Wednesday, June 9, 2010

Federal Reserve Exit Watch: Part 11

The basic monetary facts are these: commercial banks aren’t lending and the money stock measures are not really growing. On the surface, it looks as if we have what Irving Fisher called, in the 1930s, the makings of a debt deflation. This is how we can interpret the statistics from the banking sector.

Contrary evidence comes from the performance of the “big banks”, the largest 25 domestically chartered commercial banks in the United States banking system. They are raking in profits right and left and are “making a killing” from the arbitrage and trading opportunities being subsidized for them by the Federal Reserve System.

The other 8,000 domestically chartered commercial banks in the United States are not doing so well. Roughly one out of every eight of these banks is on or very near the list of problem banks of the Federal Deposit Insurance Corporation. These are the banks that the Federal Reserve is trying to preserve through the low target interest rate policy it is following that is the ‘cash cow’ for the largest banks.

The Federal Reserve got us into this position by following a very destructive monetary policy in the early part of this decade. Then, once the financial system began to collapse, Chairman Ben Bernanke and the Federal Reserve threw everything it had against the wall to see what would stick.

We talk about financial innovation in the private sector! No group, organization, or institution initiated more financial innovation over the past fifty years than did the United States government and the Federal Reserve takes the individual prize for financial innovation during this period for what it did over the last three years or so. But, there was no real sophistication to the Fed’s financial innovation: the task of the Federal Reserve was to throw as much money as it could into the financial markets to protect the ‘liquidity’ of the market and its instruments.

Now the banking system (excuse me, the 8,000 ‘other’ domestically chartered commercial banks) is teetering on the brink of a ‘debt deflation’ (while the 25 large domestically chartered commercial banks are cleaning up) and the Federal Reserve cannot remove whatever ‘stuck’ to the wall from the banking system for fear that the rate of failure of the ‘smaller’ banks will accelerate.

The FDIC is overseeing the closure of approximately four commercial banks a week this year and the feeling is that this rate of failure could rise to five banks a week this summer or next fall. Analysts now expect the Fed will continue its “low interest rate target” into 2011.

Wow! The big banks are going to love this!!!

The ‘other side’ question is how is the Fed going to “get the stuff” that stuck on the wall, off the wall? That is, how is the Fed going to ‘exit’ its stance of excessive ease?

We are still waiting. The only ‘trick’ it has applied so far is to get the United States Treasury to
park funds in something called the “United States Treasury, supplementary financing account.” This account has risen by roughly $200 billion since the first of the year, $175 billion over the past 13 weeks, and this has drained some of the excess reserves from the banking system.

Again, no straight, classical monetary policy: the Fed used gimmicks…whoops, financial innovations…to get us to this point. Looks like we are going to use various gimmicks…whoops, financial innovations…to help get “the stuff” off the wall.

Excess reserves have declined about $80 billion from January, a little over $70 billion in the last 13 weeks, primarily due to the buildup in the Treasury’s supplementary financing account. Excess reserves, however, still are in excess of $1.0 trillion, averaging $1.048 trillion in the banking week ending June 2.

The only thing that the Federal Reserve has continued to do over the past quarter is to continue to increase its holdings of Mortgage-Backed securities. Over the last 13 weeks, the portfolio of Mortgage-Backed securities rose by $87 billion, $16 billion of the increase came over the past 4 weeks.

And, what impact does this seem to be having on the monetary aggregates. Well, the M2 money stock measure is hovering around a 1.6% year-over-year rate of growth. If the expected real rate of growth of the economy is around 3.0% then this monetary growth is certainly deflationary.

But, note this. The rate of growth of the non-M1 part of the M2 money stock measure was only 0.3% in May, on a year-over-year basis. The M1 year-over-year growth rate is 6.8% which shows that people are still transferring their wealth into transactions balances in order to have cash to pay for their daily needs. Given all the unemployment, foreclosures, and bankruptcies, the concern is that this movement will continue putting additional pressure on the 8,000 other domestically chartered commercial banks in the country.

The United States banking system does not seem to be healthy (except for the biggest banks). The monetary system is stalled. Ben Bernanke has traveled to Detroit, Michigan to hold a discussion about getting loans out to small businesses: see his “Brief Remarks at the Meeting on Addressing the Financing Needs of Michigan's Small Businesses, Detroit, Michigan” ( The Fed doesn’t seem to understand what is going on.

This is my eleventh post relating to the Federal Reserve’s Exit Strategy. I started these posts 10 months ago because of the concern expressed over how the Fed was going to “get the stuff” off the wall. The Fed wanted to be totally transparent about how it was going to “exit” its position of extreme ease and so it started talking about what it was going to do.

The concern is still there. As far as I can see, there is little confidence that the Fed can safely lead us to the “promised land”, the land of low unemployment, strong economic growth, and little or no inflation.

The Fed has acted with very little subtlety and sophistication over the past decade. Why should we expect it to act any differently over the next ten years, let alone over the next year?

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