Koo on reserves time bomb – 500% inflation

So much for yet another legacy.
:(

From Richard Koo’s latest report:

But nightmare scenario awaits when private loan demand recovers. The problem is what happens when private loan demand recovers. Loan books could grow more than tenfold in the US and five fold in Japan and Europe if bank reserves remain at current levels, triggering inflation rates of 500% to over 1,000%.

To avoid this outcome, central banks will have to mop up excessive reserves by raising the statutory reserve ratio, raising the interest rate paid on reserves, and selling government bonds. All of these measures will serve to lift interest rates, sending bond yields sharply higher and triggering a possible crash in the bond markets.

A sharp increase in government bond yields could lead to fiscal collapse in countries with a large national debt. For Japan, where the national debt amounts to 240% of GDP, the results would be catastrophic.

Expanding quantitative easing because it appears to be doing no harm is grievous error. Mr. Abe and his advisors may believe that all they have to do once their anti-deflationary policies succeed and JGB yields start to rise is have the BOJ buy more bonds. However, bank reserves under quantitative easing have risen to a level capable of fueling a 500% inflation rate, in which case the BOJ would have to sell, not buy, JGBs.

Nomura | JPN

BOJ purchases of JGBs in that situation could cause the potential inflation rate to rise from 500% to 600% to 700% and trigger an economic collapse.

I do not know whether the German finance official who was opposed to reckless quantitative easing based his view on this kind of scenario. Nevertheless, it is extremely dangerous to assume that since quantitative easing does no harm in a balance sheet recession, it can be continuously expanded without concern. The real danger posed by this policy will become apparent only after private-sector balance sheets are repaired, and then it will happen suddenly.

BOJs excess reserves could become a time bomb. I would now like to bring some actual numbers into the discussion so that readers may appreciate the implications of this scenario.

Only 7.7 trillion in bank reserves are required to maintain Japans money supply. With the Japanese government now running annual fiscal deficits in excess of 40 trillion, BOJ financing of the entire deficit would require the Bank to supply reserves equal to more than five times the amount needed to maintain the money supply. Over a two-year period, it would have to supply reserves equal to more than ten times the required amount.

In other words, the purchase of one years worth of newly issued government debt by the BOJ has the potential to generate a 500% inflation rate. I suspect few Japanese are willing to accept such a trade-off.

Moreover, the BOJ has already engaged in substantial quantitative easing under heavy pressure from politicians, pushing excess reserves to 29.8 trillion. In my view this represents a time bomb.

Saudi production

A modest drop in demand for Saudi crude, which means they sell a bit less at their posted prices.

Not sure what, if anything, makes them change price at this point.

Supply shocks that could cause demand for their output to fall further include a resumption of output from Iran, an increase from Iraq where development was going full tilt last I checked, and a bit from continued output increases and falling consumption in the US.

On the other hand, if Iran shuts down completely the call on Saudi output could spike beyond their ability to increase production and they’d lose control of prices on the upside.

Fed policy

I wrote this (published) paper on 0 rates 15 years ago.

The trimmed Fed forecasts are confirming the ‘tax’ aspect of QE?

The $80+ billion the fed turns over to the tsy each year would have otherwise been earned by the economy.

It’s all confirming my suspicions that the Fed has been stepping on the brake when it thinks its stepping on the gas.

And when it ‘doesn’t work’ they just step on it that much harder.

Tragically, after all these years and with all the hard evidence in our face we continue to have both fiscal and monetary policy backwards.

yen dynamics

A while back I wrote about euro strength and yen weakness. this is an update on the yen side. Fundamentally the euro side remains firm as previously discussed.

History:

Japan had a ‘weak yen’ policy to support its exporters. The export model was to keep domestic demand low via relatively tight fiscal policy/large demand leakages/institutionalized ‘savings’. And then dollar buying to keep the currency/real wages in check.

They had accumulated over $1 trillion, back when that was a lot of money, when US politics put an end to it, with Paulsen calling them currency manipulators and outlaws.

Japan takes that kind of thing seriously from the US and stopped buying dollars, with the yen subsequently appreciating from over 100 to something less than 80.

With the politics now changing, so is policy. Japan tested the waters with an announced dollar buying policy a while back with no negative political ramifications from the US. And the euro zone’s financial crisis has caused the EU to welcome foreign buyers of national govt debt, which firms the euro.

Japan has not announced dollar buying but their dollar fx reserves are growing. Those dollars have to come from somewhere?

And there is reason to believe a hopelessly out of paradigm US Treasury Secretary might be welcoming dollar buying our of concern of the US Treasury being able to fund itself, particularly when the Fed stops its purchases.

And Japan’s trade surplus has been going away as well.

So it may be the case that Japan is in the process of resuming it’s traditional dollar and euro buying, which can move the currency to whatever level it desires. Which is probably back to north of 100 to the dollar?

Lastly, there is a record yen short position being reported. While this could mean it’s getting over sold and subject to a rally, it could also mean insiders have been tipped off to this policy shift and will profit immensely.

Caveat: If all the noises around the coming election and weak yen policy result only in an increase in the inflation target and ‘unlimited qe’ involving only yen financial assets, that policy will only serve to make the yen stronger and a wicked short covering scramble will follow.

Nothing short of buying fx, directly or indirectly, will do the trick.