Biden needs to double down on banking oversight

Crony capitalism at its worst.

Banks and the coal-mining industry, with the help of lobbyists, blocked Joe Biden’s appointment of Sarah Bloom Raskin — a former deputy Treasury Secretary and member of the Fed board during the Obama years — as the Fed’s primary regulator to oversee the banking industry.

Sen. Patrick J. Toomey (R-Pa.) and other GOP lawmakers have attacked her view that the Fed should do more to mitigate the financial risks of climate change, including by potentially changing the way it regulates energy producers. (Washington Post)

Democrat Senator Joe Manchin’s opposition was the final straw, adding to the Republican stonewall. Manchin’s West Virginia constituency boasts a strong coal mining industry and the Senator is heavily supported by coal-mining donors.

March 15 (Reuters) – Sarah Bloom Raskin on Tuesday withdrew as President Joe Biden’s nominee to become the top bank regulator at the Federal Reserve, one day after a key Democratic senator and moderate Republicans said they would not back her, leaving no path to confirmation by the full Senate.

“Despite her readiness — and despite having been confirmed by the Senate with broad, bipartisan support twice in the past — Sarah was subject to baseless attacks from industry and conservative interest groups,” Biden said in a statement.

Raskin had become the most contentious of Biden’s five nominees to the central bank’s Board of Governors, generating strong opposition from the outset from Republicans who said she would use the vice chair of supervision post to steer the Fed toward oversight policies that would penalize banks who lend to fossil fuel companies.

Raskin had been favored by progressive Democrats, such as Senator Elizabeth Warren of Massachusetts, who had pushed Biden to install someone who would pursue stiffer banking oversight after regulatory rollbacks under the previous supervision czar, Randal Quarles.


Joe Biden’s administration should not be deterred from appointing a tough regulator to oversee the banking industry. Many bankers would argue the opposite — that the economy would benefit from light regulation of the industry — but their track record says otherwise.

The banking industry is one of the key vulnerabilities in an already fragile financial system. Failure to effectively regulate them would risk another financial crisis, especially with current global volatility.

The big shrink commences

“The Federal Reserve left its benchmark interest rate unchanged and said Wednesday that it would begin to withdraw some of the trillions of dollars that it invested in the US economy after the 2008 financial crisis.” ~ Binyamin Applebaum

The Federal Reserve balance sheet ballooned in the last decade to current holdings of $2.5 trillion of US Treasury securities and $1.8 trillion of mortgage-backed securities.

Hourly Wage Growth

Fed total assets of $4.5 trillion (the red line on the above chart) does not give the full picture. Of the cash injected into the economy, $2.2 trillion found its way back to the Fed by way of excess reserves deposited by banks (the blue line). These deposits earn interest at the rate of 1.25% p.a., providing a secure return on surplus funds. What this means is that the net effect of the balance sheet expansion is the difference between the two lines, or $2.3 trillion.

Even $2.3 trillion is a big number and any meaningful sale of securities by the Fed would contract the supply of money, tipping the economy into recession. So how does the Fed propose to manage “normalization of its balance sheet” without disrupting the economy?

Firstly, the Fed does not intend to sell securities. It will simply decrease the “reinvestment of principal repayments it receives from securities held” according to its June 2017 Normalization Plan.

The amount withheld from reinvestment will commence at $10 billion per month ($6bn US Treasuries and $4bn MBS) and step up by $10 billion each quarter until it reaches a total of $50 billion per quarter.

That means that $100 billion will be withheld in the first year and $200 billion in each year thereafter….”so that the Federal Reserve’s securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.”

Second, the Fed will reduce the level of excess reserves by an appreciable amount in order to soften the impact of the first step. So a $100 billion reduction in investments may only result in a net reduction of say half that figure, after taking into account the decline in reserves.

Third, the federal funds rate will remain the primary tool of monetary policy and will be used to fine tune monetary policy to fit economic conditions.

It appears that the Fed will start quite tentatively, withholding only $30 billion in the first quarter, but the longer term targets seem ambitious.

With currency in circulation now growing at an annual rate of $100 billion, even a $50 billion reduction in the first year (net of excess reserves) could leave a big hole.

Currency in Circulation

This is bound to take some of the heat out of the stock market. The plus side is it may restore some sanity to market valuations, but any sudden moves could cause an overreaction.

