Beware the coiled spring.

I’ve mentioned before that I think this graph tells the most important story about the health of our banking and monetary system. Inflationists point to the monetary base as a clear demonstration that inflation is here. My analogy still holds: If I had a genie that was able to grant me a trillion dollars and I went out and spent it, that money would circulate in the economy and you’d have clear inflation as a consequence of the juiced money supply. If, however, the genie granted me a trillion dollars and I buried it in a hole in my backyard, there wouldn’t be inflation as a result. If prices happened to rise on a few goods, you couldn’t blame my increase in the money supply as the cause. The money that has been created is still buried in a giant hole on the banks’ balance sheets. Any changes we observe in prices right now is a consequence of trade balances, supply, demand, and other economic factors.

At some point, this money must go somewhere. When it does, the inflationary impact will be determined by how fast the Fed is able to remove this money from the system. Unfortunately, it’s a lot easier to give banks money than it is to take it away.

With the problems increasing in commercial real estate, it’s quite possible that the hole in the banks’ balance sheets will continue to grow. Before this crisis, the largest bank reserves was $63 billion, set in 1989, because of a different banking crisis. Reserves are now $1.2 trillion. Nobody really knows how high they’ll need to rise to fill that balance sheet hole. But once that hole is finally filled, I would suggest standing back and observing the consequences from a safe distance.

(source: St. Louis Fed: FRED Graph)