Federal Reserve Report: No Need for QE3

I keep reading that some people want to have the Federal Reserve begin a new round of quantitative easing…QE3.

I see nothing in the financial figures that calls for more quantitative easing.

For one, there seems to be no pressure on interest rates.  Looking over the last 13-week period the yield on the 10-year US Treasury (constant maturity) has remained relatively constant.  The weekly average for the week of November 4, 2011 was 2.07 percent: for the week of January 27, 2012 the weekly average was 2.01.  And, the market yield on 10-year Treasuries has been below 2.00 percent all of this week.

The European sovereign debt situation has certainly contributed to this weakness in yields.  Hence, there does not seem to be any demand pressure on interest rates at this time.

Economic growth continues to be modest and consequently is not adding any demand pressure on rates.

The commercial banking system is quiet and even though bank closures average around 2 per week adjustments are being made smoothly and with little or no disruption to the industry. 

Excess reserves in the banking system have fluctuated around $1.5 trillion over the past three months indicating little or no pressure on the financial system on the loan demand front.  This, too, is consistent with the modest economic growth.

Overt Federal Reserve actions have been absent over the past 13-week period indicating that the Fed is allowing operating factors to work themselves out without undue disturbance to the monetary system. 

The big change on the Fed’s balance sheet has to do with the European debt crisis.  Central bank liquidity swaps have risen by a little more than $100 billion since November 2, 2011 as the Fed moved to assist central banks in Europe.  It appears as if part of this increase went to take pressure off the market for Reverse Repurchase agreements with foreign official and international accounts.  The account recording this activity fell by about $41.0 billion over the same time period.

This has resulted in a net increase of about $53 billion in Reserve Balances at Federal Reserve banks but this has had little or no immediate impact on the United States banking system.

Actually, Reserve Balances at Federal Reserve banks declined by $7.0 billion over the past four-week period.  The increase in central bank liquidity swaps was just about totally matched by the decline in reverse repos with foreign official and international accounts as other factors removed reserves.

In terms of Federal Reserve open market operations, the securities account at the Fed actually declined in both the latest 4-week and 13-week periods.  Securities bought outright dropped by a little more than $11.0 billion since November 2 and by a little more than $5.0 billion since January 4. 

Over the past 13 weeks, about $20.0 billion in federal agency issues and mortgage-backed securities ran off in the portfolio.  The Fed only replaced this runoff by a little more than $8.0 billion.  In the latest 4-week period, the runoff in securities was across the board.

The conclusion I draw from the latest Federal Reserve statistics is that the Fed has had a relatively peaceful 13 weeks.  Money continues to flow into the United States Treasury markets seeking a “safe haven” from what is going on in Europe.  This, along with the mediocre economic growth in the country, has taken pressure off the Fed to buy more securities in order to keep interest rates low.  The fact that the securities portfolio at the Fed has declined over the past 13 weeks indicates that the Federal Reserve is letting market forces keep interest rates low and, for a change, is staying out of the market. 

If these conditions continue, I see no justification for any talk about another round of quantitative easing.

The money stock numbers are continuing to maintain excessive growth rates.  The year-over-year rate of growth of the M1 measure of the money stock for the week ending January 24, 2012 is 18.7 percent; the M2 measure of the money stock is growing at 9.7 percent.

Over the past three years I have been arguing that the reason that these money stock growth rates are so high, given the fact that commercial banks did not seem to be lending and that the reserves being pumped into the system by the Fed were going into excess reserves, is that the dire economic conditions have caused individuals and businesses to move their funds from interest bearing assets to transaction assets like currency and demand deposits.  The very low interest rates on the interest bearing assets also contributed to this movement.

Now, however, it seems as this re-arrangement of liquid asset holdings has slowed down.  This is something I think we want to keep our eyes on, for it could be that households and businesses have done all they can do to “be liquid” in bad times.  Thus, we will either see a slow-down in money growth measures (the rates have dropped since the first of November from a 20.0 percent year-over-year rate of growth for M1 and a 10.0 percent rate for M2) or we will see spending starting to increase as these transactions accounts are being used to actually buy things.  It will be interesting to see what happens here.

If people and businesses do speed up their expenditures, this fact would be another reason why another round of quantitative easing would not be necessary.  The Fed would have done enough.   

Monetaray Policy in 2011: Looking Back

Total reserves in the banking system rose by almost 50 percent in 2011 to average around $1.6 trillion.  The increase during the year was slightly more than $511 billion. (Remember in August 2008 when total reserves in the banking system averaged less than $45 billion?)

Excess reserves in the banking system rose by about $490 billion from December 2010 to December 2011 to a total of about $1.5 trillion. (Remember in August 2008 when excess reserves in the banking system averaged less than $2 billion?)

The Federal Reserve continued to pump reserves into the banking system in 2011 and about 95% of the reserves going into the banking system went into excess reserves. 

Bank loans fell during the year by approximately $50 billion.  There was a pickup in business loans (commercial and industrial loans) of about $122 billion, but real estate loans (primarily commercial real estate loans) fell by $150 billion and consumer loans dropped by $22 billion. 

Note that the pickup in business loans was predominately located in the largest 25 domestically chartered banks in the United States.  The increase here was approximately $95 billion. 

One can conclude from this that the reserves that the Fed pumped into the banking system did not, on balance, go to support an increase in lending.

