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. 

Federal Reserve Is Providing Cash For Foreign-Related Banking Institutions

Since the end of December 2010 (the banking week ending December 29, 2010) the Federal Reserve has injected almost $200 billion in new reserve balances into the banking system. (See my post of December 18: http://seekingalpha.com/article/253787-fed-s-liquidity-machine-full-speed-ahead.)


Since the end of December 2010 (the banking week ending December 29, 2010) cash assets at commercial banks have risen by more than $280 billion!


Since the end of December 2010 (the banking week ending December 29, 2010) cash assets at foreign-related banking institutions in the United States have risen by more than $175 billion!


In addition, trading assets at these foreign-related banking institutions have risen by $33 billion and a catch-all asset account has risen by $12 billion. (This catch-all account includes things like loans to foreign banks, loans to nonbank depository institutions and loans to nonbank financial institutions.)


All together these accounts at these foreign banking organizations have risen by about $220 billion in the last six weeks, about $30 billion more than the total assets of these foreign-related banking institutions have increased. One could argue that the foreign-related banking institutions are doing pretty well by the quantitative easing that the Federal Reserve is conducting. These foreign-related organizations seem to be doing a lot of trading!


During this same time period the total assets of large domestically chartered commercial banks in the United States have declined slightly.


The total assets of small domestically chartered commercial banks rose by about $30 billion.

Also, during this time period cash assets at the largest 25 domestically chartered banks rose by more than $72 billion and the cash assets at all other domestically chartered banks rose by $38 billion.


Thus, the Fed's QE2 is getting the cash out into the banking system. However, almost two-thirds of the cash seems to be going to foreign-related organizations and not to domestically chartered commercial banks!


Is this what was supposed to have happen?


Over the past 14-week period, cash assets in the banking system have risen by almost $300 billion. Again, over two-thirds of the increase (about $205 billion) came in the cash assets of the foreign-related banking institutions. All of the increase in cash holdings at the largest 25 banks came after December 29, 2010, while cash assets holdings in the rest of the banking system fell in the period before December 29 before rising in the last 6-week period.


One would think that this distribution of cash would not bode well for domestic lending. And, in fact, bank lending was abysmal over the past 6-week period and the last 14-week period.


Since the end of the year, loans and leases at the largest 25 domestically chartered banks in the United States dropped dramatically by about $50 billion, much of this coming in consumer lending although loan amounts were down across the board. Loans and leases held roughly constant in the eight weeks that preceded December 29 at these large banks.


In the rest of the banking system the declines in the loan portfolio came primarily before the end of the year. After falling by about $60 billion in November and December, loans at these institutions rose slightly in the first six weeks of 2011. Notable decreases came in both residential lending and in commercial real estate loans, each declining by a little more than $20 billion over the last 14-week period.


One interesting thing also appeared in the recent statistics. The securities portfolio of the banking system declined over the latest 14-week period by a little less than $40 billion.

However, there were huge differences in the behavior of the largest banks and the smaller banks.


The largest banks REDUCED their holdings of securities by about $96 billion; $67 billion of the total were in U. S. Treasury and Agency securities.


The rest of the domestically chartered commercial banks INCREASED their holdings of securities by almost $60 billion with a $63 billion increase in their holdings of U. S. Treasury securities.


The larger banks got out of securities as interest rates rose through November, December, and January. The smaller banks increased their securities. Is this bad timing on the part of the smaller banks?


So, here we are with the Federal Reserve pumping reserves into the banking system like crazy.
But, two-thirds of it is going to foreign-related banking institutions?


And, commercial bank lending continues to contract?


What is wrong with this picture?


I am feeling such a disconnect between Ben Bernanke’s view of the world and what seems to be going on in the world. When Mr. Bernanke speaks I really wonder what planet he is on…it certainly doesn’t seem to be the one that I am on.


Also, I am getting tired of Mr. Bernanke putting the blame for all his troubles on the backs of others. He began this practice in the early 2000s and it continues on today. He doesn’t accept the fact that some of the mistakes of the past are his. As Stephen Covey has said, if all the blame for the problems one faces is “out there”…that’s the problem!

Federal Reserve QE2 Watch: Part 3.2

The Federal Reserve’s liquidity machine continues “full speed ahead”!

In the banking week ending February 16, 2011, the Fed injected almost $31 billion in new reserve balances into the banking system.

Over the past two banking weeks the Fed has pushed almost $140 billion in new reserve balances into the banking system.

Since the end of 2010 (the banking week ending December 29, 2010) the Fed has increased reserve balances with Federal Reserve Banks by almost $200 billion!

Thus, reserve balances at the Fed, a proxy for excess reserves in the banking system, have increased by a whopping 20% over the past six weeks.

The Federal Reserve is doing to the banking system what it said it was going to do.

In the fall of 2008 and winter of 2009, Chairman Ben Bernanke tossed as much Spaghetti against the wall as he could toss to see what would stick.

It appears that we are not necessarily in the middle of Quantitative Easing 2 (QE2), but are instead in the middle of Spaghetti Toss 2 (ST2)!

The Fed continued to buy more government securities last week, increasing its portfolio by about $23 billion. This supplied reserve funds to the banking system.

The big increase in bank reserves came, once again, in the U. S. Treasury Supplementary Financing Account. (For more on this account and its use see my post http://seekingalpha.com/article/199444-the-fed-s-new-exit-strategy) This account declined by $25 billion for the second week in a row. When this account increases it “absorbs” funds from the banking system. Therefore, when it declines it releases funds into the banking system.

Thus, over the past two weeks when reserve balances rose by almost $140 billion, $50 billion of the increase came from the Fed adding more Government securities to its portfolio and $50 billion came from the Treasury releasing funds to the banking system from its supplementary financing account.

