The Banking System Through the First Half of 2012

Total reserves in the banking system have actually dropped from June 2011 to June 2012 by about 6.6 percent or about $110 billion.  These are according to the latest figures released by the Federal Reserve.

Yet, required reserves in the banking system have increased by a little over $21 billion during this time period representing a rise of almost 28 percent.

The reason why these numbers are moving in opposite direction is that individuals and businesses are continuing to move their assets from short-term interest bearing instruments into currency or into transaction accounts at financial institutions.

Coin and currency in the hands of the public rose by 8.5 percent, from June 2011 to June 2012.  Cash holdings are continuing to run at relatively high annual rates because a lot of people are keeping their funds in currency these days because of the bad economic times.  This high of a rate of increase in currency holdings is a sign of weakness in the economy and the bad financial condition so many people find themselves in.  It is not a sign of economic health.

The M1 money stock measure increased by 16.0 percent over the past 12 month period.  One can note right off that this figure is down from the March 2011 to March 2012 period which was 17.4 percent and also down from the December 2010 to December 2011 period which was 18.4 percent. 

Since the rate of increase in currency outstanding has not changed much from the end of the year, this means that the other components of the M1 measure of the money stock have declined.  And, this is true.  The June-over-June rate of growth for the non-currency component of the M1 measure of the money stock now rests at 16.0 percent. 

The M2 measure of the money stock was growing by a little more than 9.0 percent in June, down since the end of last year, but this decline has not been caused by a drop in the non-M1 component of M2 which has remained relatively constant through the first half of 2012. 

The movements of funds are very clear:  small-denomination time accounts at financial institutions are down by 17.0 percent, June-over-June; retail money funds are down by almost 3.0 percent; and institutional money market funds are down by almost 8.0 percent. 

Individuals are moving funds from short-term interest bearing assets to currency holdings and transaction accounts either because of their economic situation or because of the low interest rates.

As a consequence, the required reserves at commercial banks have grown quite rapidly.  Since, there are so many excess reserves in the banking system, the total reserves in the banking system can decline while the required reserves in the banking system can increase.  This is not the case in more "normal" times. 

And, the transaction accounts at financial institutions can also increase at historically high rates, at almost 28.0 percent, year-over-year, and yet this rise is not looked on as inflationary because of the massive movement of funds around the financial system.

It can be seen, however, that loans and leases within the banking system are now increasing at a faster pace.  Total loans and leases increased at a 5.3 percent year-over-year rate in June, the highest rate of increase in a long time. 

More specifically, commercial and industrial loans (business loans) expanded at a 14.0 percent annual rate in June, with C&I loans at the largest 25 domestically chartered banks in the United States rising by almost 17.0 percent.  This is the strongest showing since the economic recovery began.

The questions one must ask here are about the type of business loan the banks are making and what kind of impact are these loans having on the various measures of the money stock? 

At the present there is no indication that these business loans are going for productive uses, for purchasing physical capital goods…investment goods.  They may be going into the financing of inventories…physical goods that are not getting sold…or information technology.

Furthermore, if these loans are having any impact on the money stock measures it is small relative to the huge flows of funds coming into the transaction-type accounts from short-term interest bearing assets.  Hence, they cannot be seen as “inflationary” at the present time.     

Commercial real estate loans continue to decline, both at the largest banks and in the rest of the banking system.  As I have discussed many times, this decline will continue well into next year because of the condition of the commercial real estate market.

Interestingly, consumer-type loans at the largest banks, consumer credit and home equity loans, declined over the past year while these types of loans did increase modestly at the smaller banks.

I still have a great deal of concern for the health of the “smaller” banks in the banking system.   Five more depository institutions were closed this past week bringing the total number of banks closed this year to 38. 

But, this is not the only number we should be looking at.  From March 31, 2011 to March 31, 2012 82 banks were closed in the United States.  But, over the same time period, the number of banks in the banking system dropped by 190.  Obviously, quite a number of banks left the banking system during this time period through merger or acquisition.  It is my view that the banking system will continue to lose individual institutions from its numbers, maybe not at the almost 4 per week rate of the period ending March 31, 2012, but at a similarly rapid rate for the next twelve months are so.  This is what the Federal Reserve and the FDIC are attempting to achieve as smoothly as possible. 

The pressure may be lessening in this area.  Over the past three months, the cash assets at both the largest 25 domestically chartered banks in the United States have declined, as have the cash assets at the rest of the domestically chartered banks.  And, excess reserves in the banking system have also declined modestly.

My interpretation of the stance of the Federal Reserve right now is to accept the high rates of growth of the M1 and M2 measures of the money stock as these rates are due to individuals and businesses re-arranging their assets and not due to the Fed’s monetary stimulus.