Yet, the growth rate in both measures of the money stock rose during the year.  For the M1 measure of the money stock, the year-over-year rate of increase rose from 7.5 percent in December 2010 to 19.1 percent in December 2011. (This is using the 13-week average of the measure.)  The year-over-year rate of growth of the M2 measure of the money stock rose from 3.3 percent in December 2010 to 9.8 percent in December 2011. (Again using the 13-week average.)

The increase was highlighted by a whopping 45% rise in demand deposits!

But, this increase in demand deposits did not come from an increase in bank lending because the bank lending that might have resulted in an increase in demand deposits and hence the M1 money stock actually declined!

The reason for the huge increase in demand deposits seems to be that people are moving assets from short-term investment vehicles to demand deposit accounts. 

For the past two years or so I have been arguing that this movement into demand deposits is coming for two reasons.  The first reason is that interest rates on short term investments are so low that people do not believe that it is worthwhile to keep their money in interest bearing assets rather than demand deposits. (For example, Federal Reserve data record a drop of almost $90 billion in Institutional Money Funds over the past year.)

The second reason is that many people are still is difficult financial condition.  Hence, they are keeping what funds they have in transaction-type accounts so as to pay for necessary living expenses.  Additional information that supports this argument is that the currency component of the money stock rose by more than 9 percent this last year.  This is, historically, an extremely high number.  People in tough economic situations also hold more cash.

The evidence from the banking system is not very encouraging with regards to a pickup in economic activity.

How did the Federal Reserve inject more than $500 billion reserves into the banking system this last year?

First, the Federal Reserve increased its holdings of securities by roughly $442 billion.  Actual acquisitions of Treasury securities amounted to about $640 billion but these purchases were offset by a $43 billion decrease in the Fed’s holdings of Federal Agency issues and a $154 decline in the Fed’s holdings of mortgage backed securities. 

One should also note that there was a net decrease in funds associated with the bailout actions of 2007 and 2008 of approximately $140 billion. Also, primary borrowings from the Fed’s discount window declined by $36 billion.  One generally assumes that these “operating” factors are offset by the Fed’s purchase of securities.  Thus the “net” addition of funds from the increase in the Fed’s outright holdings of securities totaled about $266 billion. 

Second, the United States Treasury also played a role in the increase in bank reserves.  At the end of 2010, the Treasury held almost $200 billion in something called the U. S. Treasury Supplementary Financing Account. (I have mentioned the use of this account many times in 2010…here is one post: http://seekingalpha.com/article/256497-qe2-watch-version-4-0-fed-is-tone-deaf-and-spaghetti-tossing.) These funds were injected into the banking system this past year…the full $200 billion of them.  This can be added to the $376 billion mentioned in the previous paragraph to account for $466 billion of reserves going into the banking system. 

Third, the currency being demanded by the public mentioned above is supplied to the public by the Federal Reserve “on demand”.  That is, the Federal Reserve generally replaces the currency flowing out of the banking system into general circulation, dollar for dollar.  This past year, currency in circulation rose by about $93 billion.  Thus the $466 billion of the previous paragraph drops to $373 billion.

Fourth, the Federal Reserve has “pumped” dollars into the European banking system due to the sovereign debt crisis in Europe.  For example, Central bank liquidity swaps have increased by about $100 over the past year, most of the increase coming in the past six months.  This is not the only way the Fed influences what is going on internationally as the Fed holds other assets denominated in foreign currencies and also engages in reverse repurchase agreements with “foreign official and international accounts”.  If one roughly nets out the accounts associated with all of these type of transactions, we can say that the Fed roughly added another $104 billion to bank reserves which brings the total injection to $477 billion 

One final operating factor influences this total figure, payments into and out to the general account of the United States Treasury.  This fluctuates with tax payments and actual government expenditures.  The year-over-year drop in this account is about $28 billion and this brings the total increase in “reserve balances at Federal Reserve banks to $505 billion, which matches very closely with the $490 increase in excess reserves mentioned in the second paragraph of this post. (The difference is due to minor operating factors that we do not need to discuss.)

In summary, the Federal Reserve (and the U. S. Treasury) put a lot of reserves into the banking system this past year.  As usual, the Fed needs to take care of other operating factors that constantly impact the banking system, but in general, the injection of reserves came from the securities the Fed purchased as a part of the QE2, the dollars being advanced to European central banks to help relieve the pressures of the sovereign debt crisis, and the injection of funds into the banking system from the fiscal activities of the United States Treasury.

As of this time, the reserves going into the banking system have not been lent out…they are just sitting on the balance sheets of the commercial banks.  The extraordinary increase in the money stock measures are the result of the low interest rates that people can earn on their money balances and the need of people who are economically distressed to hole transaction accounts.

The efforts of the monetary authorities are not being felt, yet, by an increase in economic activity.

Bernanke "Transparent" About His Lack of Self-Confidence

This post is about the Fed’s latest effort to build confidence in the financial system by “providing the predictions of its senior officials about their own decision, hoping to increase its influence over economic activity by guiding investor expectations.” (http://www.nytimes.com/2012/01/04/business/economy/fed-to-start-publicly-forecasting-its-rate-actions.html?_r=1&ref=business)

“The inaugural forecast will show the range of predictions made by Fed officials about the level of short-term interest rates in the fourth quarter of 2012, 2013, and 2014….  It will also summarize when they expect to start raising short-term rates….”

