“There is a $1 trillion stash of cash idling in the banking system,” writes Peter Eavis in this morning’s Wall Street Journal. “It’s too big to ignore, and it’s a cause for concern.”  (see “The U.S. Economy’s $1 Trillion Question“)

Banks are required by the Federal Reserve to hold a small amount of funds in reserve to meet their liability needs. But these bank reserves now exceed the minimum by over $1 trillion — up from a surplus of just $2 billion in September of 2008.

By now, most our readers should have seen the inflation scare chart — the expansion of the monetary base.   With such an explosion in the potential money supply, it is understandable why inflation hawks have caused a stir.  As Eavis continues, “In theory, these sleeping funds could be ‘activated’ to support a huge volume of new loans, which in turn could fuel demand and inflation… [But] for now, though, the inflation fears look overdone. Bank credit is actually falling, despite the excess reserves. That raises an opposing fear: That banks remain nervous, even after all that has been done to support them. They would rather cling to low-yielding cash than lend it.”

In case anyone wonders where all of the Fed’s newly “printed”money has gone, you now have your answer.  Rather than lending out the massive bulge of liquidity you see in the link above, banks have decided to sit on it — all one trillion dollars of it!

So, what does this actually mean? It means that inflation is not an imminent threat.  Until banks recover their appetite for risk (and consumers recover their appetite for new debt), the velocity of money will remain depressed and deflation — not inflation — will remain the primary concern.

Charles Sizemore, CFA

Co-author of the recently-published Boom or Bust: Understanding and Profiting from a Changing Consumer Economy

The Fed and Treasury propped up the banking sector fearing that a collapse would choke the life out of the economy.  Credit had to keep flowing, or the economy would grind to a halt, and this was particularly true in the housing market.

Today, the banks are indeed making mortgage loans again, but not quite the way the government intended.  As the Wall Street Journal reports, “Banks Load Up on Mortgages, in New Way.”

Rather than use TARP funds to make mortgage loans, the newly risk-averse banks are instead using the funds to buy government-guaranteed Ginnie Mae bonds.  And they’ve been buying them by the truckload.  Read the rest of this entry »