Business lending may be getting stronger, but, as of this point in time, there is little or no indication that this lending is going into constructive physical assets.  This area, however, needs to be watched.  On the other side, one also needs to continue to watch what happens to the commercial real estate area.  As discussed before, many of these loans are loans that are paid off at maturity and these maturity dates are coming due over the next 12-to-36 months.  Many of these loans may not get refinanced.  This could be very difficult on the banks…especially the “smaller” ones.

Finally, the Federal Reserve…and the FDIC…are still keeping a close eye on the health of the banking system.  Especially the Fed does not want to do anything silly at this time…like it did in 1937…and prematurely remove excess reserves from the banking system before the system is ready to “let them go.”  I still believe that there are a lot of banks in the system that are technically insolvent and that the Fed and the FDIC are being extra careful to “not rock the boat” while these institutions need to be closed or merged out of business.  This remains a major concern at the Fed.   

The Federal Reserve is Doing Enough...For Now

The economy is recovering.  It is not recovering as fast as we would like, but it is recovering.

Within this recovery there may be only so much that government can do to speed on this recovery.  In my mind, we need to keep this thought in mind when considering what else the Federal Reserve can do at the present time. 

Fed Chairman Ben Bernanke takes pride in the fact that he has increased he openness of the Fed and has helped to provide greater transparency into the understanding of what the Federal Reserve is doing with regards to monetary policy.

Right now, however, I believe that he is not saying much because he has said enough for the time being. 

The market is concerned about whether or not the Federal Reserve is going to engage in another round of quantitative easing…QE3.

I believe that Mr. Bernanke is staying quiet at this point because he believes that the Fed is doing enough…for now! 

One part of the Fed’s dilemma right now is that if jumps into an overt position on implementing QE3 it will be accused of acting for political reasons.

The Republicans will jump all over a Federal Reserve that seems to be “pumping up” the economy right before the election.  Should the Federal Reserve begin a QE3 before the November election, it…the Fed…will be accused of supporting a desperate president in his bid for re-election.  How political can this be?

But, some members of the Federal Reserve’s Open Market Committee are concerned about the weakness that still exists in the economy.

The Fed has published the minutes of its last Open Market Committee meeting and the discussions within the committee showed mixed feelings about starting up a QE3.  But, even the weak economic information released in the last week or so have not been severe enough to change the minds of the decision makers…and, especially Bernanke.

The minutes do reflect that the Fed is keeping a watchful eye on the economy.  The Fed has promised to act strongly if the economic situation gets much worse.

There are other concerns at work, however.

There is real concern over just how much monetary policy can do at this particular time.  First, there is the concern that it can do little to impact the unemployment rate.  The unemployment rate is a “real” economic variable and is determined by “real” economic variables.  Monetary polity does not work with “real” economic variables.

Second, there is the time lag in the effect that monetary policy has on the economy.  One can argue that the Fed has done all it can do to impact the economy over the next six- to nine-months and that anything else done now would have next to no effect on the economy before the November election.

This presents the question to Open Market Committee members: “Why start out now on a major monetary initiative like QE3 which would bring about tremendous political criticism when this initiative would have next to no impact on the economy before the election?”

The most the Federal Reserve can do at this time to generate confidence is to assure the financial markets that “if the economy gets worse” that it would take appropriate actions to combat a worsening situation.  And, Fed officials must continually provide evidence that it is “on the watch” and ready to move. 

The release of the minutes of the Open Market Committee serves this purpose.   The essence of the minutes was the split between committee members over whether or not the Fed should engage in further easing.

The other major issue besides the state of the economy, which will not go away is the condition of the banking industry.  Readers of this blog know my position on this:  the banking system is still quite fragile with many banks still unsure about the value of their assets, especially in the areas of residential real estate and commercial real estate. 

I believe that the Federal Reserve feels comfortable that it has done what it can to keep the banking system functioning and that the injection of $1.5 trillion in excess reserves into the banks allows the banking system to continue to function smoothly so that the FDIC can continue to close banks without creating significant disruptions to the industry.

Through the first half of 2012, more than one bank is still being closed every week at least one other bank per week is acquired and hence is merged out of existence.  The banking system continues to shrink!

There is little else the Federal Reserve can do at this time with respect to the health of the banking system.  

My belief is that Mr. Bernanke has already told us all that he is going to tell us at this time.  Mr. Bernanke has told us that the Federal Reserve is not going to act in a political way.  In other words, for the near term, the Fed is going to do pretty much what it has been doing in the recent past.  It will continue to try and “twist” interest rates, but no new excess reserves will be created in this effort.  And, the Federal Reserve will continue to watch the economy closely and stands ready to act if it appears as if the economy is sinking into another recession.  But, don’t expect anything more.

