A reverse repo is a short-term agreement to buy securities and then sell them back at a slightly higher price. The banks are effectively stashing their excess reserves with the Fed rather than lending them out at a significantly higher rate, even though the Fed removed all its regulatory reserve requirements last year.
As Shvets said, the $US4 trillion or so that US banks now have on deposit with the Fed (about 20 per cent of US GDP) effectively sterilises to a large degree the Fed’s quantitative easing program — its monthly purchases of $US120 billion of bonds and mortgages.
The bank deposits with the Fed equate to the increase in the size of the Fed’s balance sheet, now above $US8 trillion, since the onset of the pandemic.
Eurozone banks are doing something similar, only on an even larger scale.
They have parked about €3.3 trillion ($5.2 trillion), or 30 per cent of the zone’s GDP, with the European Central Bank.
Japan’s banks have the equivalent of about 100 per cent of Japan’s GDP (about $6.4 trillion) sitting inside the Bank of Japan and the UK banks have £830 billion ($1.5 trillion), or 42 per cent of GDP, deposited with the Bank of England.
Vast amounts of reserves
Shvets’ explanation for the vast amounts of bank reserves sitting in central bank (virtual) vaults is that the banks aren’t seeing demand for the money the central banks are pumping into their systems.
There just aren’t the commercial opportunities for them to lend and create the credit multiplier effects that motivated the implementation of the QE programs.
According to Fed data, the proportion of assets of the largest US banks held as loans and leases has been falling over the past year (down nearly 10 per cent) even as bank holdings of Treasury securities and government agencies’ securities have been rising (up more than 33 per cent).
Over the past 12 months the total commercial and industrial loans in all US commercial bank balance sheets has fallen from more than $US3 trillion to about $US2.5 trillion even as the US economy mounted a sharp recovery from its pandemic nadir.
That says the issue is one of demand rather than supply. The banks aren’t seeing sufficient demand from borrowers with good credit metrics to deploy the excess liquidity they are holding.
There is a multiplier effect that occurs when banks lend money. It leads to multiple transactions – it increases the velocity of money – as the funds are spent to acquire goods and services.
The unwillingness of banks to lend, or the absence of sufficient creditworthy opportunities, has created that perverse outcome where the volume of money has greatly increased but its velocity within the financial systems has decreased.
It isn’t just the Fed’s balance sheet that has been swollen by this phenomenon, which is in many respects simply an exaggerated version of what’s been occurring since the 2008 crisis.
Boost for financial assets
If there is insufficient real-economy demand for credit, even as interest rates have crashed to unprecedented lows and the volume of money in the system is equally unprecedented, it either rebounds to the central banks or ends up being invested in financial assets.
It isn’t therefore that surprising that sharemarkets keep pushing towards new records, the prices (as opposed to yields) of bonds have been inflated, commodities have been “financialised” and new forms of speculative activity (think cryptocurrencies, NFTs or “meme” stocks) have developed.
The relative dearth of demand for credit for productive investment could be influenced by demographics and the ageing of the baby boomers, or the capital-light nature of the new transformative technologies.
Another element, perhaps, might be the relatively low levels of economic growth experienced since 2008, when a host of new and capital-intensive regulatory requirements were imposed on the world’s banking systems, impacting their capacity to lend and changing the psychology and economics for them of riskier forms of ending.
Shvets argues that despite the diminishing effectiveness of their QE programs – he likens it to “pushing on a string” – central banks are essentially caught in a bind of their own making.
Central banks can’t stop their QE programs as the consequences for financial markets’ volatility and asset prices could be devastating, in turn unwinding the wealth effects that they had worked so hard to create, he said.
“Pensioners might discover that they have no pension, derivatives might unwind and the same might happen to property prices,” he wrote.
Another way of looking at the dilemma the central banks confront is that while their core rationale for introducing QE programs was to support and encourage real economic activity, the impact of the programs on that core purpose has diminished to the point where it has almost disappeared.
The side-effects of the programs on financial markets and asset prices more broadly, however, have been and remain so significant,that winding back QE could trigger asset price implosions and another financial and economic crisis that would dwarf what happened in 2008-09.
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