To me, this is Ben Bernanke’s latest effort to justify himself and what he has done.  It is Mr. Bernanke’s cry to financial markets: “please understand me.”

But, the more Mr. Bernanke cries for understanding, the more he digs a hole for himself with respect to the future.  For one, who can believe that anyone can forecast short-term interest rates for a three-month period let alone for a three-year time frame?  The record of the people at the Fed is no better than that any other group of forecasters. 

Second, by telegraphing the Fed’s intention, the Fed will be setting itself up for financial markets to “bet” against it.  This is always a possibility when central banks or governments explicitly state their policy goals.  And, the “bet” many times can become a “sure thing.”  Perhaps the best, most recent example of this is the Soros “bet” against the British government in the 1990s about the value of the pound. 

Ultimately, to me, this effort at “transparency” is a sign of Mr. Bernanke’s real lack of self-confidence in his ability to lead the Federal Reserve through this difficult time.  He can’t understand why people don’t understand what he is doing and so he tries, harder and harder, to create this understanding.  His steps to gain greater “transparency” over the past six months is just evidence of his struggle.        

I will admit that I am not, nor have I ever been, a fan of Ben Bernanke as the Chairman of the Board of Governors of the Federal Reserve System.  I was in favor of him being the Chair of the Economics Department at Princeton University…but not Chair of he Fed. 

I was against Bernanke’s re-appointment as the Chairman (http://seekingalpha.com/article/151474-exit-strategy-an-argument-against-bernanke-s-reappointment) and disappointed in President Obama for actually re-appointing him (http://seekingalpha.com/article/158762-bernanke-s-disappointing-reappointment).

In reviewing Bernanke’s record since being a member of the Board of Governors, I see nothing but a competent academic, out of his element and over-his-head in the deep water of a twenty-first century whirlpool. 

In more peaceful times when he was just a member of the Board of Governors (August 5, 2002 – June 21, 2005) he was a lackey of the then Fed Chairman Alan Greenspan, developing the argument for Greenspan’s defense of recent monetary policy that used the savings of China and the Middle East to finance U. S. Treasury debt. 

He was a strong supporter of Greenspan’s effort to keep the Federal Funds rate at one percent in the 2003-2004 period to combat the possibility of the economy going into a deep recession.  This effort helped to underwrite the “bubble” that took place at this time in the U. S. housing market. 

Then, once he was became Chairman of the Federal Reserve on February 1, 2006, he was a firm advocate of pushing the target rate for the Federal Funds rate to 5.25 percent and keeping it there into August of 2007 so as to combat the possibility that inflation might get out-of-hand.  

The Fed move was in response to the financial market meltdown of “Quant” financial firms that took place in August 2007. (See book review on “The Quants”, http://seekingalpha.com/article/188342-model-misbehavior-the-quants-how-a-new-breed-of-math-whizzes-conquered-wall-street-and-nearly-destroyed-it-by-scott-patterson.)

The recession in the United States began in December 2007.

The next episode of Bernanke’s “steady hand on the tiller” came in the fall of 2008.  I have characterized Bernanke’s reaction to the Lehman Brothers failure as one of panic.  (See my post “The Bailout Plan: Did Bernanke Panic”, http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)

But, what Bernanke and the Fed did next has been the basis for the claim that Mr. Bernanke saved the United States from a second Great Depression.  The Federal Reserve acted to increase its balance sheet from slightly less than $900 billion is assets to more that $2.0 trillion in assets by the beginning of 2009.  Through various stages of Quantitative Easing (QE), the Fed’s total assets now amount to more than $2.8 trillion.

This injection of funds into the banking system has resulted in around $1.6 trillion in excess reserves on the balance sheets of U. S. banks.  It has created little in the way of bank lending or economic growth.    

However, many people have given credit to Mr. Bernanke for saving the country and this may be an appropriate gesture on the part of a grateful country.  My concern has been that this policy is nothing more than a policy of throwing sufficient “stuff” against the wall to see what would stick.  As a consequence, monetary policy in the United States has become a tool of ignorance, not of professional competence. 

And, that is exactly where we are today.  That is why there is so little confidence in the Chairman of the Federal Reserve System in world financial markets.

Thus, that is why the Chairman of the Federal Reserve System is struggling to reach out to the financial markets to justify what he has done…and is doing.

This effort, in my mind, will achieve little or nothing…and could do much harm.

Recent Monetary Policy and the Growth of the M1 Money Stock

Since the end of June 2011, excess reserves held by commercial banks have declined by about $107 billion. (Remember in August 2008 when excess reserves in the banking system totaled only $2.0 billion…for the whole banking system!) For the two-week period ending November 30, 2011, excess reserves averaged almost $1.6 trillion.

Reserves balances held at Federal Reserve banks dropped by about $110 billion over the same period of time. On December 7, 2011, reserve balances were slightly under $1.6 trillion.

Excess reserves held by the banking system and reserve balances at the Federal Reserve tend to move in the same direction and in about the same magnitude.  The reason for focusing on reserve balances held at Federal Reserve banks is that this number comes from the Fed’s balance sheet and can be related the movements of line items that appear on the balance sheet.

This decline in reserve balances has not been overtly driven by Federal Reserve actions.  In fact, three factors have dominated this decline, and each of the three is independent of what the Federal Reserve might be overtly doing. 

