Federal Reserve Review as of August 1, 2012

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. 

The European Central Bank met last week and produced an outcome that was very similar to the one chosen by the Fed.

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 ofter driven by loan demand.  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 constant, around 8 basis points, from August 2011 into January 2012, roughly the first six months of the past year.  After January the rate increased up until 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. 

General operating factors actually put reserves into the banking system: 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 as the Treasury spent tax money that had been collected earlier.

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.   

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 any further.  In this respect, I believe that the Open Market Committee was right in keeping monetary policy unchanged. 

The Fed Disappoints the Stock Market

The stock market had been up most of Wednesday morning…the Dow-Jones average was up 30 points or more almost from the start.

Somewhere around 2:00 PM, Eastern Standard Time, the Open Market Committee of the Federal Reserve System produced a statement summarizing the results of its two-day meeting.  The gist of the meeting is captured in this sentence: “The committee will closely monitor incoming information on economic and financial developments and will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”

The stock market immediately went down.  The Dow moved into negative territory.

Disappointment…

Investors in stocks are looking all over for positive news so that they can justify higher stock prices.  Last week they rallied as “Super Mario” Draghi, President of the European Central Bank, promised unconditional support to the Euro.  They rallied the week before on something else…and they rallied earlier on another thing…

Investors were putting their hopes on the Federal Reserve that it would come up with a QE3…or another Operation Twist…or something else…that would possibly help spur the economy on and rationalize buying into a rising stock market.

This, in spite of the fact that the earlier actions of the Fed…QE1…or QE2…or whatever…had done little or nothing to spur on economic growth…bring down unemployment…or anything else.

This is the state that investors…business people…families…find themselves in these days…hoping and hoping that something positive will take place.

In the extreme, it shows us just where everyone is concerning the leadership in the United States…and the leadership in Europe…and the leadership elsewhere in the world.

Two words keep coming up to capture the essence of the situation…uncertainty and risk.

No one seems to know what is going on…and no one seems to be presenting any ideas about how we can move into a better future. 

The only positive spin that analysts could put on the Fed’s statement: “The Fed signaled more strongly it will take action as needed to boost the economy…”

Big whoops!

Man, I learned a lot from this…

But, let’s look at the situation.

For one, there is very little that the Federal Reserve can do to “goose up” the economy at this time.  The Fed acted to stop the liquidity crisis that plunged the financial system into a crisis.  The Fed has done about all it can to calm down the solvency crisis.  The Fed has poured more than a trillion dollars into the banking system to provide time for the banking system to shrink in numbers and the FDIC to close problem banks. 

The Fed cannot make businesses and families borrow.  The Fed cannot hire people and put them back to work.  The Fed cannot eliminate the foreclosures and bankruptcies that are still looming in families, small business, and in local governments.  The Fed can do only so much…

And, to use economic terms, over time a central bank can only impact “nominal” variables, like the monetary base and the money stock and prices, and not “real” variables, like real economic growth and the unemployment rate.

Still, investors were looking for some sign that a (somewhat) trusted institution was going to provide some kind of leadership that would help.

Where there is a vacuum…people keep looking for someone or some thing that will fill in the void. 

In this case, to me, investors were looking for too much.  There is very little that the Federal Reserve can do now.  This is especially true since so many of our economic problems are coming from structural dislocations and not from cyclical movements.  These structural problems that exist within the economy are not going to be overcome, over night.  I have tried to express this repeatedly in my blog.

The good news is that the United States economy is recovering.  Not as quickly as we would like but it is recovering.  There are many potential bumps-in-the-road ahead…like the recession in Europe and the slowdown in the rest of the world…like the “fiscal cliff” facing Congress and the President…along with several other impending problems.  But, the economy is growing.

The bad news is that there seems to be an almost total absence of confidence in our elected officials and their appointees…and in the institutions we used to have so much faith in.  And, until this confidence begins to rise, the structural problems that are the essence of any real future economic recovery will just tend to languish.

Whether or not the Federal Reserve comes up with any more “stimulus” to combat further economic slowdown is irrelevant to me.  I believe that the financial markets should stop looking for their “savior” to come from the halls of the Fed…although, unfortunately, it looks like it might be the only show in the town of Washington, D. C.    

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.