US bank reserves at the Federal Reserve rose by a further $72 billion in the week to Wednesday, to $1.22 trillion – just below the peak of $1.23 trillion reached in February 2010 and equivalent to 8.2% of annual GDP. The increase reflected the Fed's continued QE2 securities purchases and a flow of cash out of the Treasury's accounts at the central bank, partly due to the rundown of the supplementary financing program* (SFP).
As previously discussed, if the Fed completes QE2 and the SFP falls to $5 billion and remains at this level, bank reserves will reach about $1.68 trillion by mid 2011, barring any offsetting sterilisation actions. This would represent a 69% increase since QE2 started in early November. Reserves would equate to 11.1% of GDP compared with less than 0.1% before the financial crisis – see first chart.
Such a reserves to GDP ratio would be unprecedented in the Fed's 98-year history. The previous high, of 6.9%, was reached in 1940 as the Fed flooded the system with liquidity after the 1937 Roosevelt recession. On that occasion, the increase in reserves was followed two years later by a surge in CPI inflation into double-digits – second chart.
The prospective reserves to GDP ratio is double the level reached in Japan during its QE experiment in the early 2000s – the ratio peaked at 5.6% in 2004.
The rise in Japanese reserves did not lead to inflation because there was little impact on monetary trends. Growth in the M1 and M2 measures was stable at annual rates of 4-5% and 1-2% respectively in 2004-05.
In the US in the late 1930s, by contrast, M1 and M2 growth started to accelerate soon after the Fed began to inject liquidity in 1937 and reached double-digits in 1939-40.
Fed Chairman Ben Bernanke claims that the current reserves surge will not result in higher inflation. With policy in uncharted territory, he cannot possibly know. Monetary trends are beginning to resemble the US in the late 1930s rather than Japan in the 2000s: M1 and M2 growth have risen from annual rates of 4% and 2% respectively in July last year to 10% and 4% in January. Further M2 acceleration would ring inflationary alarm bells.
*The SFP was instituted as a crisis measure in late 2008 and involved the Treasury issuing additional bills and depositing the proceeds at the Fed for onlending to distressed financial institutions. It reached a peak of $559 billion in November 2008 and was stable at $200 billion between April 2010 and January 2011. In late January, however, the Treasury announced its intention of reducing the SFP to $5 billion in order to slow the rate of increase of the federal debt, which is approaching the legislated ceiling. As of Wednesday, it had fallen to $150 billion. The Fed repays the Treasury by creating new bank reserves.