The $1 trillion tax on cash

One under-appreciated side-effect of the Fed's quantitative easing and zero-bound interest rate policies is the sizable "inflation tax" borne by all those who have been holding cash, cash equivalents, and short-term securities since the end of 2008. By my estimates, this tax could total $1 trillion or more. As the public becomes increasingly aware of this under-the-radar tax, the demand for cash and short-term securities (cash equivalents) is likely to decline, and that will complicate the Fed's QE exit strategy.

The Fed's target for the fed funds rate (the rate banks charge each other to borrow bank reserves) sets the tone for all short-term interest rates. Since late 2008, the nominal target for the the overnight Fed funds rate has been 0.25%, and the Fed has been paying 0.25% on bank reserve balances held at the Fed. As the graph above shows, this extremely low level of short-term rates is unprecedented in modern times. For their part, banks, which have invested essentially all of their savings deposit inflows since 2008 in bank reserves, have paid very low rates to the holders of savings deposits: 1-mo. Libor has averaged 0.24% since the end of 2008 and is currently a mere 0.16%, and most banks and money market funds now pay between 0 and  0.15% on short-term savings deposits. Obviously, banks need to pay less on their deposits than they earn on their assets (e.g., bank reserves). Taking fees into account, the effective nominal interest rate on most savings deposits today is zero or even slightly negative.

The extremely depressed level of nominal interest rates since late 2008 has been exacerbated by the fact that inflation has averaged about 1.5% per year, according to the Core Personal Consumption Deflator, the Fed's preferred inflation measure (see graph above). 

The combination of very low short-term interest rates and 1.5% inflation has resulted in 5 ½ years of negative real short-term interest rates. As the graph above shows, this is the longest and most significant period of negative real interest rates in over 50 years. Recall that the negative real interest rates of the late 1970s occurred during a time of sharply rising inflation.

Negative inflation-adjusted short-term interest rates affect a lot of people and a lot of money. Anyone holding cash and cash equivalents (e.g., currency, checking accounts, savings deposits, money market funds—the things that comprise the M2 measure of the money supply, arguably the best measure of the public's store of readily-spendable cash) during this period has suffered a significant loss of his or her purchasing power—on the order of 7% or so. Bank savings deposits now represent about 65% of M2, while checking accounts ($1.6 trillion) and currency ($1.2 trillion), represent another 25%.

By the end of this year, when interest rates are almost certainly going to remain very close to zero, the cumulative loss of purchasing power suffered by those holding cash and cash equivalents (as proxied by the M2 measure of money and using the real Federal funds rate as a proxy for the real yield on M2) will be, by my estimates, at least $700 billion.

Using M2 as a proxy for cash and cash equivalents gives a lowball estimate of the inflation tax, however, since it does not include the purchasing power lost by those who held short-term notes yielding less than 1.5% (i.e., less than the annualized inflation rate) since late 2008. That would include any Treasury securities with less than 5 years' maturity, since the yield on 5-yr Treasuries has averaged 1.5% over this period. (For example, 2-yr Treasury note yields have averaged 0.5%, so those who held 2-yr Treasuries have suffered a -1% annual real rate of return. For holders of T-bills it's even worse, since the average nominal yield on 3-mo. T-bills since late 2008 has been a mere 0.08%.) It also doesn't include the inflation tax effectively paid by holders of institutional money market funds, commercial paper, and bank CDs not included in M2. So the total inflation tax on cash and short-term financial instruments is probably well in excess of $1 trillion.

The "inflation tax" I'm referring to is the loss of purchasing power that results from holding a monetary instrument with a yield less than the inflation rate. The holder suffers a loss of purchasing power, while the issuer—in most cases the U.S. government and the Federal Reserve, for whom money, bank reserves T-bills, and short-term notes are a liability—benefits because their liabilities can be repaid with cheaper dollars. In other words, the purchasing power you lose every day as a result of holding cash, cash equivalents or short-term securities is equal to the amount the federal government and the Fed benefit. The inflation tax is a direct, and largely underappreciated transfer of wealth from the private to the public sector. And it's big.

The M2 measure of money supply has been growing at about a 6.4% annualized rate for over 7 years. This growth is very much in line with the past history of M2, which has grown at an annualized growth rate of 6.4% over the past 15 years and 6.1% over the past 20 years. The lion's share of M2 growth in recent years has come from bank savings deposits, shown in the graph above. This isn't money that the Fed has "pumped" or "dumped" into the economy, it's money that people want to hold for reasons of prudence and safety. Nobody holds onto currency they don't want, and nobody is being forced or encouraged to hold bank savings deposits, since they yield almost nothing.

For the past 5 ½ years, the public has had a very strong demand for cash, cash equivalents, and short-term securities, even though they "cost" over $1 trillion to hold. The public has been willing to pay this inflation tax because the public has been very risk averse. However, as I've noted before, risk aversion is on the decline. As time passes, the public will be less and less likely to want to hold safe assets that carry with them a significant inflation tax. Banks too will be less willing to hold the current $2.6 trillion of excess reserves that currently pay only 0.25%; they will be more likely to use them to increase lending, which could potentially yield a lot more. All of this will make more urgent the need for the Fed to reverse its QE efforts by draining reserves and increasing the interest it pays on reserves, lest a surfeit of bank reserves lead to an excess of money supply vis a vis money demand—the classic prescription for rising inflation.

As money demand declines, the public will want to reduce its holdings of money and safe assets in favor of assets with a positive real yield. A reduction in money demand will thus put inexorable pressure on short-term yields to rise and riskier asset prices to rise. Some might call this a "melt-up," and it wouldn't be far-fetched.