In its September 21, 2010, press release, the Federal Open Market Committee said, “Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the long run, with its mandate to promote maximum employment and price stability.” Over the past couple of years, the Fed’s informal inflation target has been between 1.5 ~ 2.0%. According to the PCE (personal consumption expenditures) Index, an indicator of the average increase in prices for all domestic personal consumption, August year-on-year inflation – the latest release – was +1.5%. With the inflation rate within the expressed target range, why is the Fed ironically attempting to convince us that ‘rising prices’ will promote ‘stable prices’? The reason: Ultra-low interest rates are contributing to currency inflation that is significantly outpacing price inflation, and unless excess liquidity is put to work, dollar buildup will accelerate until global confidence in the U.S. dollar is destroyed.
As you know, banks borrow from the Federal Reserve at zero-to-0.25%. In 2009, banks reportedly lent over $1 trillion in typical day-to-day activities, which included, but not limited to, mortgage loans, auto loans, student loans, small business loans and credit cards. On a weighted basis, banks yielded about 6.25%, minus anticipated default losses. If we assume a 15% overall default rate, we are conservatively looking at a net gain of about 5.25%.
Also, U.S. Treasury auctions currently bring in over $2 trillion in borrowings, about half of which is for domestic consumption held within the U.S. banking system. One way or another, Treasury investors are borrowing at near 0.25% from the Fed and buying debt securities. The weighted-average rate across the yield spectrum – from 4-week bills to 30-year bonds – is roughly 1.39%. Hence, debt investors net a 1.14% yield (1.39% minus 0.25%) by simply holding Treasuries.
If banks earn 5% (5.25% minus 0.25%) on $1 trillion, and debt investors – which include banks, credit unions, insurance companies, mutual funds, pension funds and REITs – profit 1.14% on $1 trillion, this would yield somewhere in the neighborhood of a 3.07% annual inflation rate of dollars. So if the PCE is at 1.5%, this means dollar inflation is growing twice as fast as price inflation; and the 1.57%-rate difference on $2 trillion creates $31 billion per year; $2.6 billion per month; $600 million per week; $86 million per day; $3.6 million per hour; $60,000 per minute; $1,000 per second of newly-printed, unabsorbed dollars pouring into the financial system.
Banks have $1 trillion in excess reserves on deposit at the Fed; and companies are sitting on $2 trillion in cash for a rainy day. These dollars, obviously, have yet to meaningfully make their way to average Americans. Why? As for banks, they are hoarding dollars, and understandably so as they are being racked with strict regulation, higher capital requirements, and rising loan losses. And companies, though having loads of dollars, would rather borrow at record-low rates than use cash, like Microsoft, which recently said it would borrow as much as $6 billion to finance stock buybacks and pay higher dividends, notwithstanding, the company is currently armed with $37 billion in cash and short-term securities. From Microsoft’s perspective, why use its own cash to finance buybacks and dividends when, as a Wall-Street insider, it can make money by borrowing at near 0.25% while putting its cash in a 3-year Treasury Note yielding 0.75%?
While such moves by banks to protect their solvency is important; and the efforts by companies to increase shareholder value and incomes are all well and good, the fact is this: The money banks hold on to and lend to their wealthy clients and cash-rich corporations is a drop in the bucket compared to the affect expanded lending would have on the millions of individuals whose spending make up 70% of the U.S. economy, and on the 27.5 million small businesses which employ half of all U.S. workers.
In order for price inflation to meet currency inflation, the $1 trillion banks hold in excess reserves have got to be lent. And the $2 trillion in cash companies have must be employed – moving beyond Wall Street and on to Main Street. Otherwise, cash-strapped consumers and small businesses will continue to keep downside pressure on prices in search of the lowest value until the Walmart motto “Always Low Prices. Always” becomes an American mindset. If this behavior continues, the ramifications will seriously call into question the relevance and wisdom of the Federal Reserve, of which its employees may indeed find themselves relying on Walmart’s low-price guarantee.
