How the Fed Starves the Economy While Inflating Assets

by The Curmudgeon

Note: This is an Addendum (or part II) of yesterday's Curmudgeon article Fed’s QE Fattens Financial Markets, but the Economy Still Starves.

Here are the facts (followed by our opinion):

 1. The Fed has bought most of the U.S. government debt the last few years, replacing foreign central banks as the largest purchaser. In effect, one branch of the U.S. government (the Fed) is buying the debt of another branch (the U.S Treasury)!

2. The "money out of thin air" created by the Fed's bond purchases is deposited in U.S. banks that are members of the Federal Reserve System. 

3. Those banks loan very little of that newly created money to businesses. Instead, they have been keeping the required and excess reserves on deposit with the Fed and earn 0.25% for doing so. Previously, the Fed didn't pay any interest on bank reserves as explained in this article.  

4. As a result of banks hoarding cash, adjusted bank reserves have grown at an 80% compounded rate the last six months! That's quite remarkable, especially considering the U.S. economy has grown <2%. 

Curmudgeon's Comment:

We think the Fed is not helping, but actually hurting the U.S. economy with its QE programs.  Almost all of the money being created is kept on deposit with the Fed and not being loaned out.   While the Fed balloons its own balance sheet, it's helping commercial banks reliquefy theirs, but not giving them any incentive to make commercial or industrial loans!  That's starving the real economy!  It's a giant Ponzi scheme run by U.S. government, Federal Reserve, and Member banks!

QE is Inflating Other Financial Assets:

A recent Federal Reserve paper explains how Fed bond purchases spill over into other financial assets:  

In particular, "Overall, our results suggest that the Federal Reserve is ultimately interacting with only a handful of investor types. Households (the group that includes hedge funds), broker-dealers, and insurance companies appear to be the largest sellers of Treasury securities when the Federal Reserve buys these securities. Households, investment companies, and to a lesser extent, pension funds, are the largest sellers of MBS (Mortgage Backed Securities) when the Federal Reserve buys. With both the Federal Reserve’s Treasury and MBS purchases, our results suggest that households are the largest, ultimate seller."

The paper goes on to suggest that those "investors" use the proceeds from the sales of Treasuries and MBS's to buy other financial assets, like dividend paying stocks, corporate, junk and emerging market bonds (which offer higher yields).  

Here are two quotes that corroborate our point:

"In principle, when the Federal Reserve buys safe, longer-term assets, it could induce investors to shift their portfolios toward other, potentially riskier assets, pushing down those yields."

"We find evidence that Federal Reserve purchases do not simply affect the yields on the assets purchased, but also induce investors to buy other assets, putting downward pressure on other market rates, as well."

QED and case closed!

The Curmudgeon

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.