﻿Adjusted for inflation the U.S. has now spent more money fighting the
economic fallout of the coronavirus than it spent fighting both world wars ... combined.
Unsurprisingly, this has caused some distortions in the economy that
may come back to bite us in the future.
In fact, there is something very concerning taking place in the global economy at this moment.
Now, I know that might be a phrase that you are sick of hearing,
especially in these last 18 months. But, this may genuinely be one of the
defining issues of the next two decades and nobody is really talking about it.
And what is this issue?
In essence, The Federal Reserve Bank of the United States,
as well as a selection of other central banks from around the world are being
forced to take back all of the cash they have been busy printing to fund stimulus efforts.
The Fed’s Reverse Repos recently spiked to 1
trillion dollars, which effectively undid over 8 months of quantitative easing efforts.
Now, if you are not sure what this all means fear not,
we are going to explain it all in this video because it is genuinely important
that everybody has at least a general understanding of what’s going on here.
If you do understand it, and think that taking cash out of circulation is a good
thing right now (especially in light of fears about hyperinflation), well,
maybe, you might be right. But if that was the case, this would – at best – a temporary
solution, or at worse, something that will mask the problem only to make it much worse later on.
But to be able to draw your own conclusions on this matter
you are going to need to understand a few things.
So.
What are these Fed Reverse Repos that have economists so concerned?
Why are people saying that this could ease the risk of hyperinflation?
And finally, why might this phenomenon make everything,
including inflation, worse in the long term?
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Ok, so Repos or "repurchase agreements", are simply a financial instrument
that is a secured very short-term loan, sometimes as short term as a day or two.
For example, if a company pays all of its employees on the 15th of the month,
but they just purchased a huge new piece of equipment on the 13th,
they may be in a position where they don’t have enough cash-on-hand to pay their employees.
Now, instead of delaying people's paychecks or going through the lengthy process of
applying for a business loan, the company simply calls up their bank and agrees to
sell this shiny new piece of equipment to the bank itself.
Say this piece of equipment was worth $1,000,000
the bank would likely only buy it under such an agreement for $500,000
but, written into the terms of this contract would be the requirement for
the bank to sell this machine back to them for say $501,000 at the end of the month.
Normally, during this time the company will also be allowed
to keep on using the big fancy machine as well.
This is a great deal all around. The company got access to the cash flow it needed to pay its staff
for a very low effective interest rate, and the bank had an extremely secure position,
because even if the company didn’t end up buying back the machine (which
they would be very silly not to do) well then the bank could just sell
this machine easily making its money back because, remember, [the bank] technically owns it.
This sale, with the Agreement to Repurchase, at a later date is how these financial instruments get
their name. Financiers are a creative bunch, just not when it comes to naming things.
Now, regular banks and central banks effectively do something very similar every single day.
If a regular bank is running low on cash, they can enter into a repurchase agreement with the
Federal Reserve. This normally involves them selling very low-risk assets like
treasury bills in exchange for cash at a very low-interest rate. This is also known as "the cash rate."
This is there to ensure that banks can lend out more and more money without the
risk of running out of cash if lots of people decide to withdraw their funds on a given day.
Not having money on hand to honor withdrawals is bad news, as it would cause a run on the banks.
So, deposit-taking institutions and The Fed take this responsibility very seriously.
Ok, this is great but repos aren’t even what we are interested in here. The problem at the
moment is actually with Reverse Repo’s, which, again, as the name would suggest is exactly the opposite.
In the same way that you can deposit money into your bank account for safekeeping,
your bank can keep money with The Fed for safekeeping through these reverse repos.
In this kind of deal, the bank will purchase assets from the fed for cash,
with the agreement that the fed will buy back the bills
the next day for a slightly higher price. And I do mean very slightly higher.
If J.P. Morgan let's say, bought a billion dollars worth of assets from The Fed they would only be
able to sell them back for a $5,000 premium, which to you or I might sound pretty good for one day,
but for a billion dollars it’s pretty terrible.
Now the fact that both Fed Repo (where the private banks sell their assets and
get given cash) and reverse repo (where The Fed sells assets and gets given cash)
happen on one-day terms is why you have likely heard the term, "overnight cash rate."
This is what The Federal Reserve Bank actually changes when it changes interest rates –
that is, the premium that it receives, or "gives", on these repurchase agreements.
Alright, so now that you understand what actually goes on under-the-hood at The Fed,
it’s time to learn why this spike in cash going back to The Fed is causing concern.
The coronavirus pandemic caused a lot of economic uncertainty. Businesses were closed,
people were out of work, companies couldn’t operate. I mean you know the drill. You were there.
In response to this economic downturn, the Federal Reserve lowered its overnight cash rates from a
2.50% effective annual rate down to a 0.05% annual rate. This is the same thing they did
after the crash of 2008, and pretty much every other economic downturn for the past 5 decades.
The hope here was that this would encourage banks to lend more money
because they could load-up on cash at cheap rates and pass this along to consumers.
It also simultaneously acted as a deterrent for banks to park piles of cash with the fed
because, as we saw earlier, they wouldn't get much money for doing so. In fact, given our
example from earlier, if J.P. Morgan was to deposit those same 1 billion dollars overnight in mid-2019
they would have received close to $70,000 in repo premiums which is “not bad”.
Anyway, the ultimate hope of this carrot and stick approach is that more money gets out
into the economy for people to spend – thus, counteracting the effects of the recession in the first place.