Since December 29 when reserve balances rose by almost $200 billion the Fed bought almost $140 billion in government securities (about $34 billion going to offset maturing mortgage-backed securities), the Treasury reduced its Supplementary Financing Account by $50 billion AND reduced its General Account by almost $35 billion.

This last movement was the usual seasonal swing from the build up in tax revenues toward the end of a calendar year. It still puts reserves into the banking system.

To put things into perspective: Remember back in August 2008, the total reserves in the banking system were $46 billion and excess reserves were less than $2 billion.

Now, within the span of six weeks the Federal Reserve injected into the banking system four times the amount of total reserves that was held by the whole banking system at that time. The wave that is coming looks like it is a part of a Tsunami!

Long-Term Yields, the Fed and QE2: The Weekly Fed Data

The 10-year United States Treasury issue backed off somewhat today. At 4:00 pm in New York the bond yielded about 3.43 percent, up from about 3.23 percent last week at this time. On Wednesday December 15, these bonds yielded around 3.55 percent, up from the previous Wednesday close of 3.30 percent.

Both Martin Wolf at the Financial Times and Jeremy Siegel, of the Finance Department at the Wharton School, in the Wall Street Journal attributed this rise in interest rates to the strengthening of the economy, which they both took as a good sign.


Although I hear their arguments, I am not quite convinced. This year, the yield on this 10-year security fell from a range of 3.80 percent to 4.00 percent in the March/April time frame. This fall in rates was attributed to the financial turmoil going on in Europe.

As can be seen in the chart, the rate feel almost constantly until late August. And, what happened in late August? Ben Bernanke spoke about QE2 at a Federal Reserve conference in Jackson Hole, Wyoming and guess what? The yield on the 10-year bond started up immediately and has continued to rise ever since. The timing of the rise was very specifically connected with the Bernanke speech and subsequent Fed releases. Where did the strength of the economy come into play? Wolf and Siegel just aren’t convincing.






So, the long term bond yield is rising. This isn’t what was supposed to happen. So the Federal Reserve got active. I reported this last Thursday evening as soon as the Fed statistics were released. (See http://seekingalpha.com/article/241050-fed-actions-aimed-at-long-term-interest-rates.)


Here is a part of what I said, “The Federal Reserve added over $32 billion in Treasury notes and bonds to its portfolio from Wednesday, Dec. 1, to Wednesday, Dec. 8. This move was not to replace mortgage backed securities as was the case over the past few weeks.
Also, this increase was not to replace reserves lost through operating transactions. Quite the contrary, deposits with Federal Reserve Banks other than reserve balances, which includes the General Account of the U.S. Treasury, fell by almost $8 billion, which also added reserves to the banking system.


All-in-all, over $50 billion was added to Reserve Balances with Federal Reserve Banks over the past week. Most if not all of this will show up in Excess Reserves at commercial banks.”


This week the Fed bought more United States Treasury securities, but this time the purchases were a substitution for the securities that were maturing in the Fed’s portfolio of mortgage backed securities. The Fed purchased outright $18 billion in United States Treasury securities. This went to offset a decline in the mortgage backs securities of almost $14 billion.


Net, the Fed supplied reserve funds in the amount of $3.5 billion. (The figures don’t match exactly because of other small changed that took place in the balance sheet.)


An interesting aberration took place in the data released at 4:30 PM today. The Fed statistics show that the “average” increase in the United States bond portfolio for the week was $23.6 billion and the decline in mortgage backed securities was $2.0 billion. These figures differ from those given above because the figures above relate to the Fed’s balance sheet as of the close of business on each Wednesday. The figures reported in this paragraph relate to the average of daily figures for the week ending each Wednesday. The only thing that can be said about the two sets of figures is that most of the purchases of Treasury securities for the week ending December 8 must have come on Monday, Tuesday, or Wednesday of the week so that the weekly average was closer to the portfolio held for the week ending December 2. That is why the numbers relating to the weekly average are so large relative to the end-of-week numbers.
Reserve balances with Federal Reserve Banks, a proxy for commercial bank excess reserves, fell by about $64 billion during the week. The primary cause of this was an increase in the general account of the Treasury held at the Federal Reserve. These Treasury deposits rose by $72 billion during the week as the Treasury sent out checks to the private sector and withdrew funds from the government Tax and Loan accounts held at commercial banks.


This movement between accounts was purely an “operational” transaction and should not be considered a part of the QE2 process.


So, the conclusion for the week is that Federal Reserve open market operations for the week were primarily a substitution of United States Treasury securities for maturing mortgage backed securities. Thus, it seems that very little effort was put into trying to keep interest rates from rising.


The 20 to 25 basis point rise in the yields, seemingly, were not resisted by the Fed.

The Fed Acts!

Federal actions on QE2 have been relatively benign up to this week. (See my Monday post: http://seekingalpha.com/article/240375-federal-reserve-qe2-watch-part-1.)

Things were different this week as the United States Treasury issued a lot of bonds this week and longer terms interest rates rose to levels not seen since the middle of June 2010. The 10-year Treasury security got up to almost 3.30 percent on Wednesday, up by about 45 basis points over the past two weeks or so.

The Federal Reserve added over $32 billion in Treasury notes and bonds to its portfolio from Wednesday December 1 to Wednesday December 8. This move was not to replace mortgage backed securities as was the case over the past few weeks.

Also, this increase was not to replace reserves lost through operating transactions. Quite the contrary, deposits with Federal Reserve Banks other than reserve balances, which includes the General Account of the United States Treasury fell by almost $8 billion which also added reserves to the banking system.

All-in-all, over $50 billion was added to Reserve Balances with Federal Reserve Banks over the past week. Most, if not all of this will show up in Excess Reserves at commercial banks.

