Monday, November 16, 2009

A Critique of Quantitative Easing

Yesterday, I posted a report on the strategy of the Federal Reserve to exit its position of excessive monetary ease. (See In that report I mentioned that since August, the total reserves in the banking system had shown a substantial increase.

Looking a little further into the data we find that the Monetary Base, defined as all financial assets that serve as bank reserves or could become bank reserves, rose from an average of $1,649 billion in the two weeks ending August 12, 2009 to an average of $2,001 billion in the two weeks ending November 4. (These data are on a nonseasonally adjusted basis, but the seasonally adjusted data are not significantly different.)

The Monetary Base rose by $352 billion during this period of time. (This was both on a
seasonally adjusted bases as well as a nonseasonally adjusted basis.)

What I am interested in reporting on is the total amount of reserves available to the commercial banking system.

Technical Note: To get the figure for total reserves we must subtract the currency component of the money stock from the reported data on the Monetary Base. This amount, according to the Federal Reserve System, is total reserves (of the banking system from the H.3 release) plus required clearing balances and adjustments to compensate for float at Federal Reserve Banks plus an amount representing the difference between current vault cash and the amount of vault cash used to satisfy current reserve requirements. This total reserve amount is different from the total bank reserves reported in the H.3 release on Aggregate Reserves of Depository Institutions and the Monetary Base.

This calculated measure of total reserves in the banking system rose by $351 billion during the time period under review. In other words, currency in circulation outside of commercial banks increased by only $1.0 billion from the August 12 information to the November 4 data.

Excess reserves in the banking system increased in this 13-week period from $709 billion to $1,059 billion, a rise of $350 billion. Thus, all the increase in bank reserves during this time period came in excess reserves, the required reserves held behind the deposits of the banks remained flat!

The truly remarkable thing is that the Monetary Base averaged around $848 billion in the two weeks ending August 13, 2008 while the total reserves in the banking system calculated using the method discussed above amounted to $72 billion.

Thus, in the time between August 12, 2009 and November 4, 2009, the Federal Reserve added $352 billion to the reserves of the banking system, a system that only averaged $72 billion in total reserves in the two weeks ending August 13, 2008. That is, the Federal Reserve added about 5 times as many reserves to the banking system in a 13-week period in 2009 as the complete banking system had in total in August 2008!

However, during the later time period, total bank credit in the banking system dropped by about $150 billion, loans and leases falling around $142 billion.

While bank reserves were increasing rapidly, the effective Federal Funds rate remained relatively constant. It averaged 16 basis points in August 2009, 15 basis points in September and 12 basis points in October. It continued to average around 12 basis points in the first half of November.

The question that needs to be asked is whether or not this scenario was what the Federal Reserve hoped to achieve when it initially went into what it called Quantitative Easing. My understanding of Quantitative easing was that Fed actions were required to combat a Liquidity Trap, a situation in which interest rates could not be pushed lower by adding more reserves to the banking system. Because interest rates could not be pushed lower, aggregate economic demand could not rise. However, it was argued that as the central bank continued to add reserves to the banking system, loans would still be granted to customers and the money stock would increase. Having more funds available, even though the interest rate on the loans could not go lower, was the quantitative effect desired, and as these funds were added to balance sheets spending would increase and the economy would be stimulated.

I don’t sense in the figures presented above the presence of a liquidity trap. The banking system seems to be demanding reserves and, in order to keep interest rates from going up, the Federal Reserve is very abundantly supplying banks reserves. That is, rather than exhibiting a fear that short term interest rates cannot decline any further, the Fed is afraid that short term interest rates (as well as rates on longer term Treasury securities and mortgage rates) might actually rise. This is consistent with the almost obsessive effort the Fed is making to be sure that the market knows the Fed is not going to let interest rates rise and that it is going to keep interest rates at current levels for “an extended period” of time.

This, to my mind, is not Quantitative Easing. It is just a continuation of the strategy the Fed has been following since September 2008: in policy actions, do not err on the side of providing too little stimulus.

This is not a refined, sophisticated monetary policy. Throwing everything you can against the wall to make sure a sufficient amount of what you throw against the wall sticks to the wall is something one does when one is desperate and unsure about what one is doing. You can achieve your goal with this strategy but the problem is that you have a big mess to clean up afterward.

And, if I am correct in this analysis, the Federal Reserve is currently only exacerbating the size of the mess that will have to be cleaned up.

No comments: