Fed Sees No Pressure on Interest Rates

The Federal Reserve has seen little or no demand pressure in the money markets over the past six months or so.  Consequently, the Fed has not had to add securities to its portfolio during this time to combat any pressure for interest rates to rise. 

The Board of Governors of the Federal Reserve System met last week and decided not to change the current stance of monetary policy, although the Board felt that it needed to be alert to any possible needs for additional monetary stimulus if the economic growth appears to be decelerating or if the unemployment situation seems to be deteriorating. 

My read on this is that the Federal Reserve believes that it can do little more than what it has already done to try and stimulate further economic growth or lower unemployment.  However, it says that it needs to stand ready in case the situation gets worse. 

This is basically the same policy the Federal Reserve has been following for the past year. 

To me the most important monetary variable to watch at this time is the excess reserves held by the banking system.  This is very important for two reasons.  The first is that I believe that the excess reserves statistics tells us something about what is going on in the banking system and the money markets.  To understand what is going in the banking system and the money markets is important because the primary target the Federal Reserve is focusing on at this time is the Federal Funds rate and what is going on with respect to excess reserves tells us something about what is happening to the supply and demand for funds in the Fed Funds market.

Federal Reserve policy right now is to keep the Federal Funds rate between zero and 25 basis points.  It has been focusing on this range since late 2008.

In attempting to keep the Federal Funds rate within this range, the Fed has been very successful.  The effective Federal Funds rate, the actual funds rate times the quantity of funds lent at the each rate, gives us a weighted average of where the funds rate was trading each day.  Over the past year the effective Federal Funds rate has traded between a low of 6 basis points and a high of 19 basis points. 

The demand side of the market represents the need of the commercial banking system for additional reserves.  The supply side of the market is dependent upon the Federal Reserve System supplying funds or withdrawing funds from the market to keep the Federal Funds rate from within the range it is aiming for.

My reading of the movement in the effective Federal Funds rate for the past year is this: the effective Federal Funds rate was relatively level, around 8 basis points, during from August 2011 into January 2012, roughly the first six months of the year.  After January the rate increased up to the middle of July when it reached 19 basis points and then dropped off to about 14 basis points where it now resides.

The important question, especially for this past six months is the reason for the rise in the effective rate…was it because of demand pressures coming from the banking system…or, was it because of supply conditions created by Federal Reserve actions.

In terms of overt actions during this six-month period, the Federal Reserve did little or nothing.  In fact, the securities portfolio of the Fed actually declined by about $16 billion from May 2, 2012 to August 1, 2012. 

What did put reserves into the banking system, however, was general operating factors, in this case the Treasury, writing checks on its Federal Reserve account, and these checks were then deposited in the banks.  At tax time, April, taxes are paid into government accounts at commercial banks and then drawn into the Treasury’s General Account when the Treasury is going to write checks.  In order to minimize the disruptions in the banking system, the Treasury attempts to keep its deposits there as constant as possible.  Thus, its General Account at the Federal Reserve can experience wide swings during tax time and afterwards.

The Treasury’s General Account at the Federal Reserve fell by $84 billion between May 2 and August 1.Thus, the reserve balances of commercial banks at the Federal Reserve rose by about $60 billion during this time period and excess reserves in the banking system rose by about $37 billion.  So the Federal Reserve acted in a relatively passive way during this time period although the banking system gained in excess reserves during the time period.  The Effective Federal Funds rate did rise over this same time period, but was the rise demand driven? 

My belief is that there might have been a little demand pressure during this time period but I don’t think that the pressure was substantial.  Certainly there has been some pickup in bank lending over the past six months, but the bank loan demand remains relatively tepid.  Most of the loan demand was in business loans at the 25 largest banks in the United States and these banks are highly liquid.  There would little need for them to go to the money markets to finance the loans.

Evidence that there was not much demand side pressure over this time period is that the Fed actually reduced its holdings of market securities.  The little pressure that might have been felt in the Fed Funds market was probably due to the where government checks were paid and the consequent slight dislocation of short-terms funds within the banking system.  The back off in the effective Fed Funds rate this past week is evidence that these funds are well distributed and the banking system is comfortable with how reserves are distributed throughout the industry.

One further note on the excess reserves situation: total reserves in the banking system actually declined by about 7 percent over the past year.  At the same time, required reserves in the banking system rose by just under 28 percent.  These figures capture the huge movement of funds in the financial system from money market funds and other short-term assets back into the banking system, primarily into transactions balances.  This movement has resulted in the M1 money stock increasing at very high, historical, rates of growth, but this increase is coming from individuals and businesses moving assets around and not from loan growth that is underwriting economic activity.  Monetary policy is just not doing much these days except keeping the banking system liquid and helping the FDIC continue to close banks without disrupting financial markets.  I believe very strongly that the Federal Reserve could achieve very little more in this economy if it opened up the monetary spigots much further.  The Open Market Committee was right in keeping monetary policy unchanged. 