In August 2008, before the Fed started pumping reserves into the banking system, total reserves at all commercial banks totaled $46.4 billion!

The initial interpretation of this is that the Fed acted to keep long term interest rates from rising further. The ten-year bond rate was down slightly today, closing around 3.23 percent at 4:00 PM, New York time. This is what QE2 is supposedly all about!

Federal Reserve Exit Watch: Part 12

This is the twelfth edition of the Federal Reserve Exit Watch. The first edition was posted in August 2009. The Great Recession, many contend, ended in July 2009 and, at that time, the major task of the Federal Reserve System appeared to be the task of reducing, as judiciously as possible, the massive amount of reserves that the central bank had put into the banking system to combat the threat that the Great Recession might turn into a second Great Depression.

On July 8, 2009 on the Fed’s balance sheet, total factors supplying reserve funds to the banking system totaled over $2.0 trillion, up from around $0.9 trillion one year earlier. It was September of 2008 when the liquidity crisis hit the financial system in the United States which resulted in the rapid injection of funds into the banking system to protect the system from a series of systemic failures. In July 2009, excess reserves in the banking system average around $750 billion.

The concern at that time was that all of these excess reserves in the banking system would eventually end up in the money stock and this would result in inflationary pressures threatening significant increases in consumer and asset prices.

One year later on July 7, 2010, total factors supplying funds to the banking system amounted to about $2.4 trillion. Excess reserves in the banking system totaled more the $1.0 trillion. Obviously, the Federal Reserve System did not remove reserves from the banking system during the past twelve months.

The reason given for not removing reserves from the banking system is that the economy has remained excessively weak: and the Federal Reserve will not start removing reserves from the banking system until the economy seems to be picking up momentum.

My belief has been that the health of the smaller banks in the banking system, those 8,000 or so banks that are smaller than the 25 largest banks, is still not good and the Fed will not begin to remove reserves from the banking system until these non-big banks get in much better shape. With about one in eight banks in the United States on the problem bank list of the FDIC, the banking system is a long ways from being healthy.

And, the Fed has promised that it will continue to keep its target interest rate close to zero “for an extended period” of time. That is, banks should not be afraid of rising short term interest rates any time soon. Many market analysts don’t expect short term interest rates to begin rising until after the start of 2011.

One crucial thing to understand about the operations of the Federal Reserve over the past 12 months is that the injection of funds into the banking system through the fall of 2008 and into the summer of 2009 consisted primarily of “innovative” efforts by the central bank to provide liquidity to specific parts of the money and capital markets. The reserves injected into the financial system were not anything like the classical operations of a central bank which mainly came from the sale or purchase of U. S. Treasury securities in the open market and discount window borrowings from the district Federal Reserve banks.

A major part of the exit strategy of the Fed related to the reduction in these “special” sources of funds and moving back into more traditional forms of central bank operations. Therefore, in the initial stages of the Fed’s exit strategy, efforts were directed at seeing the “special” sources of reserves decline as their needs receded and replacing the reduction in reserves with the purchase of securities from the open market.

The twist in this effort was that the Fed focused, not on the purchase of traditional source of open market securities, U. S. Treasury issues, but on acquiring a lot of mortgage-backed securities, up to $1.250 trillion worth, in order to provide support for the mortgage and housing markets, and on acquiring Federal Agency issues. On July 8, 2009, mortgage-backed securities on the books of the Federal Reserve System totaled about $462 billion. On July 9, 2010, this total reached $1.1 trillion. Federal Agency issues rose from around $98 billion on the earlier date to $165 billion on the latter date. U. S. Treasury securities rose as well, but only by about $104 billion.

Thus, in this 12-month period, total factors supplying reserve balances rose by $341 billion, and the amount of securities the Federal Reserve bought outright rose by $826 billion. The portfolio purchases replaced a lot of the “special” sources of funds supplied to the banking system by the Fed over the past ten months. This was an important part of the Fed’s exit strategy.

So, in the past 12-month period, the Fed actually increased the amount of excess reserves in the banking system. However, in the last 13-week period, excess reserves have actually fallen slightly. One could strongly argue that the decline in excess reserves has come more from operating factors rather than from any overt efforts to reduce bank reserves.

One cause for the reduction in excess reserves was the increase in U. S. Treasury deposits at the Federal Reserve in the Supplementary Financing Account. This is an account set up by the Treasury Department to specifically help the Fed drain reserves from the banking system. (See my post of April 19, 2010, “The Fed’s New Exit Strategy”, http://seekingalpha.com/article/199444-the-fed-s-new-exit-strategy.) During the past 13-week period this account rose by $50 billion, helping to bring down bank reserves. Other operating factors that drained reserves from the banking system was a $12 billion increase in currency in circulation. Also, reducing reserves was a decline in central bank liquidity swaps that fell by about $8 billion during this time period.

Over the past thirteen weeks, these factors draining reserves from the banking system was offset by about $50 billion in Fed acquisitions of mortgage-backed securities.

The net effect of all factors affecting reserve balances: a $50 billion decline in excess reserves.

Over the past four weeks Federal Reserve actions have remained relatively minor. Excess reserves in the banking system fell by about $19 billion, but this primarily resulted from operating transactions like the increase in currency in circulation and a rise in U. S. Treasury balances in the Treasury’s general account which is usually connected with tax receipts. So the last 4-week period can be considered to be uneventful.

One other thing we need to check in this analysis is the behavior of the M1 and M2 measures of the money stock. All that can be said here is that the growth rate of these two measures continues to be modest and actual growth rates have been achieved by people and businesses re-arranging assets rather than from commercial banks making loans. The year-over-year rate of growth of the M1 measure in June was about 6% while the M2 measure rose by only 1.6%.

