monetary system all over the place. Borrowers are lenders and lenders are borrowers. With half of it being securitized by social security loaning money it doesn't have to people who can't pay it back.

SheepDog-One's picture

OR, is it another one of Leo's Chinese solar stock chart boners?

eatthebanksters's picture

If you take a look at what the stimulus money has been used for, you will find much of it was for pork, thus much of the stimulative effect was never realized.

bugs_'s picture

Are all my increases in money stock so small?

Ripped Chunk's picture

Cornered Itself Between Deflation And (Hyper) Inflation

Rock and a hard place

In a fireworks factory with a lit cigarette

Standing below a crumbling dam with backpack full of rocks on its back

ZH's please add more to this list.

tmosley's picture

For a few Fight Club references:

A space monkey smoking next to the ether storage room.

Or firing a gun at his imaginary friend next to a thousand gallons of nitro-glycerin.

There is a plan.  The question is whether they will be able to see it through before something goes wrong and it all blows up in their face.  Even if we're all nuts, if we make enough of a ruckus, we'll set that shit off right in their faces.

SheepDog-One's picture

Maybe more fight club is needed- 'Fuck Martha Stewart, shes polishing the brass on the Titanic! I say let it all implode, fuck these space monkeys Geithner, Bernanke, Obama, all the rest of these idiots, lets EVOLVE! In death, you have a name!

Ripped Chunk's picture

Attempting to surf a tsunami on a belly board

SWRichmond's picture

By introducing moral hazard ("counterfeiter of last resort") and by being a tool of the pillaging bankster cartel, the Fed has always been cornered between Deflation and Hyperinflation.  They are apparently just now realizing it.  Or, perhaps, they have always known this would be the outcome and just don't want to admit it.

StychoKiller's picture

Speaking as an electronics Engineer, this reminds me of trying to fix an OpAmp problem:  Input looks fine but the ouput is sitting at ground -- ya try cranking up the gain adjustment -- nothing.  Crank the adjustment the other direction nothing (unbeknownst to you, a small solder splash is shorting the output to ground).  After a physical examination of the circuit, you see the small solder splash and scrape it off (wrong move, because while the OpAmp has internal short-circuit protection from grounding, the adjustment you made to the gain control will send the output to the positive supply rail, and there's NO protection in the OpAmp for that!).  So you go back to the output and see the output pegged to the positive supply rail, while smoke and a feeling of FAILURE seep out of the now-ruined OpAmp.  Only solution left now:  Power down, remove and replace the OpAmp and re-adjust the new chip into proper operation.

We're at the waiting for the smoke to come out phase...

romanko's picture

Austrian bitchez!

Spitzer's picture

Even corporations that are sitting on cash will start buying gold if the Fed loses control.

-1Delta's picture

They are not in cash... they are in cash equivalents-treasuries

Spitzer's picture

Even worse.

I am going to laugh my ass off when some Austrian economist reads the riot act to somebody like Steve Jobs and, in the interest of his shareholders, he starts a run on treasuries.

Hephasteus's picture

That's not how gold works any more. Corporations are too full of shit and too big for their britches  to run to gold. If they tried to do it they would get a COUNTRY pissed off at them. They have to stick with economic system and all it's bullshit until the retrenching consumer and gold bugs just freaking pants them.


Ripped Chunk's picture

Haven't seen too many big corps. where credit agreements list gold as an allowable asset purchase in the covenants.

Wonder why?

SheepDog-One's picture

Buying WHAT gold, Spitzer? Now even Bob Chapman is out trying to peddle his bullshit paper gold stocks, theres not enough gold already so where are the new tonnes coming from?

spinone's picture

I would not be so quick to jump to the conclusion that the FED can stimulate us out of this Depression, and improve the money multiplier.  There is the probability that the economy is debt saturated.

hugolp's picture

Sitimulus wont take the USA out of this Depression, but that wont stop prices from rising.

This explians why prices can raise even in a recessionary environment (as it has happened serveral times in history):


NotApplicable's picture

Saturated? Well, that's only because my credit limit is too low, and the interest rate on my credit-card too high!

Give me the tools that fedgov has, ZIRP and an ever increasing debt limit, and I promise, I'll stimulate so much, that I'll wipe out the last of the seed corn.

Better yet, how 'bout I just write checks, and everyone else can use them as currency instead of cashing them. Hell, I'll even pay some of my debt down from time to time.

Surely that'll help!

jwthomps's picture

From Richard Koo

It took the US 30  years to normalize

interest rates after 1929

pyite's picture

Exactly.  Without generous bankruptcy reform, this will drag on for decades.  If the government is trying to print & distribute money, they should be paying off people's mortgages & credit cards.

They have already guaranteed enough to pay off every mortgage in the country.

I think a major factor in slowing down consumers was the 2005 bankruptcy reform.

Henry Chinaski's picture

The answer is obvious.  They will nationalize the banks.

Henry Chinaski's picture

True.  Next time they will make it official to complete the ongoing consolidation of Central Planning.

weinerdog43's picture

No they did not.  The same group of criminals and thugs are still running things.  If it was nationalized, there would be a different group of criminals and thugs in charge.

redpill's picture

Nationalize the banks that have privatized the government?

Treeplanter's picture

The zombie banks that were not nationalized will come out to bite Ben and timmy when they sell off their Treasuries.  

Henry Chinaski's picture

Yep, it's a wacky system we have.

Noah Vail's picture

"If and when the Fed rights the economy . . ." Anybody think that is going to happen?