The first two factors relate to components of the Federal Reserve’s portfolio of securities.  After the Fed’s holdings of U. S. Treasury securities, the largest part of the portfolio is made up of mortgage-backed securities.  From the end of June through the current banking week, the amount of mortgage-backed securities on the Fed’s balance sheet dropped by $82 billion and represented maturing securities. 

The Fed’s holdings of Federal Agency securities also feel by almost $11 billion during this same time period again from the run-off of maturing issues. 

The third factor that helped to decrease reserve balances was a $31 billion increase in currency in circulation outside the banking system.  That is, when currency is drawn out of the banks and moves into the hands of individuals, families, and businesses, bank reserves go down…unless these outflows are offset by other actions of the Federal Reserve. 

Just these three factors alone resulted in a $124 billion reduction in bank reserves.  Some open market operations as well as other operating factors offset this decline, but the net result, as mentioned above, was that overall excess reserves in the banking system decline by more about $110 billion over this time period.

While these excess reserves were declining, however, we observed during the same time period, a sizeable change in the speed at which the money stock was growing.  For example, in June, the year-over-year rate of growth of the M1 measure of the money stock was about 6 percent.  In July, the rate of growth increased to 16 percent, in August it was slightly more than 20 percent where it has stayed. 

The M2 measure of the money stock did not show such dramatic increases, since the M1 measure is a subset of the larger total, but it, too, increased during this time period.  In June, the year-over-year rate of growth of the M1 measure was about 6 percent.  In July the growth rate of this measure rose to 8 percent and then jumped to 10 percent in August where it has remained. 

In July and August, the banking system experienced huge gains in demand deposits while in June, July, and August savings deposits at depository institutions rose dramatically. 

These movements along with the continued strong demand for currency in circulation can still be used as evidence that the economy remains very weak.  The $31 billion increase of currency in circulation mentioned above has resulted in the currency component of the money stock measure showing a year-over-year rate of growth by the end of October of almost 9 percent, which is a very high figure historically.  

The movements taking place in the money stock figures point to the weak economy in two ways.  First, with people under-employed, with people trying to stay away from debt, and with businesses trying to build up large stashes of cash, the demand for currency and for transaction balances at financial institutions rises.  Weak economies cause economic units to keep more of their wealth in a form that is readily accessible and spendable.

The second piece of evidence, however, is the extremely low interest rates associated with the weak economy.  With interest rate so low, it just does not pay for people to keep funds in interest-bearing accounts. Over the past five months, savings deposits at financial institutions have dropped by almost $75 billion and funds kept in institutional money funds have dropped by $160 billion over the same time period.  A large portion of these funds has apparently gone into currency and transaction balances.   

People are still getting out of short-term assets and placing their funds, more and more, in transactions-type accounts.  This is a sign of the weak economy and not of economic growth or a successful monetary policy. 

This is “debt deflation” type of behavior. (http://seekingalpha.com/article/307261-debt-deflation-is-it-a-possibility) It is a type of behavior that the Federal Reserve has not yet been able to over come. And, having the Fed toss more “stuff” against the wall does not seem to be the policy to turn things around.

Federal Reserve officials keep talking about up the fact that they have not run out of things that they can do to continue to try and stimulate the economy.  Unfortunately, it seems to me that fewer and fewer people are listening to their pleading. 

With a banking system that is still much weaker than the authorities are willing to talk about; with a consumer sector and business sector that, for the most part, are still trying to reduce their debt load; and with a public sector that is sorely out-of-balance and doesn’t seem to know where it wants to go; people are confused and uncertain about their future and about what to do.  

In this kind of environment, people want to hold onto what they have and want to avoid as much risk as they can.  They don’t want to borrow if they don’t have to and they want their assets to be as liquid as possible.

This is what the Federal Reserve is facing. 

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. 

Federal Reserve QE2 Watch: Part 4.0

The Federal Reserve continues to pump funds into the banking system. Reserve balances at Federal Reserve banks reached $1.3 trillion on March 2, 2011. This is up from $1.1 trillion on
February 2 and up from $1.0 trillion on December 29, 2010.

These balances serve as a relatively good proxy for the excess reserves in the banking system which averaged $1.2 trillion over the two-week period ending February 23, 2011.

As we have reported before, there are two drivers of this increase in bank reserves. The first, connected with the Fed’s program of quantitative easy, is the acquisition of United State Treasury securities.

Over the past four weeks the Federal Reserve has added almost $100 billion to its portfolio of Treasury securities. Only about $18 billion of these purchases were offset by maturing Federal Agency issues and mortgage-backed securities.

Since the end of last year, the Fed has added $220 billion to its Treasury security portfolio. In this case the Fed was replacing a $48 billion decline in the other securities that were maturing.

And, in the past 13-week period, Almost $320 billion were added to the Treasury portfolio, replacing about $80 billion in maturing Agency issues and mortgage-backed securities.

The second driver has been the action surrounding Treasury deposits with Federal Reserve banks. Since these deposits are a liability of the Fed, a reduction in these deposits increases reserves in the banking system. There are two important accounts here, the Treasury’s General Account and the Treasury’s Supplementary Financing Account.

The Supplementary Financing Account has been used for monetary purposes and in the current case, the Treasury has reduced the funds in this account by $100 billion. All of this reduction came in February.

The Treasury’s General Account is used in conjunction with Treasury Tax and Loan accounts at commercial banks and is the account that the Treasury writes checks on. Generally tax monies are collected in the Tax and Loan accounts and then are drawn into the Federal Reserve account as the Treasury wants to write checks. When the Treasury writes a check, it is deposited in commercial banks, so that bank reserves increase.