Note that the non-M1 component of M2 grew by only 0.6% during this time period. This was because, small denomination time deposits at financial institutions have fallen by more than 22% over this time period and Retail Money Funds have dropped by more than 25%. All of these funds seem to have gone into demand deposits, other checkable deposits, and money market deposits, part of M1. This, as I have written before, is not a sign of health in the economy because people continue to transfer funds out of interest-bearing accounts and into forms of money that can be used for spending. This is a sign of desperation not of an improving economy.

A consequence of this has been that the required reserves at commercial banks have continued to rise so that the Federal Reserve must increase the total reserves in the banking system so as to keep excess reserves constant.

One other measure reflecting this shift in assets: monies in Institutional Money Funds have also fallen by 25% year-over-year.

The conclusion to this Exit Watch report is that the Federal Reserve HAS NOT YET started taking reserves from the banking system. That is, over the past year the Fed has not, if fact, exited. And, people and businesses in the aggregate still need to reduce their portfolios of invested funds in order to have money available for spending on their daily needs.

Federal Reserve Exit Watch: Part 5

Something new this week: the Fed started to see how the financial markets would accept its strategy for reducing the size of its security portfolio. At the close of business on Wednesday December 9, 2009 the Federal Reserve showed $180 million on its balance sheet under the line item “Reverse repurchase agreements”.

The Federal Reserve had warned us that it was going to start “testing” the use of reverse repos as the mechanism for reducing the size of its securities portfolio. It had also informed us that a “test period” would begin last week.

It has begun, albeit in a very small amount.

Reserve balances with Federal Reserve Banks changed by only an insignificant amount last week.

Reserve balances did rise over the past 4 weeks and the past 13 weeks. In the last 4-week period reserve balances rose by a little more than $60 billion, $52 billion coming from factors supplying reserves and a negative $10 billion from factors absorbing reserves.

The $52 billion increase in factors supplying reserves was centered on an $85 billion increase in securities held outright ($79 billion in Mortgage-backed securities and $6 billion Federal Agency securities) and a $36 billion reduction in two accounts associated with the insertion of funds into the banking system early in the financial crisis last year. The Term Auction Credit Facility (TAF) dropped by almost $24 billion in the last four weeks and Central Bank Liquidity Swaps fell by about $13 billion.

The rest of the items connected with the innovative market facilities that the Fed created during the time of financial distress changed very little.

So the “Special Facilities” continue to wind down and the Fed continues to substitute marketable securities in its portfolio for the funds that were injected into the banking system to stem the crisis.

In terms of factors absorbing reserves at this time, the general account of the U. S. Treasury Department, its operating account at the Fed (it pays its bills out of this account), dropped by about $8 billion and this added reserves to the banking system and was the primary factor in the additional $10 billion increase in Reserve Balances mentioned above. The Treasury writes checks, they get deposited in banks, and bank reserves increase.

Over the longer term, the last 13 weeks, the government accounts have played a big part in the injection of reserves into the banking system. There is an account titled “U. S. Treasury, Supplemental Financing Account” which has been around since October 2008 (and reached a maximum of about $560 billion in November 2008 (Connected with TARP?). This account declined by $185 billion over the last 13 weeks.

The U. S. Treasury general account rose by $51 billion during this time, apparently the funds from the supplemental account were transferred to the general account so that they could write checks on it. Consequently, the net of the two, $134 billion got into the banking system and ended up as a part of Reserve Balances with Federal Reserve Banks.

During this 13-week period, the Fed also supplied $100 billion in reserves to the banking system through open-market purchases. To do this the Federal Reserve added $281 billion to the securities that it bought outright. The purchases were across the board: $229 billion in Mortgage-backed securities; $33 billion Federal Agency securities; and $19 billion in Treasury securities.)

The run-off in the special accounts over the past 13 weeks is obvious. The Term Auction Credit Facility (TAF) declined by $126 billion and Central Bank Liquidity Swaps fell by $45 billion, a total of $171 billion.

Primary bank loans from the discount window also fell by $10 billion so, over the past 13-week, period the Fed supplied reserves by buying $281 billion in securities and this was offset by a decline in “crisis” accounts of $171 and $10 in bank borrowing so that $100 billion additional funds reached Bank Reserves.

Conclusions:

1. The Federal Reserve continues to let accounts connected with the financial crisis run off. This appears to be going along quite smoothly.
2. The Federal Reserve continues to substitute funds from open-market purchases to replace the funds that are running-off. This appears to be going along quite smoothly.
3. The Fed is now testing the mechanism, Reverse Repurchase Agreements, by which it means to reduce its portfolio of securities and drain excess reserves from the banking system. The first test went along quite smoothly.
4. The U. S. Treasury supplemental financing account is now just $15 billion and will probably not be a big factor in changing bank reserves in the future.
5. The Federal Reserve is going to be facing a lot of “operating factors” over the next month that may cloud up any other actions that the Fed may be taking. These “operating factors” relate to government deposits and the increased use of currency in circulation during the holiday season. These disruptions should end by the middle of January 2010.

Note: Excess Reserves in the banking system still are running above $1.1 trillion. There is little evidence yet that banks want to do anything with these reserves other than hold onto them: this, in spite of the efforts of the Obama administration to get banks lending, especially to small business.

A Critique of Quantitative Easing

Yesterday, I posted a report on the strategy of the Federal Reserve to exit its position of excessive monetary ease. (See http://seekingalpha.com/article/173556-federal-reserve-exit-watch-part-4.) In that report I mentioned that since August, the total reserves in the banking system had shown a substantial increase.