Loan Growth Continues to Pick Up at Commercial Banks

My report on bank lending last month had the headline, “Finally, some real loan growth at the banks.” (http://seekingalpha.com/article/426601-finally-some-real-loan-growth-at-the-banks)

Well, loan growth has continued through March.  Loans and leases at commercial banks increased by over $10 billion in March, bringing the total rise in loans and leases up to $95 bullion for the first quarter. 

The interesting thing is that this increase occurred predominately in the “small” banks in the country, the roughly 6,265 banks that comprise the Federal Reserve’s definition of small.  The “large” banks are the largest 25 domestically chartered commercial banks in the country.  A total of $79 billion, or, 83 percent of the increase in loans and leases at commercial banks in the United States over the first quarter, came from these “smaller” banks. 

This is certainly good news.  Economic growth in the United States had been rising since June 2009, but the growth rate has been pretty tepid.  Two reasons for the slow growth were that many individuals and businesses in America were deleveraging and the commercial banking system was trying to get itself in order given all the bad assets that were on the balance sheets of the banks. 

The concern has been that as long as the banks were re-structuring and individuals and businesses were attempting to lessen the debt on their balance sheets, economic growth would remain shaky.  For things to feel more secure, banks would have to start lending again. 

Loans and leases at commercial banks were up 4.7 percent, year-over-year, in March.  Almost two-thirds of this growth came in the past six months, and over one-third of the growth came in the last three months.  This is encouraging.

In the smaller commercial banks, the largest increase in loans came in the residential real estate area.  Residential loan growth rose by more than $31 billion in the past quarter and about $53 billion in the past year. 

The interesting “turn-around”, however, was in commercial real estate loans.  For the year as a whole, commercial real estate loans at the “smaller” banks were down by almost $13 billion, but, for the last quarter they were up by more than $14 billion, a $27 billion reversal. 

Commercial real estate loans were still down in the largest 25 banks by over $5 billion in the quarter, but on the whole, the strength shown in this area is ‘hopeful” and worthy of continued watching.

Business loans at commercial banks (commercial and industrial loans) have been up year-over-year for several months now, but the real strength has been at the largest banks.  For example, year-over-year, commercial and industrial loans at the largest 25 banks in the country were up by almost $105 billion compared with an increase of $42 billion at the smaller banks. 

However, in the first quarter of 2012, business loans at the largest banks rose by $25 billion as compared to a $24 billion increase in the “smaller” banks. 

This, to me, is a good sign for economic growth.  Although it may not translate immediately into much faster growth, I take this strength in lending as protecting against a downside fall-off.

Consumer lending was particularly weak in the first quarter of 2012 as consumer lending fell by more than $2 billion.  This would seem to indicate that consumers were still consolidating and/or reducing their debts and were not out spending.  This, of course, can help to account for the continued weakness in economic growth. 

Overall, the information coming from the banking system is encouraging.  Commercial bank lending is increasing and it is increasing in both the business and real estate sectors of the economy.  Furthermore, bank lending is showing more strength amongst the “smaller” banks in the country.  This is good news to me not only because it might indicate that “main street” is beginning to show some life, but this could also be an indication that the health of the “smaller” banks is improving. 

One final point has to do with the cash balances carried by the commercial banks.  In March 2011, commercial bank cash holdings averaged $1,443 billion.  In March 2012, cash holdings averaged $1,594 billion, up $151 billion for the year.  Commercial banks are still carrying a lot of cash on their balance sheets.  (According to Fed statistics, excess reserves in the commercial banking system averaged $1,362 billion in March 2011, and averaged $1,510 in March 2012.)

However, this cash figure for March 2012 is down from the $1,838 figure of September 2011.  So, commercial banks are holding less cash now than they were at certain times last year. 

One reason for this is that foreign-related institutions are holding a lot less cash than they were last year.  In September 2011, these institutions held almost $1.0 trillion in cash assets.  In early April 2012, this figure was down to about $650 billion.  A large portion of these assets were lent out to “related foreign offices” of the foreign-related institutions.  From March 2011 to a peak in February 2012, roughly $285 billion flowed from these foreign related institutions to their “related foreign offices.”  These flows were closely connected with the financial problems being faced in Europe.  With the efforts to resolve the debt crisis in Greece and with the lending down by the European Central Banks, the needs for cash from the United States lessened.  Lending to “related foreign offices” fell by almost $90 billion between early February and early April as the pressure from the crisis in Europe receded. 

We are not yet out-of-the-woods in terms of the problems in Europe and in terms of our need for stronger economic growth in the United States.  However, particularly concerning the latter, I feel better now that commercial banks seem to be producing more loan growth.   We can only hope that this loan growth will continue to modestly expand.