In recent years, the Federal Reserve has almost quadrupled the monetary base, a key determinant of money supply. The pace of it has increased lately: Treasuries (according to J.P. Morgan, the Fed would soon account for 90% of all new debt issuance), MBS… even foreign debt, hidden under the “other assets” category (“I do for you, you do for me” style deal with other Central Banks in order to keep the Ponzi scheme a bit longer… but this is not the aim of this article).
The FED (along with other CB) is becoming the ultimate bidder in the market, injecting Tones of liquidity in the economy.
Taking into account the above statements, several analysts predicted that by this time a runaway inflation would have hit our lives. I agree with the outcome, not so with the timing. Why so many errors in timing the high inflation / hyperinflation scenario?
The reason is because Monetary theory changed for good with shadow banking practices starting in the 80’s. The liabilities backing the assets shadow banks create out of thin air are not to be seen through conventional monetary theory lenses, the way we were taught in College: nevertheless they should be analyzed, as account for more than half of the credit money in circulation. Let me give you a first approach to the subject:
The main source of credit is not savers deposits anymore: “collateral chain” is. Collateral Chains are securities, debt, bonds, REPOs… pledged from one party (Banks, Hedge Funds etc…) to another for credit.
Imagine a bank’s reserves are comprised in one part of Spanish debt: with this “asset” in the Balance Sheet, the bank does not need to wait for a customer to deposit extra cash for obtaining new financial resources, it can pledge it as collateral for further credit exposure: margin calls, further buying of other financial instruments etc… The other part has to agree on the collateral for allowing the operation, a component of trust then is necessary for this type of credit creation. Bear in mind, every time a collateral is pledged, a “haircut” is applied by the credit giving counterparty though. But here we go with the amazing deal: the newly bought item (p. ex. conveniently “AAA” rated MBS, in the good old times) can be rehypothecated AGAIN for fresh credit… in fact, it can go indefinitely as far as the “haircuts” allow the principal to be collateralized (this is true in the U.K. that is why The City it is the real hub for financial engineering not New York, remember the “London Whale” and other scandals in UK). This is pure fractional reserve credit formation, parallel to the traditional banking one: in fact, the traditional reserve required ratio equals the haircut applied in the rehypothecation shadow chain.
The same underlying debt ends up as securing loans worth multiples of its value. Several lenders are counting on the underlying asset as backup in case things go wrong.
And as we know, it all went wrong indeed: assets given as collateral were not as good as the inter-bank trust standards dictated. No good collateral exist anymore to be pledged, increased haircuts are demanded and the Inter Bank trust is currently broken. A real bank run happened as explained by Gary Gorton in his haircuts “Increases in repo haircuts are withdrawals from securitized banks—that is, a bank run. When all investors act in the run and the haircuts become high enough, the securitized banking system cannot finance itself and is forced to sell assets, driving down asset prices. The assets become information-sensitive; liquidity dries up. As with the panics of the nineteenth and early twentieth centuries, the system is insolvent”
The FED and other CB had to step in to stop the chain reaction.
Going back to the point of the essay: The reason inflation has not exploded yet, is because the massive FEDs QE(n), ECB’s LTRO and the Bank of England’s asset purchase programs are swallowed by the current Shadow Banking implosion.
One important detail is to be highlighted: Shadow Banking liabilities are not made out of deposits, let us think of it as something circular, as the money inside is self-contained. That is why its expansion-contraction process has a contained impact in the inflation rate. The money/credit remains in “the shadow” not in customers savings accounts, not in the general Economy. The dam holds… just yet.
As long as the ongoing Shadow Banking implosion absorbs all the newly printed Central Bank Money, Inflation will not take off. But as the chart below suggests, fiat Money absorption might be slowing as shadow bank liabilities are contracting. Because now, banks rely on their traditional credit sources (and specially in FEDs unsterilized created reserves) for plugging the holes. The FED cannot and will not stop QEs, it must compensate the deleveraging of the Shadow Banking liabilities.
Hyperinflation, as a loss of confidence in a currency will come: because of the reasons explained above. Because the faith in the FED will no longer be able to be maintained, its Balance Sheet will tell the truth. When matched against the currency it creates out of thin air, people around the world no longer will want to keep it.
But main street people unfortunately will be the last ones in making the shift from fiat to real assets: Shadow banking intervenants know politburo type economic systems are ultimately unsustainable, and have already started unwinding their positions (thanks to the FED of course). This weeks’ Goldman “recommendation” to all muppets to sell their gold (I just wonder who will be in the long side of it) is nothing but a warning that the time-window is closing.
Buy gold, buy silver and store it outside the banking system. Be prepared for what is to come.
The (other) deleveraging: What economists need to know about the modern money creation process . Manmohan Singh, Peter Stella, 2 July 2012
The (sizable) Role of Rehypothecation in the Shadow Banking System. Manmohan Singh and James Aitken July 2010
Are the brokers broken. Matt King September 2008
Haircuts. Gary Gorton and Andrew Metrick December 2010
ZeroHedge: various articles