A currency collapse is not hyperinflation because the currency goes to zero. That's when people look to alternative money. Anybody got pesos and loonies?

Things that go bump's picture

I like those little airline bottles of booze.  They are real assets not paper. 

dan22's picture

Marching Towards a Yo-Yo Depression

(inflation then deflation then inflation then...?) 

Henry Chinaski's picture

Hah! At our house the term "Yo-Yo" is the acronym for Yer On Your Own

My children get that alot and it will serve them well in the long run.

TheMonetaryRed's picture

Why do people never question why it is that bankers - who generally HATE low interest, AAA lending - are so eager to change their mix of assets to low-yielding, AAA securities?

Of course we know why:

1.) When banks fill their balance sheets with fraudulent credit instruments - written to generate fees rather than interest on real, economic returns - of course they are going to favor AAA credits with new deposits. Their portfolios are a nightmare.

2) They just don't want to do the hard work of re-financing the economy. All that due diligence is very tiring and not exciting. Bankers hate to live like, well, bankers.

the grateful unemployed's picture

seems to me during the lost decade the BOJ had to resort to parking cash in MM accounts to keep their system going, and periodically they would mop up that money. Since we have already had a MM moment, (when a dollar isn't really a dollar, the NAV connundrum) it may be they want to avoid another such event, but as the Fed waves it magic wand, the market gets very sleepy, very sleepy, your eyes are getting slantly, very slanty. There now you will sleep through the next decade and wake up refreshed. Thank you Dr Bernanke

Sudden Debt's picture

Looks like a scenario in Simcity 3000:

Chose financial option:



Press ENTER to proceed

StychoKiller's picture

Reminds me of the time my daughter played with "The Sims".  Somehow the kitchen caught fire and her sim's parents died in the blaze.  It went downhill from there.  I still josh her about it!

Hang The Fed's picture

The only steps the Fed will take will those that serve to further the destruction of the dollar.  The age of a global currency may in fact be not far off...

Now, I'm not an economist, but the paper is blatantly exploring the weaknesses of the dollar as the standard reserve currency.  My guess is that it probably wouldn't take much movement from the Fed to piss off the holders of the 64% of the world's dollars in reserve.  If that were the case, I'm sure that resistance to the institution of a global currency would be a much easier sell, especially if it were a currency ostensibly based on the SDR. 

Just as corporate mergers are nothing new, the bankster scum have most likely decided that their stranglehold can be kept far more efficiently if they just consolidate their operations some more. 

Maybe that scenario sounds like a tinfoil-hat routine, but...I can hardly find another context into which the actions of the Fed and the other central banks of the world fit, except for abject stupidity.

To a large extent, though, the answer being either scenario is pretty much irrelevant.  Global conspiracy or catastrophic idiocy...either way, the rest of us get fucked, plain and simple.

bjbrey's picture

Commentators always assume that banks unwillingness to lend is the sole cause of the collapse of the Money Multiplier and the Velocity of Money.  Decreased credibility of borrowers is definitely a factor, but willingness is not the only factor.  Ability to lend is a major factor that has not been given enough play in the media.  The massive expansion of the Fed's balance sheet was to plug the negative capital that resulted from the loans made going bad, not new money on top of existing healthy capital bases.  So that money created is being used just to stabilize prices, b/c without it we would be deep into deflation right now.  So commercial banks are now sitting on this new reserve base and buying securities to rebuild their capital base.  Borrowing at close to zero and lending to what is the closest thing to a risk free borrower (US Govt) and making a 275 - 325 basis point spread, which can be levered, is more attractive than lending to riskier borrowers at very little excess yield to compensate (mtg rates at all time lows & corp yields are low as well - IBM just borrowed 3yr money at 1% annual coupon).  So with little to no margin of error the commercial banks will be content to simply take their free money from the still high spread carry trade and rebuild their capital bases.

The other major factor, not discussed by most commentators, is that there is not demand for loans like there was in the past.  This is a classic occurence in a debt deleveraging period - people want less debt, not more. 

There are numberous papers authored by the Fed on the Japan situation - they all indicate that the Fed would rather maintain an anti-deflation stance for longer than may seem optimal and risk some inflation rather than the alternative.  They can always raise rates and suck out liquidity if things begin to pick up, and a little inflation would be good for the country as it would lessen our debt load.

As for hyperinflation, we are not even close to that and talks of hyperinflation ignore what the requirement is for hyperinflation - i.e. being shut out of the bond market.  On a relative basis, the US is not in terrible shape compared to the other major developed nations and is still the global reserve currency with the #1 military and #1 economy in the world. 

Near term, I think we should be more worried about the magnetic reversal of the poles that is mythically supposed to happen in 2012 than hyperinflation.



centerline's picture

Debt saturation.  Borrowers have had enough and in the wake falling asset prices are not going to have an appetite for debt for quite some time.  In a largerly consumer driven economy where small businesses (which are suffering) drive 70% of employment, this means trouble.  Likewise, average debt levels will take years and years to deleverage, especially in an environment of higher taxes, higher energy costs, higher healthcare costs, higher commodity prices (i.e. food), etc.  

My big issue here is how is the Fed going to suck the liquidity out of the system by raising rates in face of current unemployment and debt-saturation?  The cost to service the debt would skyrocket for most and finish off the consumer for good.  It just isn't that easy in this situation to combat inflation.  The fed is between a rock and hard place, and they know it.  And, in the process creating a bubble in the bond market - which very well could be the primer for a hyperfinflationary run.