I have been paying close attention to the yield curve.  When the 10-year yield drops below the 3-month yield, I will be ready to call a recession.  We are not there yet (as of this writing), but it is close.

The Federal Reserve went on an unprecedented digital money-printing spree from 2008 to 2014.  The adjusted monetary base nearly quintupled.  However, this did not result in exorbitant consumer price inflation as some predicted.

I generally contribute the relatively low price inflation to two things.  First, the economy has been rather lackluster since the financial crisis of 2008.  It scared a lot of people.  It’s hard to say that consumers have been hesitant to spend and take on debt, but I think the last 10 years have been a little less crazy than the previous 10 years.  There may be another housing bubble now in some areas, but it is still not to the extent of the previous housing bubble in most areas.

The other major reason that consumer price inflation has been somewhat low over the last decade, at least compared to the massive increase in the Fed’s balance sheet, is that the commercial banks have piled up excess reserves.

Up until 2008, the excess reserves were close to zero.  In our current world of central banking, the banks lent out almost all of their deposits that they were legally allowed to.  If they fell below their legal limit, they would just borrow overnight from other banks that had a little extra.  The interest rate paid was essentially the federal funds rate.

It all balanced out as long as there were no massive cash withdrawals, which wouldn’t have been allowed anyway.  As long as the money stayed within the banking system, the banking system basically stayed solvent. Or at least that was the case until the financial crisis, when banks got caught with a lot of bad loans, mostly in the form of mortgages.

In response to the 2008 financial crisis, banks piled up excess reserves, which was basically unprecedented in our world of central banking.  This coincided with the Fed’s new policy of paying interest on bank reserves, including excess reserves.  While the rate was very small (0.25%) to start, it was still something. It is better for a bank to earn a risk-free one-quarter percent than to make risky loans at slightly higher rates.

Until 2008, the total excess reserves were around $2 billion, give or take.  In our world of trillions, it was basically a rounding error.  But from 2008 to 2014, coinciding with QE1 through QE3, the banks increased excess reserves to about $2.7 trillion by 2014.  This was at about the same time that QE3 was winding down.

The Slow Wind Down

Currently, the Fed is engaging in a slow wind down of its balance sheet.  It is allowing about $50 billion per month to roll off its balance sheet, which reduces the adjusted monetary base.  The Fed is not actually selling off assets. It is just not rolling over all of its maturing assets.

Excess reserves have fallen to about $1.5 trillion.  This is quite a drop from its high in 2014.  It is somewhat corresponding to the decrease in the monetary base. This major fall is in spite of the Fed now paying a higher interest rate on bank reserves.

This is what makes it so tough to see what is coming.  The Fed went on a massive money creation spree for 6 years.  It obviously caused major misallocations, but it could have been so much worse.  The Fed has gotten away with this because of the relatively low consumer price inflation.  There has certainly been asset price inflation in housing and stocks, but people generally cheer this.

Now the Fed is tightening.  The Austrian Business Cycle Theory tells us that the malinvestments should be exposed, and we should see a correction/ recession.  But while the Fed is tightening, the excess reserves are dropping fast.  So just as the monetary inflation was not amplified on the way up, the monetary deflation is not being amplified on the way down.

According to the CPI, consumer prices are fairly stable, so this is not telling us much.

We really are in uncharted waters.  We have never seen anything like this, or even anything close to this.  It is amazing the Fed has essentially gotten away with this, at least up until now.

The major drop in excess reserves is making me more cautious in predicting that a major crash is imminent.  If banks are lending a little more right now, it may extend the boom.  It may extend the bubbles.  But the large majority of the decrease in bank excess reserves is because of the drop in the Fed’s balance sheet.

I am still leaning towards an economic downturn.  I thought almost for sure it would happen before the 2020 election, but that isn’t all that far off now.  I don’t know if the major drop in excess reserves will buy enough time to keep the artificial boom going past the 2020 election.

That is why I am mostly paying attention to the yield curve these days.  There are so many other moving parts going in different directions, but the interest rates tell the best story.

If the yield curve inverts, then a recession is coming in the near future.  But until that happens, I don’t want to bet against the U.S. economy.