Over the past four weeks, the Treasury’s General Account has dropped by almost $70 billion. Thus, between this account and the Treasury’s Supplementary Financing Account the Fed has injected almost $170 billion reserves into the banking system in February.

I need to call attention to the fact that funds moving into and out of the General Account can vary substantially. For example, since the end of the year (which includes the February change) this account has only fallen by $39 billion. Over the last 13-week period, the account has actually increased by $4 billion. Tax collections build up toward the end of the year and then are spent during the first quarter of the year preparing for another buildup around April 15, tax collection time.

The bottom line, the Federal Reserve is seeing that plenty of reserves are being put into the banking system. But, the commercial banks seem to be holding onto the reserves rather than lending them out.

Still, the growth rates of both measures of the money stock seem to be accelerating. The year-over-year growth rate of the M1 measure of the money stock was growing by about 5.5% in the third quarter of 2010. The growth rate increased to 7.7% in the fourth quarter and is growing at a 10.2% rate in January 2011.

The M2 measure of the money stock has also accelerated, going from a year-over-year rate of increase of 2.5% in the third quarter to 3.3% in the fourth quarter to 4.3% in January.

On the surface these increases in money stock look encouraging in terms of possible future economic growth. However, we are still seeing the same behavior of individuals and businesses in the most recent period that we have observed over the past two years.

The growth rates of both measures of the money stock still seem to be coming from people that are getting out of short term “investment” vehicles and are placing these funds in demand deposits or other transaction accounts, or in currency.

The first piece of evidence of this relates to the reserves in the banking system. The total reserves in the banking system have remained roughly constant over the past year. Yet, the required reserves of the banking system have increased by 10% year-over-year. This situation could only happen if demand deposit-type of accounts, which require more reserves behind them, were increasing relative to time and savings accounts, which have smaller reserve requirements.

Looking at the individual account items we see that demand deposits at commercial banks rose at a 20% year-over-year rate of growth in January. The non-M1 part of the M2 measure of the money stock rose by only an anemic 3% rate. Thus, the substantial shift in funds from time and savings accounts to transaction accounts continues. There is no indication of a speeding up of money stock growth connected with the reserves that the Fed is injecting into the banking system.

An even more dramatic shift can be seen if we include institutional money funds in the equation and look at what has happened in the banking system over the past nine weeks. The non-M1 portion of M2 increased by $22 billion over this time period. However, funds kept in institutional money funds declined by roughly $40 billion. This means that accounts that Milton Freidman would have labeled “a temporary abode of purchasing power” actually declined by $18 billion since the start of the year.

Demand deposits and other checkable deposits rose by about $21 billion. One could note that currency in the hands of the public also rose by $16 billion.

The public continues to move money from relatively liquid short-term savings vehicles to assets that can be spent by check or cash. This is not the kind of behavior one gets in an economy that is confident and expanding. This behavior can roughly be called “defensive”.

So, another month has gone by. The Fed is aggressively executing its program of quantitative easing. Yet, it still seems to be “pushing on a string.” Why is it I retain the feeling that the Federal Reserve’s effort is just spaghetti tossing, seeing what might stick to the wall?

The longer this policy continues, the less confidence people seem to have in both Ben Bernanke and the Federal Reserve. I shutter to think what Bernanke and the Fed will do to us when the banking system actually does start lending again.

Note that some members of the Fed’s Open Market Committee are suggesting that QE2 end abruptly at the end of June when the current program is slated to expire. (See "Policy Makers Signal Abrupt End to Bond Purchases in June": http://www.bloomberg.com/news/2011-03-04/fed-policy-makers-signal-abrupt-end-to-bond-purchases-in-june.html.)

Does everyone in the Fed seem “tone deaf” to you? They just seem to act on pre-conceived ideas and have no sense or feel of the banking system and financial markets. Another confidence raiser.

It's Your Fault, Not Mine!

The headlines this morning from London: “Fed Denies Policy is Causing Rising Food Prices.” (http://www.ft.com/cms/s/0/5c4aeaea-2fbd-11e0-91f8-00144feabdc0.html#axzz1CzURFR8C)

Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System, spoke to the National Press Club yesterday and basically said:

“It’s Your Fault!”

The response: “No, it isn’t!”

Bernanke’s come back: “’Tis too!”

And, so we see the basic defense the leader of our central bank relies upon. “The problem is ‘out there’, it’s not in here!”

Bernanke: “I think it’s entirely unfair to attribute excess demand pressures in emerging markets to U. S. monetary policy, because emerging markets have all the tools they need to address excess demand in those countries. It’s really up to emerging markets to find appropriate tools to balance their own growth.” (http://professional.wsj.com/professional-search/search.html?ar=1&dt=4&mf=0&pg=1&ps=25&sb=0&pid=0_0_ES_1000&cnt=&st=4&nfbg=SUDEEP+REDDY)

Throughout his history at the Fed, Bernanke has always seen our problems as coming upon us from someone else or somewhere else in the world. Our problem in the early 2000s was the fault of the Chinese because they saved too much! Our problem in the housing bubble was that others in the rest of the world purchased the mortgage-backed securities being created to finance residential real estate! Our problem in the summer of 2007 was that inflation still had to be combated because prices were rising too fast in the rest of the world. (See chart in this article on world food prices to confirm this:
http://www.nytimes.com/2011/02/04/world/04food.html?ref=todayspaper.) And, now, other countries are not acting strongly enough to combat rising food prices in the rest of the world.

