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Catching a Falling Financial Knife

Why Inflation in 2013 Is Imminent

Economics / Inflation Feb 14, 2013 - 03:48 PM GMT

By: Money_Morning

Economics

Jeff Uscher writes: Is a spike in the monetary base - currency in circulation plus bank reserves at the Fed - the first sign of imminent inflation?

Art Cashin, the well-respected director of floor operations at the New York Stock Exchange for UBS, recently told King World News the increase in the monetary base may well be a sign of impending inflation.


Monetary base, sometimes called high-powered money, is the basis for the bank lending that drives our economy. When interest rates are normal, banks use their reserves for lending.

Unfortunately, these are not normal times. The U.S. Federal Reserve and other central banks around the world continue to hold interest rates at zero.

Zero interest rates mean zero returns. Investors don't get paid for investing. Banks don't get paid enough interest to compensate for the risk of lending money into the economy. Looking at it another way, there is no penalty for doing nothing with your money.

Unprecedented Accumulation of Excess Reserves
Most of the money the Fed pumps into the market each month ends up sitting on bank balance sheets as reserves held by the Fed itself. That money never gets into the economy, where it can do some good.

To put it in economic terms, the velocity of money - the rate at which money is exchanged - has slowed.

From January 1959-August 2008, banks held an average of $0.8 billion in excess reserves at the Fed. The one exception was in September 2001, when excess reserves rose to $19 billion in the immediate aftermath of the September 11 terrorist attacks.

Between 9/11 and the collapse of Lehman Brothers in September 2008, banks held an average of $1.7 billion of excess reserves at the Fed.

Following the Lehman collapse, excess bank reserves held at the Fed soared. Excess reserves peaked at more than $1.6 trillion in July 2011 and remain at more than $1.5 trillion as of the end of January 2013.

That's more than $1.5 trillion that could be put to work in the economy, but is just gathering dust in the Fed because interest rates remain at zero.

That is where all of the Fed's quantitative easing has gone.

"To use [Fed Chairman Ben] Bernanke's own analogy, let's assume he printed up a billion dollars of brand new money and he flew over your house ... and dropped it on your lawn," Cashin told King World News. "But you were so worried about the market, worried about the economy, worried about everything that you simply picked it up and put it in the garage. That's why we haven't seen any inflation with all this aggressive money printing."

Money Morning Global Investment Strategist Martin Hutchinson agrees.

"Monetarists will tell you that the decline in monetary velocity is due to the massive balances, over $1 trillion, which the banks have on deposit with the Fed, which just sit there and do nothing." Hutchinson said. "That's probably correct since while the deposits exist, the ordinary mechanisms of monetary movement simply don't work, since that money has no velocity."

The Danger in the Fed's Exit Strategy
Through quantitative easing, the Fed has created a gigantic amount of money that has had no impact on the real economy. Some Federal Open Market Committee members have started to talk about ending quantitative easing but keeping interest rates at zero.

The question is whether rates can be kept at zero when the Fed's balance sheet is shrinking.

Most market observers think long-term interest rates will rise once the Fed stops buying Treasury bonds for its quantitative easing operations. If long rates start to rise, it may awaken inflationary expectations that might be amplified by the Fed keeping short rates artificially low.

If that happens, banks - once again able to earn a reasonable risk-adjusted return - may start to mobilize that $1.5 trillion in excess reserves and that is when you will see inflation take off out of nowhere.

Check out Martin Hutchinson's full analysis of why there's no U.S. inflation -yet - in 2013.

Source :http://moneymorning.com/2013/02/12/u-s-economy-recovery-doesnt-fool-struggling-americans/

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