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.  

Federal Reserve Remained Quiet in April

As reported in my last review of Federal Reserve actions, all remains quiet on the monetary front. Right now, as far as monetary policy is concerned, there is not much for the Fed to do…and, to me, this is good.

Things are quiet in the banking system…except for the complaints of top bankers about new rules and regulations that are being discussed.  The FDIC closed only one bank this week, bringing the total for the year up to 23.  But, closers are going “smoothly”.

Economic growth, year-over-year, continues to be in excess of two percent, although not by much.  And, other data being reported contain some good information…and some not-so-good information.

The European crisis continues along with more stress being placed on the creation of growth rather than continuing “austerity.”  The question is how much the elections of the weekend will change the near term future for the eurozone.

And, with the presidential election in full swing, the Fed seems to be content with the above scenario.  There is little or nothing it can do between now and the election to change the trajectory of the economy before November.  It “stands by” in case there is any “fire” that needs to be put out in the meantime.  (For more on this see my post.)

Furthermore, it seems as if we have had the last of the “education” sessions put on by Professor Bernanke for a while.

Thank goodness!

In terms of the actions of the Federal Reserve over the past month, most changes that occurred on the Fed’s balance sheet seem to be “operational”.  That is, the Fed was just responding to general “operating” factors impacting the banking system. 

The largest “operating” factor that occurred in April was connected with the yearly tax collections.  Deposits at Federal Reserve banks rose in April by almost $80 billion.  This is a seasonal swing as funds are collected at tax time in “tax and loan accounts” at commercial banks.  Then, the Treasury transfers these balances to its account at the Fed, the account the Treasury writes checks on.  This movement absorbs bank reserves at the same time the Treasury writes checks, which will then go back into the banking system as the recipients of those checks deposit them.  This procedure minimizes disruptions to the amount of reserves in the banking system.  Hence, these actions are called “operational”.

Two other factors can catch our attention.  First, over the past four weeks, the Fed has increased its holdings of mortgage-backed securities by $11 billion.  This is the first increase in mortgage-backed securities for more than a year.  In total, this account declined by almost $80 billion from May 4, 2011 to May 3, 2012.  Some support for this sector of the financial markets?

The second factor is the decline in Central Bank Liquidity Swaps.  This account increased over the past year as the European sovereign debt crisis expanded into the fall of 2011.  But, these liquidity swaps began to decline since the second Greek bailout was accomplished.  Central bank liquidity swaps declined by about $19 billion over the last four-week period, and declined by over $77 billion during the last 13-week period.  As of May 3, 2012 there were slightly more than $27 billion swaps still on the Fed’s books. 

Reserve balances with Federal Reserve banks on May 3, 2012 stood at $1,481 billion ($1.5 trillion rounded off) only $8 billion more than existed on May 4, 2011.  Excess reserves in the commercial banking system, a two-week average, were $1,458 billion, just about what was in the banking system one year ago, $1,452 billion.

This relative stability on the Fed’s balance sheet was achieved despite substantial changes taking place within the banking system itself. 

Although the total reserves in the banking system only increased by a little less than 4%, required reserves in the banking system rose by about 32%.  The reason for this difference is that demand deposits at commercial banks, deposits that have the highest reserve requirements, increased by more than 41%.  Time and savings deposits at commercial banks, which have lower reserve requirements, rose by a little more than 8%.  Thus, there was a shift in the banking system from deposits with lower reserve requirements to deposits with substantially higher reserve requirements.

This shift from time and savings deposits to demand deposits has been going on for a long time.  I have been reporting on this for more than two years now.  The shift is taking place, not only because of the low interest rates being paid by banks (and thrift institutions), but because of the weak economy.  People out of work or on the edge financially transfer the wealth they have to “transaction” type of accounts so that they can live and pay their bills.  They don’t have the resources to “manage” their wealth across a spectrum of assets.  Thus, the growth in demand deposits, to me, is a sign of weakness in the economy and not a sign that monetary policy is working.

