Monday, February 15, 2010

Economy Still Seeks Liquidity, but Move Slows Down

Over the past sixteen months or so, since September 2008, people and businesses have moved a great deal of their wealth into very short-term assets. This continued into January 2010, but the pace has tapered off.

In September 2009, currency in the hands of the public was more than 10% higher than it was one year earlier. Demand deposits at domestically chartered commercial banks were almost 20% larger than in the same month in 2008, and other checkable deposits at commercial banks and thrift institutions were about 16% higher. Movements into these accounts represented the flight to liquidity in the United States economy that accompanied the financial crisis.

Funds also flowed into savings accounts as well: these accounts rose by 14.5%. However, small-denomination time deposits dropped by about 5% during this time and retail money funds fell by almost 16%.

There was also a shift in funds from all thrift institutions except credit unions into commercial banks over this time period.

The move into more liquid accounts continued into January 2010, but at a slower pace than was seen early last fall. For example, NOW accounts and ATS balances at both commercial banks and thrift institutions rose by 20% in the year ending this January.

Also, savings deposits at commercial banks and thrift institutions continued to rise: they rose by more than 15% from January 2009 to January 2010. (Note that currency in circulation increased over this time period at a more normal 4% annual rate and demand deposits at commercial banks rose only by 1.6%.)

However, the withdrawal of funds from small-denomination time deposits and from retail money funds accelerated. The former deposits dropped at a 21% rate over the twelve months ending in January while the latter fell by almost 27%.

Again, the evidence pointed to a shift in deposits from thrift institutions to commercial banks. Overall, at thrift institutions all checkable deposits and time and savings accounts rose by only 1.7% in the year ending January 2010. Taking credit unions out of this total and you get an actual decline at all other thrift institutions. At commercial banks, the total of these accounts rose in excess of 9%.

This shift in funds has had a very dramatic impact on the two narrow measures of the money stock. In January 2010, the year-over-year rate of growth of the narrow, M1, measure of the money stock rose by 6.5%: the year-over-year rate of growth of the broader, M2, measure of the money stock increased by just 1.9%.

These rates of growth are substantially less than they were in the middle of 2009, when the growth rate of the M1 measure was in excess of 17% and in the M2 measure was around 9%. These numbers were, of course, not generated by the actions of the Federal Reserve but by the movement of assets in the economy as the economy de-leveraged and moved into more liquid assets.

The fact that these rates of increase were not driven by the Federal Reserve can be shown in the January figures. The rates of increase in the M1 money stock (6.5%) and in the M2 money stock (1.9%), bear no relation to the injection of reserves into the banking system that has taken place since September 2008.

If we look at the year-over-year rates of growth for January 2010, we observe that total reserves in the banking system rose by over 29% and that the monetary base increased by almost 17%. Obviously, the reserves that have been forced into the banking system have not found their way into loans and thereby into deposits. This, of course, is why the excess reserves of the banking system remain so high, reaching a new average high of $1.119 trillion in the two banking weeks ending February 10, 2010.

The behavior of the banks is confirmed in the numbers produced by the Federal Reserve on the commercial banks. The banking industry continues to shrink in terms of asset size and the amount of bank loans, every kind of bank loan, is dropping. The commercial banking industry, on net, is just not lending. See and

Historically, a 2% growth rate for the M2 measure of the money stock is incapable of producing economic growth. In fact, to sustain this number would imply a deflationary economy.

However, there are two contradictory things going on here. First, as mentioned above, the growth rate in BOTH measures of the money stock over the past year or so has been generated by people and businesses de-leveraging, becoming more liquid, and moving existing assets around. This is the deflationary scenario.

The growth rates in BOTH measures of the money stock have not been achieved through Federal Reserve actions. The reason is, of course, that the banks aren’t lending! If the banks continue to stay on the sidelines, money stock growth will continue to be anemic…at best!

Second, the inflationary scenario, the Fed has injected over $1.1 trillion of excess reserves into the banking system. A major concern is whether or not the Fed can unwind this injection without having repercussions on bank lending, money stock growth, and inflation. We can only hope that the Fed is successful in its “undoing.” See

We need to keep an eye on these figures because it is going to be important to observe how people are allocating their assets and how they are spending their money. Couple this with information on lending in the banking system and we should get some idea of the health of small- and medium-sized business, the hoped-for foundation of an economic recovery.

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