Fed to Money Market Funds: Get Your Money Out of Europe

How near the cliff are things in Europe? The Federal Reserve is telling money market funds to pull money out of Europe.

During an interview with WSJ, Philadelphia Fed President Charles Plosser said: http://blogs.wsj.com/economics/2012/05/28/qa-philadelphia-fed-president-charles-plosser/?mod=wsj_share_twitter

The Fed and regulators have tried to stress to money market funds, for example, to reduce their exposure to European financial institutions.

This warning is in sync with comments made to me by a former senior Treasury official. Clearly, U.S. officials are very concerned about the eurozone blowing up. How concerned? This Keynesian former senior Treasury official asked me in something close to exasperation, "How would the Austrians handle this situation?"

That said, any eurozone crisis is not likely to have significant impact in the U.S. in terms of panic. The Fed will print whatever is needed to prop up and prevent any run on U.S. banks. Plosser said as much:

The swap lines we have with the European Central Bank are one way to support U.S. dollar funding in Europe. I don’t think a flood of liquidity is a huge problem. That would be manageable. The bigger problem is if it dries up for everybody. The Fed still has the tools it used during the crisis. We have the discount window and we have the ability to lend to financial institutions at a penalty rate against good collateral. And we have on the shelf some of the tools we used during the crisis: the Term Auction Facility and longer-term lending through the discount window to help mitigate that. So I think we have the tools at our disposal if they become necessary.

Amazingly, in the interview, Plosser correctly warns that the trillion dollars plus sitting in excess reserves could become a major problem. This is the first time I have heard this from a Fed official:

The inflation risk we have is longer term. The problem is that as the U.S. economy grows we have provided substantial amounts of accommodation. We have $1.5 trillion in excess reserves. Inflation is going to occur when those excess reserves start flowing into the economy. When that begins to happen we’ll have to restrain it somehow. The challenge for the Fed is will we act quickly enough or aggressively enough to prevent that from happening.

It may be a challenge politically when we have to start selling assets, particularly if we have to start selling (mortgage backed securities) to shrink the balance sheet and to prevent those reserves from becoming money.

Note well: The Fed selling assets means the Fed would be pushing up interest rates.

Print this post out and tack it to your computer, this is the most accurate analysis I have ever seen by a Fed official and it describes the exact truth as to when the Fed will start pushing up rates. It's when that money starts flowing out of excess reserves. And Plosser is also correct in indicating that it will be very difficult, for political reasons, for the Fed to push rates up high enough fast enough to battle the price inflation at that time. That's why at some point down the road, we are likely to experience quickly accelerating price inflation and interest rates.