The U.S. Federal Reserve has tripled the size of its balance sheet by "printing" an ocean of money. But despite the hand-wringing of the gold bugs, recent data proves that deflation, not inflation, remains the biggest threat to the U.S. economy.
The loan-to-deposit ratio for U.S. banks explains why Fed stimulus is not translating into inflationary pressure – the added funds remain trapped in the banking system and are not reaching the real economy.
When the Federal Reserve buys securities in the open market, they credit accounts held by banks at the Federal Reserve. These funds are not eligible to be lent out – they can only be transferred to other Fed accounts held by banks.
The money amounts held by banks at the Fed count as deposits and assets on their balance sheets. Larger balance sheets allow banks to provide more loans to their customers (similar to households using added collateral to borrow more).
This is where things have broken down. Bank clients, including corporations, appear to have no interest in borrowing. U.S. banks have the ability to extend more loans, but haven't.
The intention behind the Fed's stimulus program was that by expanding bank balance sheets, customer lending would rise, and this would create consumer and corporate demand for products and services. The loan-to-deposit ratio illustrates that the process is stalled at step two – big bank balance sheets are bloated but aggregate demand in the U.S. economy has barely improved. The output gap remains.
Quantitative easing did succeed in protecting asset values – bonds, equities (through lower rates for corporate debt refinancing) and housing (mortgage rates) – from deflation.
It's not hard to see why markets reacted so negatively to the prospect of tapering. Removing stimulus would take away a key form of protection against deflation, at a time when credit growth and aggregate demand are still weak.
The expected appointment of the dovish Janet Yellen as Fed Chairwoman could delay the withdrawal of monetary stimulus far into the future. Investors should hope this is the case – despite the Fed's efforts, deflation risk remains high.
Click here to view the loan-to-deposit ratio chart on mobile: http://bit.ly/19jXrO6
Scott Barlow