Looking a little further into the data we find that the Monetary Base, defined as all financial assets that serve as bank reserves or could become bank reserves, rose from an average of $1,649 billion in the two weeks ending August 12, 2009 to an average of $2,001 billion in the two weeks ending November 4. (These data are on a nonseasonally adjusted basis, but the seasonally adjusted data are not significantly different.)

The Monetary Base rose by $352 billion during this period of time. (This was both on a
seasonally adjusted bases as well as a nonseasonally adjusted basis.)

What I am interested in reporting on is the total amount of reserves available to the commercial banking system.

Technical Note: To get the figure for total reserves we must subtract the currency component of the money stock from the reported data on the Monetary Base. This amount, according to the Federal Reserve System, is total reserves (of the banking system from the H.3 release) plus required clearing balances and adjustments to compensate for float at Federal Reserve Banks plus an amount representing the difference between current vault cash and the amount of vault cash used to satisfy current reserve requirements. This total reserve amount is different from the total bank reserves reported in the H.3 release on Aggregate Reserves of Depository Institutions and the Monetary Base.

This calculated measure of total reserves in the banking system rose by $351 billion during the time period under review. In other words, currency in circulation outside of commercial banks increased by only $1.0 billion from the August 12 information to the November 4 data.

Excess reserves in the banking system increased in this 13-week period from $709 billion to $1,059 billion, a rise of $350 billion. Thus, all the increase in bank reserves during this time period came in excess reserves, the required reserves held behind the deposits of the banks remained flat!

The truly remarkable thing is that the Monetary Base averaged around $848 billion in the two weeks ending August 13, 2008 while the total reserves in the banking system calculated using the method discussed above amounted to $72 billion.

Thus, in the time between August 12, 2009 and November 4, 2009, the Federal Reserve added $352 billion to the reserves of the banking system, a system that only averaged $72 billion in total reserves in the two weeks ending August 13, 2008. That is, the Federal Reserve added about 5 times as many reserves to the banking system in a 13-week period in 2009 as the complete banking system had in total in August 2008!

However, during the later time period, total bank credit in the banking system dropped by about $150 billion, loans and leases falling around $142 billion.

While bank reserves were increasing rapidly, the effective Federal Funds rate remained relatively constant. It averaged 16 basis points in August 2009, 15 basis points in September and 12 basis points in October. It continued to average around 12 basis points in the first half of November.

The question that needs to be asked is whether or not this scenario was what the Federal Reserve hoped to achieve when it initially went into what it called Quantitative Easing. My understanding of Quantitative easing was that Fed actions were required to combat a Liquidity Trap, a situation in which interest rates could not be pushed lower by adding more reserves to the banking system. Because interest rates could not be pushed lower, aggregate economic demand could not rise. However, it was argued that as the central bank continued to add reserves to the banking system, loans would still be granted to customers and the money stock would increase. Having more funds available, even though the interest rate on the loans could not go lower, was the quantitative effect desired, and as these funds were added to balance sheets spending would increase and the economy would be stimulated.

I don’t sense in the figures presented above the presence of a liquidity trap. The banking system seems to be demanding reserves and, in order to keep interest rates from going up, the Federal Reserve is very abundantly supplying banks reserves. That is, rather than exhibiting a fear that short term interest rates cannot decline any further, the Fed is afraid that short term interest rates (as well as rates on longer term Treasury securities and mortgage rates) might actually rise. This is consistent with the almost obsessive effort the Fed is making to be sure that the market knows the Fed is not going to let interest rates rise and that it is going to keep interest rates at current levels for “an extended period” of time.

This, to my mind, is not Quantitative Easing. It is just a continuation of the strategy the Fed has been following since September 2008: in policy actions, do not err on the side of providing too little stimulus.

This is not a refined, sophisticated monetary policy. Throwing everything you can against the wall to make sure a sufficient amount of what you throw against the wall sticks to the wall is something one does when one is desperate and unsure about what one is doing. You can achieve your goal with this strategy but the problem is that you have a big mess to clean up afterward.

And, if I am correct in this analysis, the Federal Reserve is currently only exacerbating the size of the mess that will have to be cleaned up.

Federal Reserve Exit Watch Part 3

This is the third post in a series designed to review the progress of the Federal Reserve in its efforts to exit the position it has created for itself by more than doubling the size of its balance sheet. (The first two posts in this series appeared on August 21 and September 18.) Some fear that if the Fed cannot reduce the size of its balance sheet that the amount of reserves that have been put into the banking system will explode in the creation of new credit which will be followed by an explosion in the various measures of the money stock. This can only be inflationary with substantial concern that such inflation could turn into hyperinflation.

The fear of many others is that the Fed will withdraw these funds too quickly thereby causing the banking industry further problems and the experience of a second financial collapse.

Bottom line: Reserve Balances with Federal Reserve Banks rose by $190 billion in the four weeks ending October 14, 2009. The rise over the last thirteen-week period was $244 billion. These Reserve Balances totaled $1,049 billion on October 14, a new record high! These data are taken from the Federal Reserve Statistical Release H.4.1.

Required reserves in the banking system averaged about $63 billion in the two banking weeks ending October 7. Excess reserves in the banking system, as reported in the Federal Reserve Statistical Release H.3 were $918 billion for the same period of time. Reserve Balances with Federal Reserve Banks were $963 billion on October 7.

Obviously, there are plenty of reserves in the banking system and the banks still do not seem to be in any mood to begin lending again. See my post on the lending activity in the banking system to support this conclusion: http://seekingalpha.com/article/165994-commercial-real-estate-lending-problems-hitting-the-smaller-banks.

Where did this $190 billion of new reserve balances come from?

Well, about $52 billion came from factors supplying reserves to the banking system and another $137 billion came from a reduction in factors that were absorbing reserve funds. For the thirteen week period, factors supplying reserves contributed $121 billion to the $244 billion increase and there was a $123 reduction in factors absorbing reserves. Let’s look at both in turn.