This is, in essence, countercyclical monetary policy.
The problem is, right now, it's not really working.
You see, a lot of money has been created recently to fund the various stimulus efforts that went
into fighting the coronavirus. Everything from the Paycheck Protection Program (PPP) to those $1,400
checks was paid for with nice fresh new piles of new money.
But despite the imagery, almost none of that money was kept as cash, but rather, is kept digitally in
people's bank accounts. Now, normally, banks would take this money and loan it out or invest it,
that’s how they make profits, but they are kind of limited in how they can do that right now.
They don’t really want to write residential home loans that will
last for 30 years at record low interest rates,
business loans are a bit hit and miss right now. And even credit card usage is falling
fast – thanks in part to competition from zero interest "buy now, pay later" companies, and also
from a new wave of educated consumers who doesn’t feel like paying 20% interest on their spending.
What's more, is that a lot of banks are afraid to invest in the stock market
while it is so hot. Remember, it’s not actually their money to speculate
with, so they do try to remain relatively conservative with their investments.
So, banks are holding piles of cash on behalf of a nation of businesses and individuals that have
been the recipients of the largest stimulus effort in history.
But okay, maybe this isn't awesome for the quarterly profits of financial institutions, but it still doesn’t sound that bad ... right?
Well, it might. For two reasons.
For starters, it shows that the overall confidence level of participants in
the economy is very low. Everybody from working-class individuals to the largest
banks in the country are hoarding as much cash as they possibly can, just in case.
Just in case they lose their job. Just in case their business is forced to close again.
Or, just in case there are better investment opportunities that present themselves in the future.
Now, this increased savings rate is not so much a problem in and of itself,
Rather, it’s just a warning sign that people might not be 100% confident in the future right now.
What could be a problem is that this much money sloshing around
fundamentally limits some of the control over the economy.
This all has to do with something that economists refer to as The Velocity of Money.
When we made our video on hyperinflation last month, a lot of people said that the
risk of sustained inflation wasn’t huge because the velocity of money was at all-time lows.
Now in fairness, this is half-correct.
So, are the doom and gloom economists wrong?
Well, the velocity of money is a measure of how fast money changes hands –
normally measured on a quarterly basis.
If, for example, you spend a dollar at a local convenience store and then that dollar gets given
to an employee of that store, who in turn spends it buying an iced tee from a vending machine,
then the velocity of money would be 2, for this quarter.
This means that we can actually work out GDP using this measure.
GDP simply equals the money supply, multiplied by the velocity of money.
And, if we wanted to get really technical, we can work out "Real GDP" (that is GDP adjusted for
inflation), by putting the whole right-hand side of this equation over the inflation rate plus 1.
I’m sorry to have to bring "maths" into this but
don’t worry it’s actually pretty simple and you will see why soon.
Now, here is the thing ... The velocity of money
normally hovers around 1.5 to 2 transactions a quarter in the U.S.A., it has
been trending down in recent years, but after the fallout of the coronavirus, it fell off a cliff.
Now, this was caused by two things. For starters, we have all seen the money printer memes.
More cash in circulation meant that the transactions as a portion of this increased
pool of cash was naturally lower. Increase the denominator, the result gets smaller.
But what's more, is that as we saw earlier, people are spending less money, either out of fear,
or lack of opportunity, or lack of ability to get outside and spend up.
People are just sitting on their piles of cash.
Now, of course, this won’t last forever. The money supply won’t decrease,
but people will eventually go out and spend it, so let’s map out what happens with that.
Let’s take our equation here again. If the velocity of money is to bounce back to a
somewhat normal level, let's say increasing from 1 average transaction a quarter to 1.5
average transactions a quarter, that would mean either real GDP would have to increase by 50%,
the money supply would need to contract by 33%, or, indeed, inflation would need to increase by 50%.
Now ask yourself: What do you think is most likely to happen?
Now, if you don’t like maths think of it like this.
Imagine the economy is a balloon, the air inside that balloon is the money supply, and the balloon bursting represents a hyperinflation armageddon.
You can pump a lot of air into this balloon – and eventually it will burst.
But if the air molecules aren’t moving around very fast in there, you'd find that you would have to put a lot more air in there than you might expect.
On the other hand, if you increase the velocity of the air particles in this balloon, you will
find that the air expands – eventually bursting the balloon ... even if no more air was actually added.
Or, worst-case scenario, let's say you pump your balloon full of air while it’s really cold,
and then wait until it heats up. Yeah it’s gonna pop. Don’t believe me?
Well, it’s like a million degrees in America at the moment go and try it out for yourself,
while I enjoy winter down here in Sydney.
Economists are worried that we are pumping the economy full of "cold money" at the moment, but
as soon as things heat up again and those particles of money start moving around
we might have a problem we are ill-equipped to handle.
Am I being overly pessimistic here? Well probably. Nobody can predict the future,
least of all people on the internet or economists, or worst of all economists on the internet.
Look, hopefully, it will be some combination of all three of these factors, and hopefully,
it will happen very slowly.
50% inflation in two years is devastating, 50% inflation over 20 years is perfectly fine.
But in the meantime, we need to come to terms with the fact that we
are sitting on top of a lot of dry powder at the moment. And the thing about dry powder,
is that if you’re not careful it, it has the tendency to blow up in your face.
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As always, thanks for watching mate. Bye.