I have read a number of predictions recently as to how stocks will collapse into a bear market when quantitative easing ends. The red line on the graph below shows how the Fed expanded its balance sheet by $3.5 trillion between 2008 and 2014, injecting new money into the system through acquisition of Treasuries and other government-backed securities.
Many are not aware that $2.7 trillion of that flowed straight back to the Fed, deposited by banks as excess reserves. So the net flow of new money into the system was actually a lot lower: around $0.8 trillion.
The Fed has indicated they will end bond purchases in October 2014, which means that the red line will level off at close to $4.5 trillion. If excess reserve deposits continue to grow, that would cause a net outflow of money from the system. But that is highly unlikely. Excess Reserves have been growing at a slower rate than Fed Assets for the last three quarters, as the graph of Fed Assets minus Excess Reserves shows. If that trend continues, there will be a net injection of money even though asset purchases have halted.
Interest paid on excess reserves is a powerful weapon in the hands of the FOMC. The Fed can accelerate the flow of money into the market by reducing the interest rate, forcing banks to withdraw funds on deposit in search of better returns outside the Fed. Alternatively, raising interest paid above the current 0.25% p.a. on excess reserves would have the opposite effect, attracting more deposits and slowing the flow of money into the market.
The Fed is likely to use these tools to maintain a positive flow into the market until the labor market has healed. As Janet Yellen said at Jackson Hole:
“It likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after our current asset purchase program ends.”
That’s Fedspeak for “Read my lips: there will be no interest rate hikes.”
Colin,
under what circumstances, if any, would the $2.7 trillion in the “excess reserves” start to have an impact on the USD purchasing power?
The impact of QE was muted by the increase in deposits (of excess reserves) with the Fed. A substantial reduction in deposits — if the Fed stopped paying interest, for example — would cause a resurgence of inflationary pressure. But I am sure the Fed are monitoring closely and unlikely to allow this to happen.
A proper insight clearly quantified. Thanks. AB
I think you’re evaluation of the situation is correct. Furthermore, stocks tend to rise in tandem with interest rates in the beginning and we are far from a state of euphoria.