Added later:

Even if we compare the reduction to the annual change in M1 money supply, it takes a big bite.

M1 money supply

M1 consists of: (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler’s checks of nonbank issuers; (3) demand deposits; and (4) other checkable deposits (OCDs), which consist primarily of negotiable order of withdrawal (NOW) accounts at depository institutions and credit union share draft accounts.

The Threat of Inflation

From the Trading Diary:

I received a message from a US reader suggesting I should “stay out of politics”.

I would love to stay out of politics. Frankly, I find it tiresome. Unfortunately, politics and the economy are so intertwined as to make the study of one meaningless without consideration of the other. I say “unfortunately” because a lot of the damage done to the economy is caused by the political system.

As for Donald Trump, I am a conservative but do not support him. He is not another Reagan who can lead from the center and inspire his country. If anything he is a polarizing force, more ego-driven than Nixon and just as unpredictable.

I hope I am wrong. Trump has many sound policies and has made some solid appointments to his team. Don’t believe everything you read from a hostile media. They could do a lot of good. Provided they are able to manage the elephant in the lifeboat — the destabilizing side of Trump’s nature.

Now that I have offended at least half of all US readers — slightly less than half if you listen to bleating about the majority vote — let me explain why politics and economics are so intertwined.

Apart from trade wars, which I will discuss at a later date, I see the main threat to the US economy as inflation.

Before I start, let me say that these dangers are not immediate and the present boom is likely to continue for the next 12 to 18 months. But they could quickly materialize, bringing the boom to a premature end, so it is best to keep a weather eye on them.


Earlier this week I discussed why the inflation outlook is so important to stock market performance:

From Tim Wallace at The Sydney Morning Herald:

Nine years on from the start of the financial crisis, the US recovery may be overheating, Legal & General Investment Management economist James Carrick has warned.

He has predicted a series of interest rate hikes will tip the US into a 2018 recession.”Every recession in the US has been caused by a tightening of credit conditions,” he said, noting inflation is on the rise and the US Federal Reserve is discussing plans for higher interest rates.

Officials at the Fed have only raised interest rates cautiously, because inflation has not taken off, so they do not believe the Fed needs to take the heat out of the economy.

But economists fear the strong dollar and low global commodity prices have restricted inflation and disguised domestic price rises. Underneath this, they fear the economy is already overheating.

As a result, they expect inflation to pick up sharply this year, forcing more rapid interest rate hikes.

That could cause a recession next year, they say. In their models, the signals are that this could take place in mid-2018.

Harvard scholar Paul Schmelzing points out that inflation is starting to rear its head in both China and Germany, with producer prices rising. This may in part be a result of the falling value of the Yuan and Euro against the Dollar, resulting in higher domestic commodity prices.

The opposite, however, is true for the US, with a rising Dollar lowering import prices and acting as a headwind against inflation.

The consumer price index (CPI) is rising because of higher crude oil prices but core CPI (excluding food & energy) has remained fairly constant, around the 2.0 percent target, over the last five years.

Core CPI and CPI

So why the concern?

Well the Fed is more concerned about underlying inflation, best reflected by hourly wage rates, than the headline CPI figure.

A sharp rise in hourly earnings rates would force the Fed to respond with tighter monetary policy to take the heat out of the economy.

The chart below shows how the Fed slams on the brakes whenever average hourly earning rates grow above 3.0 percent. Each surge in hourly earnings is matched by a dip in the currency growth rate as the Fed tightens the supply of money to slow the economy and reduce inflationary pressure. And tighter monetary normally leads to recession.

Hourly Earnings Growth compared to Currency in Circulation

Two anomalies on the above chart warrant explanation. First, is the sharp upward spike in currency growth in 1999/2000 when the Fed reacted to the LTCM crisis with monetary stimulus despite high inflationary pressures. Second, is the sharp dip in 2010 when the Fed took its foot off the gas pedal too soon after the financial crisis of 2008/2009, mistaking it for a regular recession.

Hourly earnings growth is currently at 2.5 percent, so the Fed has some wiggle room and is only likely to react with tighter monetary policy when the figure reaches 3.0 percent.

Recent rate rises are more about normalizing interest rates — not taming inflation — and are not cause for alarm.

But Paul Schmelzing warns that the combination of a tight labor market and fiscal stimulus could fuel inflation and lead to a bear market in bonds similar to the 1960s.

