Sunday, September 11, 2011

Post QE2 Federal Reserve Watch: Part 2

Excess reserves in the commercial banking system did not change much over the past quarter.  The two-week average for the banking week ending September 7, 2011 was $1, 569 billion.  At the start of August the total was $1,602 billion and at the start of June the total was $1,549 billion.  So roughly, excess reserves averaged around $1.6 billion over the past three months.

It’s kind of hard to appreciate the irony of saying excess reserves didn’t vary much over the past three months when in August 2008 the excess reserves in the whole banking system totaled only $2.0 billion. 

QE2 ended June 30.  So, we were not to expect the Federal Reserve to do too much to the banking system after this period of quantitative easing ended.  And, so far the Fed has done little or nothing.

This does not mean things were not happening in the commercial banking system. 

For example, the required reserves in the banking system rose by more than 20 percent from the banking week ending June 1 to the banking week ending September 7.  The rise was from about $76 billion to around $92 billion.  These are the reserves banks must legally keep on reserve to back up transaction and savings account balances.    

Most of the increase came in the last week of August and the first week in September when required reserves increased by more that $10 billion. 

The rise in required reserves came about due to a massive jump in the demand deposits held at commercial banks in August, which require the highest amount of reserves to be held by the banks! 

There also was a surge in savings deposits at commercial banks in August.  

The increases in demand deposits and savings deposits seemingly came about due to a large movement of funds from small savings accounts and institutional money funds. 

It was during this time that the Federal Reserve announced that it was going to keep short-term interest rates at very low levels for the next 24 months.  This announcement seems to have accelerated the movement out of short-term interest bearing assets to bank accounts…transaction accounts and savings accounts.  In a real sense the disintermediation continues. 

The point is that these movements on the part of wealth holders have influenced the money stock figures.  For example the year-over-year growth rate of the M1 money stock, the measure most affected by the shifts in money, the shifts toward demand deposits, has risen from about 12 percent at the end of May to just under 17 percent at the end of August. 

The M2 money stock measure has also risen but its growth rate remains under 50 percent of the growth rate of the M1 money stock.  Its rise has gone from about 5 percent to 8 percent over the same time frame. 

As I have pointed out for about two years now, the money stock measures appear to be growing because people are shifting out of short-term interest bearing assets because of the exceedingly low interest rates and are parking the funds in commercial banks in transaction balances and savings accounts. 

Some of this transfer is also occurring because people who are under-employed or having other financial difficulties want to keep their funds in accounts that can be accessed quickly to meet daily and weekly needs.      

The money stock growth is not occurring because the banking system in gearing up the lending machine and providing the loans needed for a more robust expansion of the economy.

I believe my interpretation of money stock growth is the correct one because this re-allocation of wealth balances from interest earning assets to transaction balances and other short-term bank assets has been taking place for two years or so and this movement has resulted in increasing growth rates for the money stock measures.  Yet, there has not been a real increase in bank lending during this time period and economic growth remains anemic with a stagnant labor market. 

Money stock growth is occurring but, one could say, for the wrong reasons.  The money stock measures are growing because people are protecting themselves and staying liquid while interest rates are so low.  This is not the behavior that drives the economy forward.  The money stock measures are not growing because of the monetary stimulus and this means that one cannot expect much economic growth from it.

The open market operations of the Federal Reserve have basically been operational over the past five weeks.  Federal Agency securities and Mortgage-backed securities continue to run off from the Fed’s portfolio and these run-offs have been replaced by US Treasury securities.  The off-set has been almost one-for-one, dollar-wise.

The interesting action on the Fed’s balance sheet has been a $34 billion increase in Reverse Repurchase Agreements with foreign official and international accounts.  Reverse repos take reserves out of the United States banking system.   In these cases, the Federal Reserve “sells” US Treasury securities under an agreement to buy them back at a later date. Over the past 14 weeks, reverse repos to foreign governments or their agencies rose by $43 billion.  One can only guess that these transactions have to do with the financial crisis that has been taking place in Europe.  More research needs to be done on this.

The net result of all this is that the Fed has done nothing overt since the end of second round of quantitative easing.  Economic activity continues to be stagnant and the under-employment situation does not improve.  Money stock measures continue to grow but for reasons not related to increases in bank lending and improving economic activity.  The question seems to be, where does the Federal Reserve go next?  Answers to this question are all over the board. 

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