FMQ Update

What they do or don’t know, time will tell. The point is the coincidence of events at the top of the credit cycle makes it highly probable that both the global and US economies are not just hitting a temporary air-pocket but will slide into a deeper slump. This being the case, the Fed will re-evaluate its monetary policies.

An important consequence of a slump is that government spending rises on added welfare costs while tax income drops. A budget deficit escalates rapidly. But the budget deficit for 2019 is already heading for $1.2 trillion on the assumption the economy will not go into even a mild recession. The cushion of excess reserves held at the Fed will not provide the banking system with much leeway, because they are already committed in accordance with Basel III. And we also know that with the 10-year UST yielding 2.7% that bonds are not valued for an unexpected rise in supply.

The burden of this funding will fall on both the Fed and the commercial banks. But we must put ourselves in the banks’ shoes. A recession not only leads to non-performing loans, but investments, such as collateralized loan obligations begin to go sour rapidly. Equity markets will fall, undermining collateral values. Furthermore, instead of having to find an extra $450bn every quarter for USTs, the figure will rise from there, even assuming the Fed abandons its tightening plans. If this prospect is not visible to far-sighted bankers now, it soon will be.

Banks attempting to remain solvent are certain to undermine the wider economy. Initially, the effect on price inflation may be for it to fall as consumers rein in spending and inventories pile up unsold. The first thing the Fed will be forced to do is to abandon all thoughts of tightening and revert to aggressive quantitative easing. QE will be required to give the banks more liquidity and fund the bulk of the burgeoning budget deficit at moderate rates.

That is likely to be only the start of it. The Fed will be inflating the money supply to rescue government finances and support the banks. FMQ will lurch even higher, threatening a growing loss of public confidence in the dollar’s purchasing power. Foreigners, after decades of accumulating dollars, will no longer be buying them because of the contraction in international trade, and for this and other reasons are likely to be net sellers. The purchasing power of the dollar will be undermined in the foreign exchanges. 

There can only be one outcome: rising price inflation while money supply is still expanding. And that will be virtually impossible to contain.


[i] Depository institutions includes commercial banks, savings banks, saving and loan associations, credit unions, US branches and agencies of foreign banks, Edge corporations and agreement corporations (See the Fed’s Reserve Maintenance Manual)
[ii] See http://www.kreditordnung.info/docs/S_and_P__Repeat_After_Me_8_14_13.pdf
[iii] https://www.minneapolisfed.org/research/economic-policy-papers/should-we-worry-about-excess-reserves
[iv] See Sheard’s Wikipedia entry.
[v] This is the difference between the St Louis Fed’s FRED series EXCSRESNS and RESBALREQ. The Fed only reports total reserves.
[vi] See https://home.treasury.gov/news/press-releases/sm613
[vii] In particular, see https://www.goldmoney.com/research/goldmoney-insights/trade-wars-a-catalyst-for-economic-crisis

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