Federal Reserve Can Do Little At This Time

By historical standards the rate of growth of both measures of the money stock, M1 and M2, are quite high.  Still the reasons for these high growth rates are related to people moving assets around their balance sheets rather than the stimulus injected into the banking system by the monetary authorities.  Money stock growth is not occurring because loan growth is increasing.

In May, 2012, the year-over-year rate of growth of the M1 money stock was just about 16 percent within the 16 to 18 percent range the year-over-year growth rate this measure of the money stock has grown in the first five months of this year.

The M2 measure of the money stock grew at a 9.5 percent rate of year-over-year increase, a rate consistent with its behavior since the end of last year.

These measures are growing as rapidly as they are, not due to the monetary stimulus of the Fed working its way through the lending of the banking system, but because people continue to shift assets in their balance sheets away from short-term interest bearing assets to transactions balances that pay little or no interest.

This shift in funds, as I have argued for over the past two years or so, should not be interpreted as a sign that people are buying things.  On the contrary, people are still moving their funds from short-term interest bearing assets to transactions balance for two reasons.  First, many people are without jobs or without full-time jobs or who face housing problems need to keep their money in a form that can provide for daily needs.  Second, with interest rates so low people are not earning enough in the short-term interest paying assets to justify them to keeping their funds there.

In the first case, the currency component of the money stock is still increasing at historically high rates, 8.5 percent, year-over-year in May, and this I continue to interpret in a pessimistic way.  People need to hold cash when times are tough. 

In addition, the demand deposit component of the M1 money stock is increasing at a 36 percent annual rate in May, an extraordinarily high year-over-year rate of growth.  Where are these funds coming from? 

Well, small time deposit accounts are down over 17 percent, year-over-year, retail money funds are down 3.5 percent, year-over-year, and institutional money funds are down slightly more than 8 percent, year-over-year.  People are taking funds out of short-term interest bearing accounts and putting these funds into demand deposits.

The increase in demand deposits is not being generated by the commercial banks lending out money to support consumer or business spending!

We can see the effect of this on bank reserves.  Total bank reserves have actually declined year-over-year by slightly less than 2 percent.  However, required reserves have risen by 31.5 percent over the same time period.  The increase in required reserves is a result of the shift in other bank accounts that have lower reserve requirements to demand deposit accounts that have a much higher reserve requirement. 

The interesting consequence of this is that excess reserves in the banking system have actually declined over the past year.  They have not declined by much, but the have declined sufficiently to cover the amount of reserves the banks’ need to cover the increase in required reserves to back up the rise in demand deposits.

This decline in the excess reserves in the commercial banking system is matched by a similar decline in the reserve balances commercial banks keep at Federal Reserve banks. 

Overall, in comparing where the Federal Reserve was last year with where it is at the present time there are two things that stand out in terms of the actions of the central bank. 

First, the Fed supported the substantial increase in the demand for currency in the economy.  In this matter, the Fed supplies currency to the public “on demand”.  That is, the Fed exercises no control over the amount of currency that is in the economy.

Second, there were substantial actions on the part of the Fed over the past year to combat what was going on in the rest of the world.  Three major line items on the Fed’s balance sheet relate to this: central bank liquidity swaps; dealing in assets denominated in foreign currencies; and reverse repurchase agreements with “foreign official and international accounts.” 

This second area that stands out is not surprising given all the problems that have been faced in Europe and elsewhere.  The Federal Reserve has provided help when and where it can.

Otherwise, the other activity that the Federal Reserve has engaged in over the past year can fundamentally be called “operating transactions.”  That is, the Fed acts to offset seasonal or special transactions to maintain relatively steady reserve balances.  For example, when cash flows out of the banking system in the Thanksgiving/Christmas time period, the Fed usually injects reserves to cover the outflow.  After the first of the year when cash flows back into the banks the Fed will reverse their previous injection.

These actions are call “operating transactions” because they help to stabilize the movement of funds in and out of the banking system that are just routinely operational.  And, these operations still have to be maintained even in the face of all the excess reserves that now exist within the banking system.

Bottom line: very little has changed in the banking system in recent months and, hence, the Federal Reserve has been relatively quiet.  There still remains a contingent of individuals in the financial markets that are calling for the Fed to engage in a third effort at quantitative easing.  My guess, however, is that QE3 will not be forthcoming, even in the face of the lower revised numbers for GDP in the first quarter of this year.

There are three reasons for this.  First, further quantitative easing will have little or no effect in stimulating faster economic growth.  There are just two many structural problems in the economy for the United States to achieve faster economic growth at this time.  What would the banking system do with more than $1.5 trillion in excess reserves?

Second, the handling of the insolvency problems within the United States banking system is going very smoothly. (See my post on “The Condition of the Banking System”.) Right now, there is nothing else the Federal Reserve can do to help this process go any better.  Thus, the Fed needs to leave well enough alone.

And, third…this is an election year.  The Fed has been criticized in the past for attempting to ease monetary policy to support a sitting President.  It does not want to look political in its actions.  

The Federal Reserve does not have unlimited capabilities.  The officials at the Fed need to know when to act, but they also need to accept the fact that there are times when they can do little or nothing to help a situation.  In these latter cases they need to back off.

To me, now is a time when the Fed need to stay quiet, continue to execute its routine “operating” duties, but still stay alert.  There is very little benefit that the Fed can achieve now through further actions, but there are potential costs of attempting to be too active.