Monday, November 7, 2011

Post QE2 Federal Resserve Watch: Part 3

I didn’t post a “Post QE2 Federal Reserve Watch” last month because I was on vacation.  You have to go back to September 12 to get Part 2 of the “Post QE2” watch. (

Early in September, the excess reserves in the banking system totaled around $1,570 billion.  At the beginning of November, excess reserves were about $1,515 billion. 

A $55 billion drop in excess reserves might seem huge, especially when total excess reserves averaged around $2.0 billion, but in these days decreases or increases of this size don’t really seem to amount to a lot.

Federal Reserve policy for the past two years has basically been to throw all the “spaghetti” it can against the wall and see what sticks.  So far, very little of the “spaghetti” has stuck as total bank loans have not increased that much over the past year although business lending has picked up some at the larger banks (

On the money stock side, however, growth has picked up substantially over the past six months or so.  The M1 money stock growth (year-over-year) has risen from just over 10 percent six months ago to more than 20 percent in recent weeks.  

The growth rate of the non-M1 component of the M2 money stock measure also accelerated during this time period, more than doubling from around a 3 percent growth rate in early April to well more than 7 percent in late October. 

The reason for this acceleration seems to be a pick up in the movement from low interest bearing short-term assets like retail money funds and institutional money funds to bank deposits and a pick up in the demand for currency in circulation.  Movements of funds into currency holdings continue to rise at a rapid rate.

The movement of funds from other short-term, interest bearing accounts can be explained by the extraordinarily low interest rates being maintained by the Fed and because of the financial stress being felt by so many families and businesses who want to keep their funds in highly liquid form.  A number of large corporations are also holding onto large cash balances for purposes of acquisitions or their own stock repurchases. 

None of these actions contribute to bank loan growth or economic expansion.  All of these reasons are anticipatory of the need to have liquid assets “near-at-hand” in order to transact.  These are not signs of a real healthy economy.

As far as the banking sector is concerned, the increase in demand and time deposits has resulted in a need within banks to hold more required reserves.  Hence, over the past six months the required reserves of commercial banks have risen $4.5 billion to $96.4 billion from $91.9 billion in early September. 
Over the past six months, the required reserves at commercial banks have risen by just under $19 billion. 

This increase in required reserves seems to be the biggest operating factor that the Federal Reserve has had to deal with over the past six months.  Thus, although excess reserves at commercial banks have dropped over the past three months, they have risen over the past six months. 

The item on the Federal Reserve’s statement of “Factors Affecting Reserve Balances of Depository Institutions” (Fed release H.4.1) that is most closely associated with excess reserves in the banking system is called “Reserve balances with Federal Reserve Banks.”  This figure has risen by about $46 billion from May 4, 2011 to November 2, 2011.  The increase came about through a rise of $102 billion in “Total factors supplying reserve funds” and a $56 billion increase in “Total factors, other than reserve balances, absorbing reserve balances.”  The $46 billion is the difference between these latter two amounts. 

The $102 billion increase in factors supplying reserve funds came primarily from Federal Reserve purchases of U. S. Treasury securities, which exceeded the run-off from the Fed’s portfolio of Federal Agency securities, Mortgage-backed securities and the decline in other operating factors that supply reserves to the banking system.

There are two interesting factors that absorbed bank reserves during this time period.  The first interesting factor is the rise in “Currency in Circulation”, which increased by roughly $33 billion from May 4 to November 3.  This movement is a drain on bank reserves and hence causes reserves at commercial banks to decline.   This increase is interesting because currency in circulation usually increases during the summer months due to vacations but decreases in the fall.  Over the past three months, from August 3 to November 3, currency in circulation actually increased by more than $15 billion.  This just adds strength to the argument made above for the increase in currency outstanding.

The other interesting factor is that the Fed’s reverse repurchase agreements to foreign official and international accounts increased by almost $68 billion over the past six months, by $56 billion over just the last three.  This increase also reduces bank reserves. 

Here the Federal Reserve is selling securities under an agreement to repurchase the securities at some stated future time period. These are international transactions and the Fed uses U. S. Treasury securities, federal agency debt, and mortgage-backed securities as collateral in the transactions.  The timing of these transactions are interesting because of the events that have taken place in Europe of the last six months. 

My summary of these movements remains much the same as in previous months.  The Federal Reserve has done just about all it can at the present time to preserve the banking system and allow the FDIC to close as many banks as it has to without major disruption. 

The Fed has thrown just about everything it can into the financial system.  Given the economic weakness in the housing market, the desire of families and businesses to continue to reduce the financial leverage on their balance sheets, and the high level of underemployment in the economy, the demand for loans from commercial banks is very weak, so total bank loans are remaining relatively constant.  A further indication of weakness is the continued movement of wealth into currency holdings and bank deposits, a movement that has resulted in the rapid growth of the money stock measures.  Throwing more “spaghetti” against the wall at this time would not change the behavior of these people or businesses to any degree. 

The Fed may just have to wait until the deleveraging is completed before it sees people starting to borrow again or to hire new workers.  That is, unless the situation in Europe explodes and further ‘search and rescue” missions are needed to preserve western civilization.         

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