As was highlighted in the previous two reports on the exit strategy of the Fed, the monetary authorities continued to allow accounts associated with the special facilities created to deal with the financial crisis to run off. These reductions were offset by purchases of financial assets. This seems to be the first move strategy of the Fed to achieve its exit from the big buildup.

Over the past four weeks, there was a $61 billion decline in three asset categories connected with the new facilities that were created. The Term Auction Facility (TAF) declined by almost $41 billion, the portfolio holdings of Commercial Paper declined by $3 billion and the line item associated with Central Bank Liquidity Swaps fell by a little more than $17 billion.

Over the last thirteen weeks these three items declined by almost $260 billion: TAF dropped by $118 billion; the commercial paper facility by $71 billion; Central Bank swaps fell by $68 billion.

The Fed replaced these run-offs by open market purchases that more than covered the outflow, hence the overall increase in bank reserves. For example, Securities Held Outright by the Fed jumped $103 billion in the last four weeks and by over $360 billion in the last thirteen weeks.

The Fed is therefore allowing the special facilities to decline where possible and is then maintaining the liquidity of the banking system by purchasing securities in the Open Market!

In purchasing securities in the open market the Fed is buffing up the liquidity in these markets and helping to keep interest rates low. Of particular note, the Fed has added $78 billion in Mortgage-Backed Securities to its portfolio over the last four weeks and $237 billion over the last thirteen. The Fed has purchased Federal Agency Securities in recent weeks: this portfolio has increased by $11 billion and $35 billion in the last four and thirteen weeks, respectively.

Two other items of note: first, something called Other Federal Reserve Assets rose by $6 billion over the last four weeks and by $13 billion over the last thirteen weeks. What is in this account? Well, the Federal Reserve states that this account includes Federal Reserve assets and non-float-related “as-of” adjustments. These may include Assets Denominated in Foreign Currencies or Premiums Paid on Securities Bought. We don’t really have any information on the totals, but these amounts are relatively substantial amounts, especially when the required reserves in the banking system only total $63 billion.

The second item that requires some attention is that the Special Drawing Rights (SDR) account at the Fed increased by $3 billion over the last four weeks. Actually the increase came in the banking weeks ending September 23 and September 30. Thus the Special Drawing Rights certificate account at the Federal Reserve rose from $2.2 billion to $5.2 billion during this period. I am going to have to do more research into this increase and what it means.
In the meantime here is a definition of the SDR: SDRs were originally created to replace Gold and Silver in large international transactions. Being that under a strict (international) gold standard the quantity of gold worldwide is finite, and the economies of all participating IMF members as an aggregate are growing, a purported need arose to increase the supply of the basic unit or standard proportionately. Thus SDRs, or "paper gold", are credits that nations with balance of trade surpluses can 'draw' upon nations with balance of trade deficits. So-called "paper gold" is little more than an accounting transaction within a ledger of accounts, which eliminates the logistical and security problems of shipping gold back and forth across borders to settle national accounts.

The other major contributor to the rise in reserve balances at commercial banks was a movement out of federal government accounts at the Federal Reserve. There was a movement of $157 billion out of government accounts in the last four weeks and $149 billion in the last thirteen. A reduction in these accounts takes place when the government disburses money and the funds end up as bank reserves. In terms of the governments’ general account, the movement of funds, in and out of this account, is usually connected with seasonal tax collections and disbursements.

There is another account that saw a large reduction, $100 billion, over the last four weeks. This was in an account called the U. S. Treasury Supplementary Financing Account. The Fed defines this account in this way: “With the dramatic expansion of the Federal Reserve's liquidity facilities, the Treasury agreed to establish the Supplementary Financing Program with the Federal Reserve. Under the Supplementary Financing Program, the Treasury issues debt and places the proceeds in the Supplementary Financing Account. The effect of the account is to drain balances from the deposits of depository institutions, helping to offset, somewhat, the rapid rise in balances that resulted from the various Federal Reserve liquidity facilities.” Thus, a movement out of the Fed injects deposits into depository institutions.” We need more information on this decline.

To conclude: The Fed continues to reduce dollars associated with the new facilities created to combat the financial crises. It is replacing these dollars with open market purchases that keep the banking system liquid. Other transactions have also taken place related to federal government disbursements that add reserves to the banking system. In restructuring its balance sheet the Fed is being sure to err on the side of being too loose in supplying bank reserves. Obviously, the leadership at the Fed does not feel that any type of constraint should be imposed upon the banking system at this time.

The Federal Reserve Exit Watch--Number Two

Due to the great concern over how the Federal Reserve plans to reduce its balance sheet from $2.2 trillion to something comparable to the level it was at in August 2008, something around $900 billion, I will be posting on a regular basis my analysis of how the Fed is withdrawing funds from the banking system and the financial markets.

The concern about having put too many funds into the banking system is one about future inflation. The argument here is that it takes a while for inflation to build up. But, as the credit bubble earlier created by the Fed earlier this decade ended up in the financial collapse of 2008-2009, the fear is that if all the reserves the Federal Reserve has put into the banking system remain there, inflation will become a factor in 2010 and beyond.

The concern about removing the funds from the banking system too quickly comes from the 1937-1938 experience where commercial banks had a large quantity of excess reserves on their balance sheets. The Federal Reserve, at that time, raised reserve requirements to establish “tighter control” over the bank activity. However, the large amount of excess reserves on hand was consistent with the conservative behavior of the banks. The increase in reserve requirement caused banks to be even more conservative resulting in a substantial decline in the money stock. The result was the depression of 1937-1938.

