A lot has changed over the last six months in terms of how the Federal Reserve conducts its operations. We are still learning how to interpret the data that are available to us in order to discern what it is the Federal Reserve is attempting to do…and whether or not it is succeeding. This post represents my attempt to present some analysis as to what has been achieved.
The three major factors occurring over the past six months, the items that have garnered the most press coverage, are the liquidity crises that peaked in March 2008, the dramatic lowering of the Fed’s target Federal Funds rate, and the dramatic rise in the price of oil. Not getting so much press but of equal importance has been the introduction of new Federal Reserve tools such as the Term Auction Facility (TAF) and the Primary Dealer Credit Facility. The conduct of monetary policy has to be put within the context of these events.
In order to try and put everything into context, let me start out be examining the supply and demand for money. Generally in a liquidity crisis there is a sudden increase in the demand for money. The central bank attempts to ease the strain on the money markets by throwing open its lending window, supplying funds to the market in other ways, and maintaining or lowering interest rates. By doing these things the Fed supplies liquidity to the market and facilitates the selling of securities so that banks and other institutions can meet their obligations. Total reserves in the banking system increase.
We know that the Federal Reserve dramatically lowered, in several successive moves, its target for the Federal Funds rate. But, what happened to bank reserves? In January and February of this year, the year-over-year rate of growth of total reserves in the banking system (not seasonally adjusted) was just above zero. In March the year-over-year rate of growth jumped to 4.7%, dropping off to 2.2% and 2.4% in April and May. Obviously, there was some growth in total reserves to help resolve the liquidity pressures in the money markets. (One can note that the year-over-year rate of growth in total reserves for June dropped back to a 0.7% rate of increase.)
So the Fed was supplying reserves during the March-April-May period, but did this have any effect on money stock growth? If we look at the narrow measure of the money stock, M1, we see that its year-over-year growth rate from January through May varied around 0.0%...it didn’t seem to grow at all. However, the broader measure of the money stock, M2, experienced a rise in it’s year-over-year growth rate going from a rate of growth in the fourth quarter of 2007 of about 5.5% to a rate of growth of 6.8% in February 2008, 7.1% in March 2008 before dropping off to 6.5% and 6.4% in April and May, respectively. (One can note that in June the rate of increase had fallen to 6.0%)
One can conclude that during the period of greatest market stress, the Federal Reserve oversaw and increase in the growth rate of total bank reserves that was accompanied by an increase in the growth rate of the M2 money stock. Thus, the Fed underwrote the lowering of its target rate of interest by supplying reserves to the banking system, thereby causing an increase in money stock growth. This is classic central bank behavior.
The question then becomes, how did the Federal Reserve accommodate the problems in the money markets by its operational actions. For this we have to go to the Federal Reserve’s Factors Affecting Reserve Balances, the H.4.1 statistical release. Here is where things get messy. Because of limited space, I am only going to deal with aggregate movements at this time. (If you would like more detail in another post, dates as well as accounts, please let me know.)
From the banking week ending January 2, 2008 through the banking week ending April 2, 2008 the Federal Reserve supplied reserves to the banking system through Repurchase Agreements ($37.8 billion), Other Loans ($39.4 billion) and the Term Auction Facility ($60.0 billion). That is, the Fed supplied the market with $137.2 billion in reserves during the first quarter of the year. But…the Fed’s holdings of securities fell by more than this, removing $156.5 billion in reserves from the banking system. This indicates that the Fed actually allowed reserves to flow out of the banking system during the first quarter of the year…something you would not expect in the period a liquidity crisis was taking place!
What happened? Well on the other side of the sources and uses statement we see that currency in circulation declined by $13.6 billion and other deposits at the Federal Reserve fell by $3.5 billion. These are regular seasonal swings as currency in circulation builds up in the fourth quarter of a year for the holiday season and then declines in the first quarter of the next year as needs for currency are reduced. The swing in other deposits at the Federal Reserve has to do with Treasury deposits and relates to tax dates. So, factors supplying reserves declined by $16.3 billion (incorporating other minor changes in accounts) while factors absorbing funds declined by $15.6 billion (incorporating other minor changes in accounts). Therefore, reserve balances at Federal Reserve banks actually fell during the first quarter of 2008.
But, as indicated above, the growth rate of total bank reserves actually increased throughout the quarter. How can this be explained? Well, the decline in reserve balances actually decreased less this year than it did last year and so total reserves increased, resulting in a year-over-year increase in the rate of growth of total reserves. The Federal Reserve actually eased the pressure on the money markets while seeing reserve balances at the Fed fall. Ah, the problems of these technical factors!
Interpretation…the Fed got $60.0 billion to the banks that needed reserves through the TAF…and a further $39.4 billion to the market through its lending facility. In the first quarter, the major increase in Fed lending came through the Primary Dealer Credit Facility, the borrowing window available to dealers in securities. The Fed continued to supply needed liquidity to the money markets through Repurchase Agreements. Basically, these efforts got funds to the organizations that needed them and did not force them into selling securities at losses…both good results.
In the second quarter, the Fed directly supplied reserves to the banking system and continued to support the year-over-year growth in total bank reserves but not at the peak rate through March 2008. The Fed’s holdings of securities continued to decline, falling $110.2 during the quarter. Also, Fed lending declined by $28.4 billion in the second quarter as both banks and securities dealers repaid borrowings. These declines were partially offset by an increase of $50.0 billion of TAF funds and an increase of $32.8 billion in Repurchase Agreements. There were new factors supplying reserves to the banking system during this time. Other Federal Reserve Assets increased by $40.9 billion. This increase was due to the drawing down of the Fed’s Currency Swap line established with the European Central Bank, the Bank of Switzerland, and other central banks. In additions, the Fed supplied $29.8 billion in reserves related to the Bear Stearns bailout. (This appears in a line item labeled “Net portfolio holdings of Maiden Lane LLC”.) Factors supplying reserves to the banking system netted out to a +$14.5 billion. Factors absorbing reserves during the second quarter netted out to +$13.1 billion (the largest factor absorbing reserves was the seasonal increase in Currency in Circulation which increased by $11.1 billion.) Taking much of the seasonal swing out of the change in total reserves resulted in a decline in the year-over-year rate of growth of total reserves, dropping to just a 0.7% increase by June.
The conclusion: the Federal Reserve seems to have gotten through the period of the credit crisis in good shape. The crucial thing is that it lubricated the market when if was in the greatest need of liquidity and then seemed to back off as the money markets stabilized. The bottom line to this is that the Fed seems to have backed off in continuing to supply liquidity after the liquidity crisis abated. I would argue that money stock growth (M2) is still too high and under the present circumstances points to a rate of inflation of around 4% per year, but the central bank had to deal with the liquidity crisis first before it could move on to other objectives. I must add, however, that we are just getting used to the new tools and institutional arrangements and so any analysis must be tentative.