Tuesday, July 3, 2012

All is Quiet on the Federal Reserve Front

Another quiet week at the Federal Reserve.  This month was very similar to last month…and the month before…and so on.

In terms of monetary policy the Fed is doing very little.  There seems to be very little the Fed can do at this time. 

The economy is still growing…but is growing quite slowly.  The recently revised figure for real GDP growth stands at 2.0 percent, year-over-year.

In terms of the state of the economy, the Fed can do next to nothing to get the economy growing faster before the Presidential election.  President Obama…what you see is what you get!

Chairman Bernanke and the Fed stands ready to act if things go south.  Again, there is very little the Fed will be able to do at this time before the election, but, if the economy begins to get worse, the Federal Reserve is prepared to do something to show that it is “on the watch.”  That is the least it can do to help the sitting President.

And, the Federal Reserve continues to keep an eye on the banking system.  I continue to interpret the stance of the Federal Reserve as one that aims to preserve the health of the banking system. 

I still believe that the banking system is not that healthy.  Therefore, in my view, the Fed continues to keep the banking system “well liquefied” so as to allow the banks to work out their asset difficulties as smoothly as possible.  The banking system continues to shrink due to bank closures and through consolidating acquisitions.  The FDIC is doing a very good job in overseeing the reduction in the number of banks in the banking system.

This banking policy, however, is dependent upon the Federal Reserve keeping plenty of excess reserves in the banking system.

In the banking week ending June 28, 2012, excess reserves in the banking system totaled $1,427 billion, roughly equal to the amount of excess reserves that were in the banking system on March 28, 2012 ($1,489 billion) and the amount that banks held on December 28, 2011 ($1,471 billion).

The Federal Reserve just does not want to “shake this tree.”  Bad dreams of 1937, I guess.

In order to achieve this relatively constant level of excess reserves in the banking system the Federal Reserve has basically done very little in supplying new reserves to the banking system and has consistently worked to offset operating factors that a could increase or decrease the excess reserves in the system.

There are two factors that should be mentioned, however, because these are things the Federal Reserve has had to “work around” in order to keep excess reserves relatively constant.

One of these has to do with the European financial situation.  In order to support European central banks and the European banking system, the Fed provided liquidity swaps to the European Central Bank, the Swiss National Bank, and the Bank of England.  In the latter part of 2011, these liquidity swaps increased quite rapidly as the financial condition of the eurozone deteriorated. 

Since the end of 2011, however, the central bank liquidity swaps originated by the Federal Reserve dropped substantially, falling by almost $73 billion. 

This removes reserves from the banking system.  And, in some way the Federal Reserve had to offset this movement in order to keep excess reserves in the banks relatively constant.

This the Federal Reserve did…quietly…and efficiently.

The other “overt” action the Fed took was to allow currency in circulation to increase by almost $35 billion over the past six months. 

Ever since the recession hit in late 2007, the public has been demanding cash holdings at a record rate.  Year-over-year, for example, the currency holdings of the public rose by over 8.0 percent, a rate that has been maintained for much of the past five years. 

This, demand for currency is not a good sign!  It is a sign of individuals, families, and businesses keeping cash-on-hand to help them meet their day-to-day needs.  This is money used by people in economic distress, not people who are employed and economically healthy. 

The Federal Reserves supplies currency to the banks and the public on demand.  Thus, it must operationally replace the currency it supplies in order to keep excess reserves relatively constant.  This is has been doing, not only the last six months…but over the last twelve months…and over the last five years.

In addition to these activities, the Federal Reserve has also altered, slightly, the composition of its securities portfolio.  Over the past six months, the total funds in its securities portfolio has hardly changed, but the Fed has substituted Mortgage Backed Securities in its portfolio for United States Treasury securities and Federal Agency Securities.  Over the past six months, the Fed increased its holdings of Mortgage Backed Securities by almost $18 billion but had allowed its portfolio of Treasury securities and Agency securities to decline by a little more than $18 billion.  This action was to help keep mortgage interest rates low to support the housing market.

In aggregate, the Federal Reserve kept a pretty “even keel” over the past six months continuing to help stabilize the banking industry and see that there was plenty of liquidity in the financial system to support further economic growth if it occurred.  The operations the Fed engaged in were primarily “offsetting” actions to keep the excess reserves in the banking system relatively constant.  In this, one could say that the Fed was very successful.

Talk still abounds about another round of quantitative easing, QE3, or more of “operation twist” or some other Fed action.  I continue to believe that the Federal Reserve can do very little at this time to achieve more growth out of the economy.  I further believe that the Federal Reserve will achieve little more in stabilizing the banking system by injecting more reserves into the banking system. 

The Fed does need to stay alert for signs of another recession in the United States, particularly given the recession now occurring in Europe and the slowdowns taking place in the economies of China and India. 

Consequently, I believe that the Federal Reserve should remain quiet…as it has for the past six months.  There is very little positive it can add to the economy right now.  In my mind, central banks are doing their best job when things are relatively calm and adjustments are taking place without a great deal of intervention by the regulators.  So, as of this minute…I am happy with what the policy of the Federal Reserve seems to be.     

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