Rising Dollar Forces Bernanke's Hand

It is really any wonder why global governments and central banks are starting to panic? As I indicated in last week's commentary on King World News, the European Central Bank decided to lower its deposit rate it pays to banks to 0%. While some foolishly believed this move would have no effect on money supply growth, we just received empirical evidence of how banks behave when the interest on their reserves are cut to nothing. Last week the ECB recently reported that overnight deposits parked at the central bank plunged by the most on record, or €484 billion in just one session. It now seems that my theory that banks would deploy their reserves was proven correct in just a matter of days.

The truth is that most global central banks are now acting in a concerted and unprecedented effort to battle deflation. South Korea cut interest rates by 25 bps and Brazil cut rates 50 bps to a record low last week; joining China, Europe, England and Japan in an aggressive attempt to raise asset prices. Not only have these central banks massively increased liquidity, but they are now moving towards taking measures to punish banks that do not do their part in expanding the money supply.

While it is true that banks don't depend on a tremendous level of reserves to make new loans, it is imperative not to ignore the increase in the level of their excess reserves. These reserves came into existence when the central banks purchased assets from banks. A bank cannot afford to have a significant portion of its assets, which used to be productive and earning interest, to then become latent for an extended period of time.

However, the key point here is that while the Bernanke Fed has sat on hold, other central banks are cutting rates, reducing reserve requirements, buying equities and ceasing to pay interest on excess reserves. That has caused the U.S. dollar to rise 12% in the past year. This factor alone has stoked Bernanke's deflation phobia to an unbearable degree.

I believe the cyclical period of deflation that I warned about several months ago is now close to an end. The Fed feels foolishly compelled to stop the rise of the U.S. dollar and will soon opt to follow the lead from the ECB and stop paying interest on excess reserves. That move will not increase bank lending to the private sector, as much as it will force banks into purchasing even more sovereign debt. If they Fed does indeed go down that road, I would expect to see U.S money supply growth increase significantly, causing gold and commodity prices to soar and the dollar tank. I would also expect to witness the global economy sink ever further into the stagflationary abyss.