By Terry Coxon, Editor
The Casey Report

Sprinkled among all the official talk about efforts to end the current recession, you’ll hear assurances, notably from Federal Reserve Chairman Ben Bernanke, that when the economy does revive, it won’t be allowed to blast off into runaway inflation. The Fed, we’re being promised, will prevent such a launch by reabsorbing the hundreds of billions of dollars of excess liquidity it recently created to halt the credit crisis.

Delivering on those assurances won’t be easy. There is no reliable, real-time guide to how much cash the economy needs, so deciding when to drain excess reserves from the banking system (by selling off T-bills or other Fed assets) and judging how rapidly to do the draining will be largely guesswork. And the consequences of guessing wrong will be unforgiving. Drain too fast, and the recovery stalls. Drain too slowly and price inflation comes charging out of the chute.

Figuring out how much cash is just right for the economy has always been the Fed’s central puzzle. And until late last year, coming up with a workably close answer, day after day, was the only thing the Fed really needed to focus on. Executing its decisions was easy. Since it could create money, the Fed had unlimited power to expand liquidity by buying Treasury securities (or anything else). And since it owned a mountain of Treasuries built up from past purchases ($480 billion as of last September), it had the power to drain liquidity by selling from its holdings.

That Was Then…

That picture of the Fed’s power may be changing. Even if the Fed were to show unprecedented skill (or enjoy unprecedented good luck) in judging when to drain the excess liquidity that today is an inflationary time bomb, it might find itself without the wherewithal to do so. We can estimate how close the Federal Reserve is to such a trap by examining its assets and seeing how they compare with the excess “reserves” held by commercial banks. It is the excess reserves that the Fed will need to soak up at some point to prevent the time bomb from detonating.

I put “reserves” in quotes because they aren’t what you might think they are. They’re not money that banks put away as a provision for bad loans or for handling a surge in withdrawals. So-called reserves are more like the transmission fluid running through the machinery that the Federal Reserve uses to control the size of the economy's money supply.

If a bank wants to issue demand deposits to its customers, by law and Federal Reserve regulation, the bank must hold “reserves” equal to 10% of those deposits. Only two things count as reserves – cash in a bank’s vault and deposits that a bank holds at a Federal Reserve Bank. The Fed can easily increase the total reserves available to banks by buying T-bills or other assets, and in ordinary circumstances it can easily drain reserves from banks by selling T-bills or something else. By altering the amount of reserves available to banks, the Fed alters their ability to maintain demand deposits for their customers, which in turn increases or decreases the M1 money supply.

The last time the Federal Reserve balance sheet looked somewhat normal (by historical standards) was in September of last year. Here is the asset picture from last fall, summarized.

Federal Reserve Assets, September 10, 2008	$Billions
Gold certificate account	11
Special drawing rights certificate account	2.2
Coin	1.4
U.S. Treasury securities	480
Repurchase agreements	127
Term auction credit	150
Other loans	24
Holdings of Maiden Lane LLC (net)	29
Items in process of collection	1.4
Bank premises	2.2
Other assets	97
Total assets	924

On the same date last September, the reserves of commercial banks and other depository institutions exceeded the legally required amounts by $22 billion. If the Fed had wanted to absorb those excess reserves, to keep them from feeding an expansion in the money supply, it would have had the means to do so – and by a wide margin. It could have done it in an instant by selling $22 billion of its $480 billion of Treasury securities. Or it could have done it overnight by refraining from rolling over $22 billion of its $127 billion of repurchase agreements. Between those two asset sources, the Fed had 28 times the power needed to mop up all excess reserves.

The Fed was more than well prepared. But it is noteworthy that if you examine the rest of the Fed’s assets, you’ll find that none of them would have been available for the job of smoothly absorbing excess reserves. In principle, the Fed had the option of refraining from renewing $22 billion of term auction credit – but that would have threatened the banks that were relying on the credit.