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.

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