In terms of the economy, the Fed has done about all it can do right now.  The major thing it has done…at least for the time being…is to stop any cumulative movement in the economy to a period of price deflation.  This is the big theoretical concern that exists in a period like this, the possibility that the economy will decline into a period of debt-deflation.

However, protecting the economy from a period of deflation does not eliminate the problem I discussed earlier this week, the problem of the extensive debt buildup in the economy.  The deleveraging of the economy is still something that needs to take place.

The deleveraging of the economy will still take some time.  For now, I would argue that the Federal Reserve has done and is doing about all it can to keep the expansion going.  The economy is recovering.  It certainly is not recovering as rapidly as we would like it to recover, but it is recovering.  Sometimes only so much can be done to assist a recovery and the rest must be accomplished by letting the system do its own part.  In the current situation, reducing the debt load is what the economy needs to do and it takes time for an economy to achieve this.     

Mr. Bernanke Needs to Speak Out About QE3...or, Has He?

Fed Chairman Ben Bernanke takes pride in the fact that he has increased he openness of the Fed and has helped to provide greater transparency into the understanding of what the Federal Reserve is doing with regards to monetary policy.

Right now, however, he is staying pretty silent. 

The market concern is about whether or not the Federal Reserve is going to engage in another round of quantitative easing…QE3.

I believe that Mr. Bernanke is staying quiet at this point for political reasons. 

He stated just the other day that the Federal Reserve is not swayed by political factors.

We can save the further discussion about the political nature of the Fed for another day.

The Fed’s dilemma right now is that if jumps into an overt position on implementing QE3 it will be accused of acting for political reasons.

The Republicans will jump all over a Federal Reserve that seems to be “pumping up” the economy right before the election.  Should the Federal Reserve begin a QE3 before the November election, it…the Fed…will be accused of supporting a desperate president in his bid for re-election.  How political can this be?

The Fed has published the minutes of its last Open Market Committee meeting and the discussions within the committee showed mixed feelings about starting up a QE3.  But, even the weak economic information released in the last week or so have not been severe enough to change the minds of the decision makers…and, especially Bernanke.

The minutes do reflect that the Fed is keeping a watchful eye on the economy.  The Fed has promised to act strongly if the economic situation gets much worse.

There is real concern, however, over just how much monetary policy can do at this particular time.  First, there is the concern that it can do little to impact the unemployment rate.  The unemployment rate is a “real” economic variable and is determined by “real” economic variables.  Monetary polity does not work with “real” economic variables.

Second, there is the time lag in the effect that monetary policy has on the economy.  One can argue that the Fed has done all it can do to impact the economy over the next six- to nine-months and that anything else done now would have next to no effect on the economy before the November election.

This presents the question to Open Market Committee members: “Why start out now on a major monetary initiative like QE3 which would bring about tremendous political criticism when this initiative would have next to no impact on the economy before the election?”

The most the Federal Reserve can do at this time to generate confidence is to assure the financial markets that “if the economy gets worse” that it would take appropriate actions to combat a worsening situation.  And, Fed officials must continually provide evidence that it is “on the watch” and ready to move. 

The release of the minutes of the Open Market Committee serves this purpose.   The essence of the minutes was the split between committee members over whether or not the Fed should engage in further easing.

The other major issue besides the state of the economy, which will not go away is the condition of the banking industry.  Readers of this blog know my position on this:  the banking system is still quite fragile with many banks still unsure about the value of their assets, especially in the areas of residential real estate and commercial real estate. 

I believe that the Federal Reserve feels comfortable that it has done what it can to keep the banking system functioning and that the injection of $1.5 trillion in excess reserves into the banks allows the banking system to continue to function smoothly so that the FDIC can continue to close banks without creating significant disruptions to the industry.

Through the first half of 2012, more than one bank is still being closed every week at least one other bank per week is acquired and hence is merged out of existence.  The banking system continues to shrink!

There is little else the Federal Reserve can do at this time with respect to the health of the banking system.

Can Mr. Bernanke tell us all of this in a way that will convince us?  Should Mr. Bernanke tell us all of this in an attempt to convince us?

My belief is that Mr. Bernanke has already told us all that he is going to tell us at this time.  Mr. Bernanke has told us that the Federal Reserve is not going to act in a political way.  In other words, for the near term, the Fed is going to do pretty much what it has been doing in the recent past.  It will continue to try and “twist” interest rates, but no new excess reserves will be created in this effort.  And, the Federal Reserve will continue to watch the economy closely and stands ready to act if it appears as if the economy is sinking into another recession.  But, don’t expect anything more.

Other than the fact that I don’t believe that “operation twist” can really be effective, I believe that Mr. Bernanke and the Fed are “spot on” concerning what monetary policy should be at this time.  To me, the primary thing that is currently impacting US Treasury rates is the “flight to quality” in financial markets that is taking place internationally and this is dominating what the Fed is doing and everything else.    