Another piece of evidence supporting this claim is the strong demand for currency outside the banking system.  Currency in circulation is increasing at a 9%, year-over-year, rate of growth.  This is an extremely high growth rate and a sign of a weak economy and not a strong one.

As a consequence of these demands, money stock growth continues to increase at a very rapid pace.  The M1 measure of the money stock remains in the high teens, growing at an 18% rate for the past year, while the M2 measure is growing at a pace slightly under 10%.

Both of these rates of growth are high, historically, but can be explained by the shift in assets toward more liquid and more transaction-based accounts.  Only recently has loan growth started to increase and this may provide some reason for the money stock to continue to increase in the future.  If loan growth does continue to increase and if this creates a reason for the money stock to grow, this would be a healthy sign for a recovering economy. 

So, not much has changed on the monetary front from last month.  I believe that this is a good situation for the monetary authorities.  It doesn’t mean that the future will be easy.  The Fed is still going to have to deal with almost $1.5 trillion in excess bank reserves when the economy begins to expand more rapidly…the threat of rising inflation is real.  Yet, the past is past and we are where we are right now…and, to me, where we are right now is hopeful.   

Fed's Interest Rate Policy Distorts Money Stock Growth

The low interest rate policy of the Federal Reserve continues to distort the growth rates of the money stock. 

The year-over-year rate of growth for the M1 money stock for the thirteen-week period ending February 21, 2012 is 18.6 percent.  Note, however, that the year-over-year growth rate for the demand deposit component of the M1 money stock is just over 44 percent!

Because of the low interest rates on bank time and savings deposits and on retail money funds and on institutional money funds, people continue to move money from these assets to transaction accounts, primarily demand deposits.  However, people seem to be holding onto these transaction balances rather than spending them. 

The M2 measure of the money stock is rising by a 9.8 percent year-over-year rate of increase, but the non-M1 component of the money stock is rising by only 7.6 percent.  Again, the primary growth in this component is coming from the movement of money from non-bank interest-bearing assets to bank deposits. 

People are still not moving their assets around in order to increase spending. As just mentioned, a lot of the movement is coming because the incentive to hold interest bearing non-bank assets is not there.  And, individuals and families that are under-employed or otherwise uncertain about their future are transferring their assets into cash.  Currency in circulation is still increasing, year-over-year by a little less than 10 percent, an extraordinary high rate of growth.

The Fed has done very little to further stimulate the domestic economy over the past three months.  Looking at the Fed’s balance sheet, there are two factors that are particularly noticeable, neither one, however, representing any kind of an aggressive monetary injection. 

First, the Federal Reserve has responded to the European debt crisis by providing additional funds to central banks through swap lines.   Over the past three months, central bank liquidity swaps have increased by $105 billion.  This increase in funds represents almost the whole rise in reserve balances at the Fed, a figure that tracks very closely with the amount of excess reserves in the banking system. 

Second, the Fed has attempted to push the interest rates on mortgages even lower in an attempt to get the housing sector going again.  Whereas the Fed has allowed its portfolio of US Treasury securities to decline along with a continued decline in its holding of Federal Agency issues, the central bank has actually added a net of almost $14 billion to its holdings of mortgage-backed securities over the past thirteen week period.  The total amount of securities held outright declined by about $2 billion.

Consistent with the monetary testimony of Fed Chairman Ben Bernanke last week, the Federal Reserve has been doing very little to provide additional stimulus to the American economy. (http://seekingalpha.com/article/402751-mr-bernanke-stands-pat) People continue to move funds from low interest bearing market assets to the banks.  Mr. Bernanke and the Fed apparently hope that these individuals will at some time in the future begin to spend more from these assets.  Banks continue to hold onto their funds as excess reserves in the banking system track around $1.6 billion.  Most banks, especially the smaller banks, are not lending as they continue to work out the problems that exist in their loan portfolios.  According to Mr. Bernanke, this situation will continue to be supported by the Federal Reserve for the near term.