For the two weeks ending September 9, 2009, depository institutions held $823 billion of excess reserves. Cash assets in the commercial banking system totaled slightly less than $1.0 trillion. In August 2008 these figures totaled less than $2.0 billion for excess reserves and around $300 billion for cash assets. Reserve balances with the Federal Reserve totaled about $860 billion on September 16, 2009; and this figure was about $50 billion on September 17, 2008.

It is an understatement to say that a lot of liquidity has been injected into the banking system!

Over the past 13 weeks ending on Wednesday September 16, 2009, reserve balances with Federal Reserve Banks increased by almost $120 billion. This increase alone represented a jump of about 13% of the Fed’s balance sheet one year earlier, so one cannot deny that the rise in reserve balances is not insignificant. The Federal Reserve is still acting in BIG NUMBERS, the size of which would have been incomprehensible 18 months ago!

Dissecting what took place during this time, however, is crucial to an understanding of how the Fed is trying to extricate itself from the situation it now finds itself in without setting off another panic in the financial markets. There were three basic changes in the Fed’s balance sheet over this time. The first change was operational in a seasonal sense and hence not crucial to the reduction in the Fed’s balance sheet. The second change is important because it relates to what is happening to all the special assets and facilities that the Fed set up to combat the financial crisis. These accounts appear to be phasing out. The third change relates to how the Fed is replacing the reserves draining out of the banking system because of the second change. Here the Federal Reserve is getting back into open market operations, something it abandoned in December 2007 as it created the Term Auction Facility (TAF).

The first major change in the balance sheet over the last 13 weeks was the swing in the general deposits the U. S. Treasury holds with the Fed. The movements here were seasonal and therefore solely of an operational nature. This swing has to do with tax receipts and the Treasury writing checks. The Treasury and the Fed have worked out operations so that tax collections and government expenditures do not disrupt the banking system any more than necessary. As a consequence you can get some pretty large swings in the balances that the Treasury holds at the Fed in this account without these movements causing large swings in the reserves that are in the banking system. Over the 13 weeks ending September 16, 2009, Treasury deposits declined by over $60 billion: however, in the last 4 weeks ending on the same date these balances increased by $32 billion. All this was handled smoothly.

It is the second of these factors that is vitally important for the exit strategy of the Fed. Accounts that can be associated with the “unusual” activities engaged in by the Fed over the last 21 months declined by over $300 billion over the last 13 weeks. The amount of funds supplied through the TAF dropped by over $140 billion. The net portfolio holdings of Commercial Paper Funding Facility LLC fell by almost $90 billion. Funding supplied through central bank liquidity swaps declined by more than $87 billion. The Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility fell by about $19 billion.

In other words, the Federal Reserve is letting these facilities decline at their own pace as the need for them recedes. Even with all these reductions, however, one can still account for almost $600 billion of the Fed balance sheet being associated with assets created for the specific needs that officials perceived were necessary to keep the banking and financial system from collapsing. So there is still a ways to go to return to normalcy.

The Fed is replacing these assets that are running off with the purchases of various kinds of open market securities. Over the past 13 weeks, the Fed has increased its portfolio of securities held by about $385 billion. (One should note that in the first week of September 2008 the Fed held “total” less than $800 billion in securities. Again the magnitudes are staggering!) Of this increase, $121 billion was in Treasury securities, $35 billion was in Federal Agency securities, and $229 billion were in Mortgage Backed securities. (Note that on September 16, 2009, the Federal Reserve held $685 billion in Mortgage Backed securities, about 88% of the “total” securities held by the Federal Reserve in the first week of September 2008.)

My best guess about how the Fed will reduce its balance sheet is as follows. (Note that I am not including in this analysis any effort on the part of the Fed to support the massive amounts of debt that will be created through the deficits of the federal government in the future.) The portfolio of Treasury securities and Federal Agency securities will not be an active part of the Federal Reserve exit strategy. In my mind, what the Fed would like to see happen is that the roughly $600 billion is “special” assets would “run off” over time without major difficulty. Then, as the market for Mortgage Backed securities stabilizes and then returns to a more normal pattern of activity, the Fed will either allow its portfolio of Mortgage Backed securities to run off or will sell them into a strengthening market and significantly reduce the size of its holdings of these securities. As mentioned above, the Fed’s portfolio of Mortgage Backed securities totaled $685 billion on September 16.

Thus, assuming the best of all worlds, if these two items on the Fed’s balance sheet were eliminated, this would account for almost $1.3 trillion. Take away $1.3 trillion from the $2.2 trillion of assets on the Federal Reserve balance sheet September 16 and you get roughly $900 billion. On September 10, 2008 the Federal Reserve balance sheet totaled a little more than $900 billion in assets!

Can the Fed do it? We’ll just have to wait and see. It is important for us to see that there is a logical path out of the dilemma the Federal Reserve is facing. However, there are many potential bumps along the path. The health of the economy is one. The ever increasing federal debt is another. Recovery around that world is also a factor. And so on and so on. We will continue to watch!

The Banking System and Bank Lending

The headlines in the Wall Street Journal shout out at us this morning, “Bank Lending Keeps Dropping” (See http://online.wsj.com/article/SB124019360346233883.html#mod=testMod.) The bank lending they are referring to is the lending at “the nation’s biggest banks”, the banks that were the biggest recipients of government money. The results: the biggest recipients of taxpayer money “made or refinanced” 23% less in new loans in February than in October, the month the Treasury kicked off the Troubled Asset Relief Program (TARP).

This is just one more piece of information that the banking system still has major problems.

