Investors: De-mystifying the Central Bank Balance Sheets

One of the many reasons that individual investors are scared witless (TM euphemism by OldProf) is a complete misunderstanding of the role of central banks and a distortion of current policies.

The critics of the Fed — and now the ECB and other European banks — have an easy path to page views and affirmation by readers who never took the class in Money and Banking.

This has the usual result.  Anyone who is willing to spend a little time while keeping an open mind can gain a significant investment advantage.

The Current Scare

Let us begin by summarizing the story that I hear from so many people through comments, emails, or calls.  It runs something like this:

  • The Fed is printing money with reckless abandon.
  • Other Central banks are now doing the same.
  • Bank balance sheets are exploding and have huge leverage ratios.
  • Gains in equity markets are a "sugar high."
  • Central banks could be wiped out with the smallest downturn.
  • Or if forced to unwind these trades, stocks would collapse.

A Typical Argument

Perhaps the most prestigious of those making such arguments is Jim Bianco.  Since he is regularly featured on CNBC, has his work published at Barry Ritholtz's blog, and has institutional clients, everyone takes his research output quite seriously.

His recent piece at The Big Picture touched all of the bases described above, and also threw in a comparison of balance sheets with aggregate stock market values.  I am going to stick to the Fed balance sheet in this analysis, but it should illustrate the point.

Here is the chart of the Fed balance sheet provided by Bianco.

Balu1

This chart repeats many of the errors from the Michael Pento arguments that I refuted here.  If Bianco had read this research, his article might have been stronger.

To start with, long-term data series should be described on a log scale.  This means that a proportional change is constant over time.  Let's look at the Fed's monetary base.

Fredgraph

This better demonstrates the recession response as well as QE II.  It also makes clear that everything else is irrelevant.

The most crucial thing to understand is that the balance sheet does not represent "printing money."  This happens when reserves are created for participating banks and they make additional loans.  This has not been happening.  Essentially, the Fed has stepped in to (temporarily) take up the slack in the money supply.  Disciples of Milton Friedman know that the long-term money supply is aligned with nominal GDP growth, so money creation is important.

To emphasize:  Printing money is necessary and appropriate — at the right pace.

The question is whether the growth in M2 has been excessive.  Here is the key chart.  As you can see, the long-term growth looks pretty reasonable.

 

M2 on log scale

The Conference Board (and I suspect the ECRI) have dropped M2 from their indicator series since the modest result described above is apparently too bullish.

Conclusion

The Bianco analysis is another example of Wall Street Truthiness.  Since so many are primed to hate the Fed, the ECB, and the entire concept of central banking, it is popular for many to rant on this every day.

The comparison of central bank holdings with equity markets is an egregious blunder.  There is absolutely no reason to compare debt holdings with anything other than the debt market.  I have frequently analyzed the Fed purchases of debt and shown these to be a modest fraction of the trading volume in Treasuries.  Experts estimate the impact on yields to be modest.

When and if the time comes to unwind these positions, it will have little long-term effect on either bond or stock markets.  I explained this in several past articles, but the most important is here.

This is an interesting choice for investors.  Most of them cannot really grasp the money and banking aspects of money creation.   It is a pretty tricky concept.

This makes it prime fodder for those who want to fool you by calling the balance sheet "printing money" when that is not correct.

There is so much mis-information and so little time.

I am now told by an investor that the GDP increase of 2.8% proves that the ECRI recession forecast is correct.  Amazing!  It takes very little for the confirmation bias effect to kick in.

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12 comments

  • Mike C February 1, 2012  

    The critics of the Fed — and now the ECB and other European banks — have an easy path to page views and affirmation by readers who never took the class in Money and Banking.
    This has the usual result. Anyone who is willing to spend a little time while keeping an open mind can gain a significant investment advantage.

    What is the actionable investment advantage based on these myths? Should investors/traders short gold?

  • Alex H. February 1, 2012  

    “This happens when reserves are created for participating banks and they make additional loans. This has not been happening. Essentially, the Fed has stepped in to (temporarily) take up the slack in the money supply.”
    Jeff, what are your thoughts on the MMT interpretation (or I guess pragcap.com) of the Fed’s role in using reserves to induce bank lending?

  • GenXCynics February 1, 2012  

    Jeff, you should write a blog on how the Fed expansion of balance sheet via QE programs help cleansing up and proping up banks’ assets, and thus ease up the credit market. You should write something about the Fed and Treasury using Fannie and Freddie as the dumping ground for bad mortgages. You should also educate the readers on the channels through which Fed’s policies can exert their effects (all through banks). Credits are several multiples of monetary base in nominal values and our economy is now a full-blown credit based, asset based one; so using M2 (deposits and CD’s of common men) to explain our economy is insufficient and misleading.

  • ZIRP February 1, 2012  

    “Essentially, the Fed has stepped in to (temporarily) take up the slack in the money supply.”
    curious to know the Krugmanite definition of temporarily?