Here is the problem: Bernanke is so focused on the fact that nothing is our fault that he is constantly behind the curve. Yesterday, I wrote in my post

“But, why should we expect the Federal Reserve to back off from QE2 any time soon? Chairman Bernanke has been late on every shift in monetary policy since he has been a member of the Board of Governors. Why should we expect anything different this time?” (http://seekingalpha.com/article/250838-long-term-treasury-yields-and-inflationary-expectations)

Bernanke’s thought process might be correct in a world in which the international flow of capital was severely constrained. Bernanke is a first class world academic when it comes to studies of the Great Depression of the 1930s. That world was a world of severely restricted flows of capital between countries.

In fact, the limited international capital movements was a part of the policy prescriptions of the world at that time. John Maynard Keynes was a strong advocate for restricted capital flows in the world. (http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell)

Keynes, and other participants in the construction of the Bretton Woods international financial system, built constrained international capital flows into the very rules of the post-World War II monetary framework.

The reason for restricting international flows of capital? In such a regime, countries could conduct their economic policies independently of one another. In such an environment, a country could forget about what was happening “out there” and focus solely on what was happening “in here.”

The world didn’t cooperate with this desire to limit capital flows and as the barriers to international flows of capital broke down in the 1960s, the Bretton Woods system had to go. The final nail in the coffin was applied by President Richard Nixon on August 15, 1971 as he took the United States “off gold” and floated the value of the United States dollar.
Capital flows freely around the world and so the United States cannot just act as if it is the only player in the world. Yet, this seems to be exactly what Bernanke wants.

Answer this: what three countries or organizations in the world hold the most amount of U. S. Government debt?

In order of magnitude: the United States with $1,138,166 million as of the close of business on February 2, 2011 ($1.138 trillion); China, a little less than $0.9 trillion; and Japan, a little less than China.

What can we take-away from this?

Capital is flowing freely throughout the world!

The contribution made by the United States to these flows is enormous!

The flows of this capital must look like a huge wave coming up on their shores, like a tsunami hitting most of the countries in the world!

But, Mr. Bernanke argues that “…emerging markets have all the tools they need to address excess demand in those countries. It’s really up to emerging markets to find appropriate tools to balance their own growth.”

What he really is saying is, "I want to do my thing...and I am big enough to do what I want. You just have to live with what I do. I can have an independent economic policy because of my size. Too bad you are not big enough to be able to conduct your own independent economic policy."

Mr. Bernanke has invested too much of his intellect in the study of the 1930s. Mr. Bernanke needs to become a part of the 2010s.

Where is the Inflation? All Around!

Ronald McKinnon writes in the Wall Street Journal this morning, “The U. S. is a sovereign country that has the right to follow its own monetary policy. By an accident of history, however, since 1945, it is also the center of the world dollar standard...So the choice of monetary policy by the Federal Reserve can strongly affect its neighbors for better or worse.” (http://professional.wsj.com/article/SB10001424052748704405704576064252782421930.html?mod=ITP_opinion_0&mg=reno-wsj0

Charles Plosser, President of the Federal Reserve Bank of Philadelphia, stated in Santiago, Chile yesterday: ”I believe we have come to expect too much from monetary policy.”

In terms of what monetary policy can do, we know that one of the fundamental lessons of economics is that “Inflation is, everywhere, at every time, a monetary phenomenon.”

Monetary policy cannot produce full employment, or retract over-investment, or fund state and municipal government pension funds that have been under-funded for years. Monetary policy cannot educate or train people for today’s jobs.

Monetary policy cannot make commercial banks solvent that have made bad loans or investments.

McKinnon asks, “What do the years 1971, 2003, and 2010 have in common? In each year, low U. S. Interest rates and the expectation of dollar depreciation led to massive ‘hot money’ outflows from the U. S. and world-wide inflation. And, in all three cases, foreign central banks intervened heavily to buy dollars to prevent their currencies from appreciating.”

But, the U. S. is a sovereign country that has the right to follow its own monetary policy...

And, how is this happening?

First, money flows into auction markets such as commodity markets or foreign exchange markets. (http://seekingalpha.com/article/246657-emerging-markets-the-bubbles-are-real)

Second, funds begin to flow into other areas of non-United States economies. Consumer price indexes have been rising in many of the emerging countries around the world. In particular, China, Brazil, India, and Indonesia have experience increases in their price indexes of more than 5% in 2010. In both the Eurozone and in England, the central banks are having to deal with the problem that, despite slow economic recovery and reductions in government spending due to the sovereign debt crisis, recorded inflation is exceeding their long run inflation targets.

Only after some lag time takes place does the inflationary pressures get built up within the United States. This lag time may be as much as five years, especially given the structural problems that exist in the United States economy. (http://seekingalpha.com/article/246404-why-debt-is-going-to-continue-to-be-problem-for-u-s) This is the historical experience.

Notice, that in two out of the three dates that McKinnon highlights, Ben Bernanke played a prominent role. Bernanke was a board member of the Federal Reserve during the 2003 time period and helped to compose the justification for the Fed’s policy at that time. Of course, Bernanke is currently the Chairman of the Board of Governors.