That is exactly where Donald Trump is headed with a major infrastructure program likely to hit the ground next year. In a tightening labor market, the Fed would be forced to tighten monetary policy, slowing the economy and leading to another bear market in stocks as well as bonds.

Politics is tricky; it cuts both ways. Every time you make a choice, it has unintended consequences.

~ Stone Gossard

Fed easing continues

Quantitative easing (QE3) ended in the second half of 2014 after the Fed announced it would taper asset purchases in December 2013. The graph below shows that total assets leveled off at $4.5 trillion and have been maintained at that level since.

Fed Total Assets and Excess Reserves on Deposit

But the graph also shows that the Fed continues to drip-feed the financial system by running down excess reserves on deposit from a high of $2.7 trillion in August 2014 to $2.25 trillion in August 2016.

Commercial banks are required to hold certain reserves at the Fed but in times of financial stress will deposit excess reserves at the Fed, when trust in the interbank market breaks down. The Fed commenced paying interest on reserves in October 2008 and increased the rate to 0.50% in December 2015. This has encouraged banks to retain excess reserves at the Fed where they earn a risk-free rate of 0.50%.

Fed Total Assets and Excess Reserves on Deposit

By raising or lowering the rate payable on excess reserves the Fed can attract or discourage deposits, tightening or easing the availability of funds in the interbank market. Banks have withdrawn $450 billion in excess reserves over two years, which suggests that they can achieve more attractive risk-reward ratios elsewhere. The Fed has not responded, indicating that they are happy for this back-door easing to continue.

Only when the red and blue lines in the first graph converge will the Fed have commenced monetary tightening. That still appears some way off.

Fed: Who Is Holding All the Excess Reserves?

Ben Craig and Sara Millington at FRB Cleveland say “liquidity is not diffusing through the banking system, but is instead staying concentrated on the balance sheets of the largest banks.” Banks from the European Union (EU) have also substantially increased their holdings of excess reserves at the Fed.

Hat tip to Barry Ritholz


From Marc Seidner:

At this point, the evidence is close to overwhelming that the Federal Reserve will embark on a tightening cycle this year. The base case for markets should be a move in September. While the pace of tightening should be very shallow and the ultimate destination for interest rates considerably lower than historical experience, investors should not underestimate the potential volatility emanating from the first interest rate increase in nine years and the first move off of the zero bound in six years….

Read more at RIP ZIRP | PIMCO Blog.

QE: The end is nigh?

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.

Fed Assets and Excess Reserves on Deposit

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.

Fed Assets and Excess Reserves on Deposit

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.”

Fed excess reserves shrinking

Commentators have highlighted the fact that bank excess reserves held on deposit at the Fed — and on which banks are paid interest at 0.25% p.a. — are declining. This would suggest that bank lending is rising, increasing inflationary pressure.

Fed Excess Reserves- Weekly

The Fed is well aware of the situation

Fed Excess Reserves and Total Assets

…and has responded to the recent slow-down by scaling back asset purchases (quantitative easing). They are likely to track the decline of excess reserves to ensure that the impact on the working monetary base (monetary base minus excess reserves) is contained — along with inflationary pressures.

Interest on Reserves, Settlement, and the Effectiveness of Monetary Policy

Joshua R. Hendrickson suggests that paying interest on excess reserves at the Fed reduces the effectiveness of monetary policy. Money paid to purchase Treasuries finds its way back to the Fed in the form of excess reserves. Here is the abstract from his paper:

Over the last several years, the Federal Reserve has conducted a series of large scale asset purchases. The effectiveness of these purchases is dependent on the monetary transmission mechanism. Federal Reserve chairman Ben Bernanke has argued that large scale assets purchase are effective because they induce portfolio reallocations that ultimately lead to changes in economic activity. Despite these claims, a large fraction of the expansion of the monetary base is held as excess reserves by commercial banks. Concurrent with the large scale asset purchases, the Federal Reserve began paying interest on reserves and enacted changes in its Payment System Risk policy that have effectively made reserves and interest-bearing assets perfect substitutes. This paper demonstrates that these policy changes have had statistically and economically significant effects on the demand for reserves and simply that the effectiveness of conventional monetary policy has been significantly weakened.

Read the entire paper at Interest on Reserves, Settlement, and the Effectiveness of Monetary Policy |
Joshua R. Hendrickson