  • oldprof February 1, 2012  

    Alex — Basically, I think there is some merit, but I don’t feel like doing a full review in the comments.
    Here is a link from a Kauffman colleague whom I respect, David Beckworth: http://macromarketmusings.blogspot.com/2011/12/market-monetarist-mmt-and-austrian.html
    Most investors should keep in mind the most dangerous words — “self-taught in Austrian economics.”
    More– eventually.
    Jeff

  • oldprof February 1, 2012  

    GenXCynics — You are on your own for that article! I am more pragmatic. I understand that helping society and the economy involves helping specific groups and institutions.
    When it comes to strengthening the financial system, it is difficult to come up with a practical plan (something I doubt you have thought about) without involving banks.
    When it comes to housing….
    When it comes to autos…..
    So you have a choice. You can refuse to accept the reality of the American political system, with all of its warts, and make your investments somewhere else.
    Or you can join me in being a political agnostic — willing to make money no matter who is in power and what they are doing.
    Good luck with your investing!
    Jeff

  • oldprof February 1, 2012  

    ZIRP — I often read Krugman, but not nearly as much as my academic friends.
    In a humorous aside, when I started tweeting, I followed him. I immediately got a message that he was following me! I forwarded this to friends who were quite impressed. Sheesh!
    Anyway, I think that if M2 starts to move higher, the Fed will sell assets pretty quickly. Bernanke has said as much.
    This is certainly the right question to ask.
    Jeff

  • David Pearson February 1, 2012  

    Jeff,
    “Anyway, I think that if M2 starts to move higher, the Fed will sell assets pretty quickly.”
    This is an incorrect view of the role of Excess Reserves in money creation. Under a Fed Funds Rate (FFR) targeting regime, the Fed supplies unlimited reserves to the system at any given FFR. Technically speaking, the supply of reserves is, “perfectly elastic”. Therefore, it doesn’t matter one bit to M2 whether ER’s are $1 or $10tr. The system does not need ER’s to induce the Fed to create reserves: it merely bids up the FFR above zero, forcing the Fed to engage in OMO to bring the FFR back to zero.
    So “selling assets pretty quickly” would do nothing to stop M2 from rising. Raising the FFR (and IOR) would.
    The only significance of ER’s is that they create duration risk for the Fed. The only reason for the Fed to sell assets is to eliminate that duration risk.

  • Angel Martin February 1, 2012  

    Jeff, this is great article that explodes a lot of bogus anti-Fed lines of argument.
    However, i do think there is a risk to what the Fed has done, and what the ECB is doing right now. One could argue that it is unlikely to occur (especially in the US), but the downside if it does occur is really huge.
    Yes, the balance sheet expansion for either the Fed or the ECB has ended up as excess reserves, and not in M2 – so no inflation.
    But there is always the risk, especially for europe, that a confidence shock could cause a big fall in the currency. A big devaluation causes some inflation, which itself can accelerate money velocity. With inflation, the incentive becomes greater to lend out excess reserves at positive real interest rates, rather than have real losses by keeping them in zero interest excess reserves at the ECB.
    If that sequence of events were to start, the ECB would really be in a bind, as they need to keep interest rates very low to support a faltering eurozone economy and eurozone banks, and the ECB needs to be able to expand it’s balance sheet to support the PIIGs.
    The risk is that the ECB will choose hyperinflation rather than raise interest rates and sell assets.
    The same sequence of events is also possible with the US and the Fed. In my view it is less likely because unlike the euro, there is no question of the future the dollar.
    I’m not arguing that the Fed did the wrong thing in 2008. Bernanke is the expert in depression era monetary policy – not me. My case is that there is a huge downside if things go wrong, and the probability is not zero.

  • David Pearson February 1, 2012  

    Angel,
    Again, the banking system does not need Excess Reserves to “lend out”. In a rate targeting regime, the following sequence of events occurs:
    -loan demand increases; banks make loans, creating new deposits out of thin air
    -as banks bid for reserves to support new deposits, the Fed Funds rate rises
    -the Fed supplies reserves through OMO to keep the rate at target
    Banks don’t “lend out” excess reserves. They create deposits when they make loans; these deposits are nothing but accounting entries; they require reserves to back them up as a means of clearing inter-bank payments.
    Excess Reserves are not inflationary. They may create losses for the Fed if it raises interest rates, and that might be inflationary if it keeps the Fed from raising rates.

  • Angel Martin February 2, 2012  

    David, i’m not an expert on central banking but isn’t it the case that a fed funds rate target increase will be swamped by the 1 trlllion plus excess reserves that are already out there?
    http://www.economist.com/blogs/freeexchange/2009/12/the_truth_about_all_those_exce
    this economist article makes the point better then i can.

  • Pmp Pmp March 7, 2012  

    Dude, this is horrible analysis. GDP growth is a joke, did you even bother to look at the deflator they were using? Your analysis of the Greek situation is typical of that of the mainstream media. The European banks are insolvent,get a clue. Until they are forced to mark to market , you and I know have no clue how much toxic crap is on the financials. Want to bet PNB Paribus is your next Lehman? The only end game is the complete wipe out of debt.BTW, if you understood economics ,you would know you can’t have a good economy without a good financial system.