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.     

The U. S. Banking System: Weak Yet Still Supplying Europe

Downgrading large, internationally significant financial institutions did little to change market attitudes about the financial condition of these institutions.  The general market response was “too little, too late.”

As is too well known, rating agencies tend to be followers not leaders.  The question always is…well how far behind are the rating agencies this time?

In this respect, the rating agencies are in the same boat as are the regulators…they are always behind the curve.

As far as the banking system itself…the banking system is not doing all that well…but, we knew that…but the U. S. banking system is doing better than the banking system in the eurozone…if that is any consolation. 

The U. S. banking system is still holding almost $1.5 trillion in excess reserves. 

To me, this means that the banking system, in general, is still is such bad shape that it does not want to make many loans and is perfectly content to be sitting on all the excess reserves that the Federal Reserve has supplied it.  

This situation is not unlike the one that existed during the Great Depression.  In general, commercial banks are not in good shape. 

This general condition also existed at the time of the Great Depression.  Too much debt had been created and individuals and businesses could not pay off the debt that they owed.  Many banks were technically insolvent.   Commercial banks continued to be closed and many of the banks that still had their doors open were just waiting for the regulators to visit them and pull down the shades on their windows.

As we have seen this year, the FDIC continues to close smaller banks, more than one per week, while many other weak banks are acquired and so go out of independent existence.

While lending in the banking system has increased in aggregate over the past year there still are disturbing signs.  For one, cash assets at the smaller, domestically chartered banks increased over the past year by about $33 billion while cash assets in the whole banking system declined.  That is, it looks like the demand for excess reserves in the small banks has actually increased, a sign of management concern.

Secondly, the commercial real estate sector continues to cause the domestically chartered banks problems.  These loans continue to decline at the largest 25 domestically chartered banks in the United States as well as in the rest of the domestically chartered banks over the past year.

Whereas there is some signs that the residential real estate market may be leveling off, problems continue to exist within the commercial real estate area.  It is here that we find why many of the smaller banks are under such stress. 

During the “glory days” of the recent expansion, many of these smaller banks strained to put commercial real estate loans on their books to generate bank expansion.  In order to support this expansion the smaller banks became “liability managers” something small banks hardly ever did in the past.  So these managements made two mistakes…they got into commercial real estate loans, which they did not have the expertise to do…and they got into the purchase of funds, again something they had never done before.

Now, these smaller banks are paying the price for their lack of discipline.  But, it was the thing to do in another time period.

The smaller banks will continue to face balance sheet problems for some time and the number of commercial banks in the banking system will continue to decline.

Another thing to watch, however, is what is happening between banks.  Nearly 40 percent of the increase in bank loans over the past year came in a category titled “Other Loans and Leases” and this category includes Federal Funds and reverse repos with nonbanks and “All Other Loans and Leases.”  This latter group is defined by the Federal Reserve as Including “loans for purchasing or carrying securities, loans to finance agricultural production, loans to foreign governments and foreign banks, obligations of states and political subdivisions, loans to nonbank depository institutions, loans to nonbank financial institutions, unplanned overdrafts, loans not elsewhere classified, and lease financing receivables.”

Foreign-related commercial banks increased loans in the first category by over $66 billion.

Large domestically chartered banks increased loans in the second category by more than $34 billion.  In order to explain this I would like to concentrate on the subset “loans to foreign governments and foreign banks.”   Indications are that these large banks committed a lot of money to “foreign governments and foreign banks” over the past year.  This is where some of it shows up.

And, what was the biggest item to increase on bank balance sheets in the United States?

Net deposits due to foreign related offices of foreign-related financial institutions in the United States.  The total increase over the past year was almost $290 billion!

It looks to me like a lot of the lending activity that took place in the United States and particularly in the largest 25 domestically chartered banks were to “off shore” entities.  In other words, a substantial portion of the funds the Federal Reserve injected into the United States banking system has migrated into foreign hands.

Thus, the Federal Reserve System is not only supporting a weak United States banking system it is also going to help support a weak world banking system. 

One final point of the current situation in banking: fundamental Keynesian economists have argued that the current dilemma facing the monetary authorities today is a “liquidity trap” much as the one they claim the central bank faced during the Great Depression.

In my mind, these Keynesian fundamentalists are as wrong about the current situation as they are about their interpretation of the Great Depression. 

Interest rates are low and yet the economy is not expanding because the banking system is still so weak that the banks are not lending, not because the economy is in a “liquidity trap.”  The problem is a supply of loans problem not a demand for money problem!

And, this applies to Europe as well as to the United States. 

A stronger recovery in the United States will not occur until the U. S. banking system becomes solvent once again, debt balances in the economy are reduced, and governments realize that they are not the solution to every problem.

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.