Monday, May 18, 2009

The Fed's Quantitative Easing Goes Forward

Lots of transactions went on in central banking over the past month or so, not only in the United States but in the UK and Europe. Quantitative easing is the game and, at least, the central bankers are getting more and more comfortable with this.

Credit is given to quantitative easing for the drop in the dollar LIBOR rate. The three month LIBOR now ranges between 50 and 60 basis points over the target Federal Funds rate chosen by the Federal Reserve. This is the lowest this spread has been in a long time. For the five years previous to September 2008, the time the financial markets collapsed, this spread averaged between 20 and 30 basis points.

This move reflects the efforts of the Bank of England and the European Central Bank to push short term interest rates lower and to engage in monetary actions that pump more liquidity into the banking systems even though the interest rates do not show a proportional response. The drop is given as evidence that perhaps interbank lending is increasing in these nations and that this is possible evidence of a thaw in credit extension.

In the United States the Federal Reserve was particularly active in April although the total factors supplying bank reserves has increased only modestly in the last four banking weeks, rising just $21.2 billion. All of the action has happened within the balance sheet.

The interesting movement has come in excess reserves in the banking system, a series that is not seasonally adjusted. Excess reserves showed a huge rise, $100.0 billion, in April 2009 from March. I reported earlier that excess reserves in the banking system in April averaged $824.4 billion, almost the entire size of the Federal Reserve’s balance sheet one year earlier.

The combination of these two factors, basically the small increase in Federal Reserve sources funding the monetary base and the huge increase in excess reserves in the banking system, indicates that much of the activity was internal to the Fed’s balance sheet and not a source monetary expansion. Let me highlight the major changes.

Within the banking system itself, excess reserves averaged $771.3 billion in the two weeks ending March 25. This figure jumped to $804.8 billion in the two weeks ending April 8 and then rose to $862.4 billion in the two weeks ending April 22. This was tax time when funds flow into government accounts in the banking system but there were apparently other things going on as well in government accounts. In the two weeks ending May 6, excess reserves dropped back to $777.5 billion, roughly equal to the level they were at in the two weeks ending March 25.

One could argue that the April bulge was just “temporary”. However, a $100.0 billion increase in the excess reserves in the banking system is “eye-catching” when this measure only averaged around $2.0 billion for the eight months of 2008 before September of that year.

What was going on in the Federal Reserve? I can only describe the Fed’s activity as a part of its efforts to provide liquidity to different sectors of the financial markets and this is a part of the plan to provide quantitative easing to the financial system. Specifically, the amount of securities that the Fed holds outright jumped by $166.1 billion between the banking week ending April 15 and the banking week ending May 13. United States Treasury securities increased by $54.8 billion during this time, the largest increase in these holdings since the Term Auction Facility (TAF) was established in December 2007.

TAF was introduced to help allocate reserves into the banking system faster and more directly to the banks that needed the reserves at the time. It was an effort to increase the liquidity in the banking system to facilitate bank portfolio adjustments in the face of the “liquidity crisis” that occurred in December 2007. The Fed continued to use Term Auction Credit over the next 15 months or so to facilitate bank portfolio adjustment.

The “new” liquidity problem, however, seems to be connected with the Treasury bond market. Now, the Fed has entered into a program to supply funds to the Treasury market to help keep long term interest rates down, a goal it has not yet achieved. However, we see this shift in the quantitative easing strategy as the Fed is increasing its holdings of United States Treasury securities while at the same time letting the amount of funds allocated to the banking system through Term Auction Credit decline by $27.0 billion, the first substantial decrease in this total since the program began.

There is another sign of quantitative easing and this is in terms of the amount of Mortgage Backed Securities the Federal Reserve holds. During the four weeks ending May 13, 2009, the Fed’s holdings of these securities increased by $96.9 billion to $384.1 billion. Obviously, the policy makers at the Fed believed that there was serious liquidity problems in this segment of the capital market that needed their attention.

This huge increase brings the holdings of Mortgage Backed Securities up to two-thirds, 67%, of the Fed’s holdings of United States Treasury securities. Who would have ever imagined that this would have happened?

Again, reflecting the shift taking place in where the quantitative easing is being applied, the Commercial Paper funding facility at the Federal Reserve fell by $83.3 billion from the banking week of April 15 to the banking week of May 13. This decline can be interpreted as an indication that some easing is taking place in short term money markets, allowing the Fed to focus more upon the longer term end. The Fed, at its peak, had supplied over $250.0 billion to the financial system through this facility.

Furthermore, there was a drop in Central Bank Liquidity Swaps during this time period of $47.0 billion. Currency markets were apparently stable enough during this time so that these borrowings could be reduced. However, there are still about $250.0 billion in swaps still outstanding to other central banks.

This last month gives us a good picture of how quantitative easing seems to work. There was very little change in the total amount of funds that the Federal Reserve supplied the banking system, but there was substantial Federal Reserve activity within its balance sheet as it readjusted its focus upon which markets it believed needed the greatest amount of assistance with regards to the supply of liquidity. The crucial factor in this exercise seems to be that once the liquidity needs of a market are satisfied by the market itself, then the market participants that used the Fed’s facility pay back the funds that they have used. This allows the Fed to address other segments of the financial markets and, hopefully, satisfy the liquidity needs in these other areas.

Overall, the dream is that all the funds will be paid back to the Fed as the financial system and the economy turn around and begin to function effectively again. Not only will this allow the Fed to cease being the “fireman” that must run from fire-to-fire putting out the latest blaze, but will also get out of the “fire-fighting” business itself and allow its balance sheet to shrink back to an appropriate size. We are not there yet, but it does provide some comfort to see that the Fed can move from one current fire to another without another massive expansion of its balance sheet. However, whether this can really be accomplished remains to be seen.

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