One must also remember that it was Chairman Bernanke who continued to fight inflationary pressures into the late summer of 2007 before the Fed totally had to reverse their policy stance when Bear Stearns declared bankruptcy. (http://seekingalpha.com/article/188342-model-misbehavior-the-quants-how-a-new-breed-of-math-whizzes-conquered-wall-street-and-nearly-destroyed-it-by-scott-patterson)

Mr. Bernanke does not have a very good record in judging when he, and the Fed, are heading in the wrong direction. Zero for three is not a very good batting average!

The consequences of inappropriate economic policy work themselves out slowly, but they also inevitably work themselves out. This is the message in the research of Ken Rogoff and Carmine Reinhart. (http://seekingalpha.com/article/171610-crisis-in-context-this-time-is-different-eight-centuries-of-financial-folly-by-carmen-m-reinhart-and-kenneth-s-rogoff)

Here we need to quote another fundamental lesson of economics: monetary policy works with long and variable lags.

Monetary policy takes a long time to work itself out throughout the economy. And, the effects of monetary policy cannot be reversed quickly.

One of the reasons why some economists have argued that monetary policy should be conducted according to “rules” rather than “authority” is that, historically, the track-record of policy makers is not so “hot.” And leaders that have a batting-record of zero for three do not add anything to the confidence level.

Where is the inflation?

It can be found throughout the world. The United States is “the center of the world dollar standard.” What the United States does in terms of monetary policy affects the world! And, what is happening in the world, sooner or later, also affects the United States. McKinnon is arguing that this is the historical record.

Is QE2 a Bubble Machine?

One of the major contributors to world economic growth and development in the post-World War II years has been the ability of capital to flow relatively freely throughout most of the world. As capital began to flow more freely throughout the world in the late 1950s and 1960s, the rules of international monetary affairs changed. One of the most dramatic changes resulting from this freer movement of capital was the breaking down of the Bretton Woods system which finally breathed its last breath on August 15, 1971 as the United States removed itself from the gold system and began to float the dollar.

We are now experiencing some of the consequences of the free flow of capital throughout the world as the impact of the world’s central bank, the Federal Reserve System, is changing the behavior of nations.

One fear is that the changes are being made in the direction of imposing controls on the flow of
capital. As Nobel-prize winning economist Joseph Stiglitz has declared, the world seems to be evolving into fragments. Not exactly what the Federal Reserve had in mind.

This concern is captured by work being done within the International Monetary Fund that points to “the rising tensions as governments impose blocks on cross-border movements of speculative money.” (See “Surging Capital Flows Pull IMF into the Fray,” http://www.ft.com/cms/s/0/85907e38-1924-11e0-9311-00144feab49a.html#axzz1AGISipQS.)
“Emerging markets from Brazil to South Korea to Indonesia are complaining that a growing flood of money is boosting the value of their currencies and undermining their competitiveness. They have imposed different restrictions on investment to try to make sure those funds can’t leave the country suddenly.” (http://professional.wsj.com/article/SB10001424052748703675904576064233644690302.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj)

“Fundamentally, the IMF wants to expand its oversight of capital flows and determine when restrictions make sense and when they are being misused.”

Up to now, the implied culprit causing this situation to occur has been the monetary policy of the United States, specifically the program of Quantitative Easing (QE2) initiated and executed by Chairman Ben Bernanke and the Federal Reserve System. The low interest rates created by the Fed, keeping its Federal Funds target in the 0.0 to 0.25 basis point range since December 2008 while flooding the financial markets with more than $1.0 trillion in liquidity, has provided the catalyst for the international flows of speculative money.

As international tensions continue to grow, more and more explicit focus will be placed on the behavior of the Federal Reserve System. Experts are expecting that the whole issue of capital controls to become a “big part” of this year’s discussion of the G-20. French President Nicholas Sarkozy, chairman of the Group of 20 in 2011 is seen as a role-player in raising the international profile of the issue.

These international flows of speculative money are also being given credit for a good deal of the world-wide run-up in commodity prices. Speculative movements of funds have been given credit for increases in the prices of oil, gold, silver , and copper, among other non-food commodities.

Now, the rise in world food prices is gaining attention and concern. Today,the Financial Times leads with an article that includes the claim of “Food Price Shock” (http://www.ft.com/cms/s/0/524c0286-1906-11e0-9c12-00144feab49a.html#axzz1AGOW6ARZ). The Food and Agricultural Organization of the United Nations has warned that the world faces a “food price shock” as its benchmark index of farm commodities prices “shot up to a nominal record last month, surpassing the levels of the 2007-2008 food crisis.” This speculative crisis may be exacerbated if certain disturbing weather forecasts for 2011 are realized.

The concern is over the unrest that these higher food prices might have on potential unrest in many developing nations. There is even fear that this unrest could reach some developed countries including those in the Eurozone.

There has been growing discussion about the role that the Federal Reserve has played in the explosion of commodity prices throughout the world. Again, there are lots and lots of dollars “out there” and the cost of borrowing dollars is close to zero, especially in markets that are experiencing various degrees of inflation. Of course, this leads to the question of “bubbles”.

No one has really gotten a handle on the concept of credit bubbles and so there is a lot of discussion about what a credit bubble actually is, if credit bubbles even exist. Like pornography, credit bubbles seem to be whatever an observer wants to define them as.