This is the case even though banks are posting first quarter profits. The latest, Bank of America posted a $4.25 billion net income figure for the quarter. (See http://online.wsj.com/article/SB124021187032334351.html#mod%3DtestMod%26articleTabs%3Darticle.) But don’t get overjoyed: Apparently, excluding merger costs, Merrill Lynch contributed $3.7 billion to the posted number which included a $2.2 billion gain related to mark-to-market adjustments on certain Merrill Lynch structured notes. The results also included a $1.9 billion pretax gain on the sale of China Construction Bank shares. What does this mean? I don’t know. Who has any trust in the financial reporting of banks anymore!

What information do we have that indicates that the banks still have massive problems? Let me suggest several bits of information that add up to an exceedingly weak banking system.

First, let it be noted, again, that the Monetary Base, the aggregate money figure that is defined as all bank reserves and anything that can become bank reserves (currency in circulation) has doubled in the past year (97.5% increase year-over-year using non-seasonally adjusted data). This measure was increasing at a 2.0% annual rate in August 2008.

The in-bank component of the Monetary Base, Total Reserves in the banking system, in March, was increasing at a 1,722% annual rate (again, year-over-year using non-seasonally adjusted data). We have never seen figures like this before!
In August 2008, the annual rate of increase was -1.0. Yes that is a negative one percent year-over-year rate of increase.

And, what are the banks doing with these funds?

They are holding onto them!

Excess reserves in the banking system (non-seasonally adjusted) were right at $2.0 billion in August 2008. These are funds in the banking system that are just sitting idle on the balance sheets of banks in the banking system—not earning interest or anything. In the banking week ending April 8, 2009, excess reserves totaled $724.6 billion.

Let me put this in perspective. On September 4, 2008, the assets of the Federal Reserve System totaled about $945 billion. So, in the first week of April 2009, the banking system was keeping, in cash, a little less than the total amount of funds that the Federal Reserve had put into the banking system in the first week of September 2008!

If I look at the Federal Reserve Release H.8, I see that commercial banks in the United States, non-seasonally adjusted, had Cash Assets on their balance sheets in March of $915 billion, again quite close to Federal Reserve assets in early September. One year earlier these banks had Cash Assets of only $300 billion, so Cash Assets rose by 205% in the past year.

Now, the total banking system, in aggregate, is lending some. Total bank credit outstanding rose at an annual rate of 3.2% from March 2008 to March 2009. Within this category, Commercial and Industrial loans rose by 4.3% and real estate loans rose by 4.7%. Consumer credit rose by about 9.0%, of which credit card debt rose by 13.0%. So lending in these categories were increasing, but not by major amounts.

The interesting thing to note, security lending—Federal Funds lending and Repurchase Agreements with brokers—dropped by a third, -33.0% and Interbank loans remained basically flat. Banks reduced their lending to other financial institutions, including other banks, during this time period. Talk about risk averse.

The major story that these data tell is that commercial banks are afraid to lend, especially to their own kind. Delinquencies continue to rise, write-offs continue to rise, and banks continue to increase the provision they set aside for future charge-offs. The banks have gone back to lending only to those that don’t need to borrow, the way banking used to be. They are afraid to lend to anyone else and they are still uncertain about the value of the assets that they already have on their books.

This situation is not going to change overnight. There is not much that the Federal Reserve can do if banks won’t even lend to banks!

We see that “U. S. May Convert Banks’ Bailouts to Equity Share.” (See the New York Times article, http://www.nytimes.com/2009/04/20/business/20bailout.html?_r=1&hp.) Still the question remains, “How deep is the hole in bank balance sheets?” We cannot provide the answer to this. Ultimately, the bankers, themselves, will have to provide that answer, and my guess is that bank lending will not start to pick up again until these bankers have that answer.

The Federal Reserve and the Banking System--Banking Week ending October 22

At the end of the banking week closing on Wednesday September 3, 2008, Federal Reserve Bank credit amounted to $887.3 billion or roughly $0.9 trillion. At the close of the banking week ending Wednesday October 22 Federal Reserve Bank credit totaled $1,803.3 billion or about $1.8 trillion. The increase in Federal Reserve Bank credit rose 103.2% in seven weeks! These figures are from the Federal Reserve release H.4.1, Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.

Reserve balances with Federal Reserve Banks on an average daily balance rose from $10.9 billion in the earlier week to $301.3 billion in the week ending Wednesday October 22. The balances were down to $220.8 billion at the close of business on Wednesday October 22.

In terms of total bank reserves, a figure that also includes vault cash used to satisfy reserve requirements, the increase has been massive. Total bank reserves (on a non-seasonally adjusted basis), averaged $44.2 billion during the two weeks ending September 10, 2008. For the two weeks ending September 24, total bank reserves averaged $111.3 billion! And, for the two weeks ending October 22, total bank reserves averaged $327.6 billion! This is a 641.2% rise in a little more than a month.

The Monetary Base also shows substantial increases. (The Monetary Base consists of all things that are bank reserves or could become bank reserves, like the currency component of the money stock.) In the two weeks ending September 10, 2008, the Monetary Base averaged $849.9 billion. This figure rose to $915.1 billion in the two weeks ending September 24 and then climbed to $1,148.6 billion or about 1.15 trillion in the two weeks ending October 22. This is a rise of 35.2% from the earlier date. This rate is lower than the others because much of the monetary base is made up of currency in circulation which does not change as much over time.

The plan of the Federal Reserve is to liquefy world financial markets as much as possible. The Fed is pushing out the liquidity and it seems as if there is they are finally getting some response.

Money stock growth finally seems to be increasing. The M1 measure of the money stock is showing a rise of 13.0% from the 13 weeks ending July 14 to the 13 weeks ending October 13. The primary growth is coming in both the currency component and the demand deposit component of the money stock. As of yet this movement has not translated itself into the M2 measure of the money stock.

These numbers are no guarantee that the Fed’s efforts are gaining some success, but it does present a little bit of hope…and in today’s financial markets we are looking for all the hope we can find!