Debate still exists about the “housing bubble” of the early 2000s. Again, the Federal Reserve kept its target interest rate extremely low for “an extended period of time” in order to insure that the economy did not collapse into a severe recession. Housing prices exploded in this period at double-digit rates of increase every year. The Fed Chairman at that time, Alan Greenspan, still refuses to acknowledge the existence of anything like a bubble in housing prices. Economist Ben Bernanke provided Greenspan with the justification for not acknowledging that a bubble took place.

So, a housing bubble took place in the early 2000s, unless it didn’t take place.

Is the flow of money into world commodity markets creating a credit bubble there? Is the flow of money into the currencies and stocks of developing countries creating a credit bubble there? Is QE2 the “bubble machine” of the world?

Something new has taken place in the world. The information Congress forced out of the Fed confirmed that the Federal Reserve System became the central banker of the world beginning in 2008. A consequence of this change in roles for the Federal Reserve is that, connected with the free flow of capital throughout the world, the Fed can become the “bubble maker” for the world. What the Fed does, does not stay at home!

I have frequently quoted the work of Raghuram Rajan, winner of the Financial Times/Goldman Sachs award for the best business book of 2010. (See a review of his award-winning book “Fault Lines,” http://seekingalpha.com/article/224630-book-review-fault-lines-how-hidden-fractures-still-threaten-the-world-economy-by-raghuram-g-rajan.) I now refer to a book written by Rajan fellow University of Chicago professor Luigi Zingales titled “Saving Capitalism from the Capitalists” (Princeton University Press). They write: “Bubbles are often pumped up by a whole new set of investors who do not have the experience or knowledge to invest carefully…There is no guarantee that even in a developed financial market the next new sector with limitless possibilities will not attract it own set of gullible investors.”

The international markets are attracting all sorts of money, a lot of it is money that is inexperienced in the investment in world commodities or the securities of emerging markets. These are the markets that have achieved a high profile in investment circles over the past twelve months or so.

QE2 seems to be working but maybe in ways that would not be recognized by Chairman Bernanke. But, he still denies that the early-2000s monetary policy of the Fed might have created a housing bubble.

Economic Policy in the Decade of the Twenty-Tens: More of the Same

Happy New Year!

I have spent a good portion of the last week and a half reviewing my perception of the foundational philosophy undergirding the economic and financial policies of governments in the United States and Europe and I come to the same conclusion over and over again.

Governments in the United States and Europe and the people working in and for them have learned little or nothing over the past fifty years.

These governments are still united in their belief that continuing credit inflation is what their economies need. It is the policy that they plan on delivering. And, if troubles develop, then they just bail troubled institutions out and continue on their merry way. Europe, in the first quarter of 2011, seems to be headed for another round of this bail and run behavior.

The underlying rationale for this is that the leaders of these governments believe that every effort must be made to keep unemployment as low as possible for as long as possible by aggregate governmental actions.

These leaders are unwilling to accept the fact that their policies only make it harder for them to achieve their goal over time and just applying more and more stimulus to the economy will just make things worse.

It is not enough to see that, in the United States alone, underemployment has gone from around ten percent in the 1960s to about twenty-five percent now and that over these past fifty years the income distribution has become more and more skewed toward the higher income end of the spectrum.

The reasons for these results? First, you cannot keep putting people back in their legacy jobs by means of fiscal and monetary stimulus and expect them to maintain their productivity and job competitiveness in a fast changing world. Second, credit inflation can only be taken advantage of by the wealthier people in the country; the less wealthy in such an environment, even though they might be benefitted by it in the short run, lose out to the wealthier over the longer run.

Stock markets, of course, like this environment of credit inflation. Note the following measures of stock market performance. Here we have charted Bob Shiller’s CAPE measure (Cyclically Adjusted P/E Ratio) and Jim Tobin’s q ratio. These statistics, obviously, roughly measure

the exact same thing, whether or not the capital stock in the United States is over- or under-valued. In the 1960s and early 1970s equities seem to be overvalued as the period of credit inflation gets underway. In the late 1970s, of course, we get the period of extremely tight monetary policy aimed at thwarting the rapid acceleration taking place at the time. However, the 1980s revived the bias toward credit inflation, and, as can be seen, the stock markets seemed to take advantage of this policy stance as both measures never dropped below their long-term averages even through the “Great Recession” up to the present time.

This fifty year period was, of course, the time in which the financial sectors of the economy grew to become such a large proportion of the economy and it was the heyday of financial innovation.

It was not the less-wealthy part of the country that benefitted from this policy stance over this period of time.

If the current foundational policy stance of the government remains one of credit inflation similar to the one in place for the last fifty years then all we can expect is more of the same.

And, in my mind, there is no separating out Republicans or Democrats on this issue. Both have proven equally committed to the same policy stance (just using different words to justify it) and both seem to remain oblivious to the facts.

Also, in my mind, the amount of debt people carry matters, but many of our policymakers seem to believe that the existence of debt carries with it no consequences. In fact, the belief seems to be that the solution to the problem of too much debt outstanding is the creation of even more debt. And, if the amount of debt outstanding seems to be troublesome, well, then just let a central bank buy it.

I see nothing on the horizon to change my mind concerning the economic philosophy that serves as the foundation for policy making in the United States and Europe. Credit inflation remains the underlying stance of the economic policies of these governments for future.

Thus, we can expect, over the next decade, a continuation of the economic and financial environment of the last fifty years.