Federal Reserve QE2 Watch: Part 3.1

I usually don’t write up Fed actions within the month unless something seems to be going on. Last week, bank reserve balances at the Federal Reserve went up by $108 billion. I thought that this increase was significant enough to warrant some notice.



There was really only one “factor” supplying reserve funds this past week. This was a net increase in U. S. Treasury Securities held outright by the Fed of almost $30 billion, which brought the Fed’s holdings of Treasury securities up to $1.167 trillion. The portfolios of Federal Agency securities and Mortgage-backed securities did not change a bit.



Furthermore, Thursday afternoon, February 10, the Federal Reserve announced that it would purchase about $97 billion in U. S. Treasury securities in the upcoming week. This total would include about $17 billion to replace the runoff in the Fed’s holdings of mortgage-backed securities, implying that there would be a “net” increase in securities holdings that would be a part of QE2.





The question we can’t answer is whether or not there will be other operating factors on the Fed’s balance sheet that the Fed needs to deal with.



This past week, the banking week ending February 9, 2011, there were substantial movements in two of the Federal Reserve accounts of the United States Treasury. The first movement was in the Treasury’s General Account and this amounted to a little more than a $55 billion reduction in the account.



This movement seems to be seasonal in nature, but was not offset this year, as it often has been in the past, by offsetting sales of government securities. That is why the decline contributed $55 billion more to bank reserves.



In 2009 there was a seasonal year-end buildup in the Treasury’s General Account which peaked in January 2010 and then dropped off to its spring low in April. This year the General Account built up to a peak again in early January before beginning to drop off.



Year-end tax receipts build up at the Fed which causes the peak to occur in early January. From these accounts the Treasury pays out more than it receives thereby causing bank reserves to increase. The difference is that this year the Fed did not sell Treasury securities to withdraw the reserves from the banking system. That would be counter to QE2 if they did..



The other actor in this play is the Treasury’s Supplemental Financing Account. (For a discussion of this see my post of April 19, 2010 (http://seekingalpha.com/article/199444-the-fed-s-new-exit-strategy). The Treasury’s Supplemental Financing Account reached a total of $200 billion in May 2010 and remained at this level until the banking week ending February 9, 2001. The account dropped by $25 billion which reduced the balance in the account to $175 billion. Reducing this account, like reducing the General Account, puts reserves into the banking system.



The Fed allowed an amount of $80 billion to flow into the banking system in the banking week ending February 9, 2011, all from government checks from the Treasury’s deposit balances at the Federal Reserve. There were roughly $3 billion offsets to this on the balance sheet so that only a net of $77 billion actually ended up in the banking system through this activity.



So, the actions were relatively “clean” this week and they resulted in $108 billion going into bank reserves at the Federal Reserve, roughly $30 from the Fed’s purchase of securities and $77 billion coming from government checks from the Treasury’s deposit balances at the Fed going into the private sector.



To my knowledge the $1,187 billion of reserve balances at the Federal Reserve at the end of business on February 9, 2011 is that largest total this account has ever reached!



The question this raises is this…are the reserves being pumped into the banking system getting into the private sector? Is all this Federal Reserve activity having any impact on the money stock numbers?



I am afraid I cannot give any different answer to this question than I have over the past year. The money stock measures are increasing but the reason for these increases still seems to be that people continue to move balances from other earning assets into assets that they can use to transact with. That is, people, in general, are reducing asset balances that were held for a rainy day or were part of their savings and have moved them into assets that they can use for daily purchases of goods and services.



I continue to think this is not a good sign. It is a sign that people are drawing down savings to have cash on hand to pay for daily needs. It is a sign that many people and businesses do not have sufficient income or cash flow to maintain their transaction balances and so have to bring money in from their savings in order to buy food, housing and so forth.



The good new is that bankruptcies and foreclosures are not increasing as fast as they once were.


The bad news is that they are still increasing at close to record rates.



How does this show up in the monetary statistics. Well, currency holdings by the public were increasing in January at a rate, almost 7%, that was roughly twice the rate of a year ago. These year-over-year increases are not near the heights that were reached in the darkest period of the Great Recession, over 11%, but they are high historically.





Demand deposits are also increasing at a fairly rapid pace. The year-over-year rate of growth of demand deposits was about 14% in the fourth quarter of 2010. In January, this figure reached 20%. The highest it reached during the Great Depression was something over 18%.



Note that the growth of the non-M1 part of the M2 measure of the money stock has increased over the past year, but at a very tepid rate. In the fourth quarter of 2010, the year-over-year rate of growth of this component of the M2 money stock measure was slightly over 2%. In January 2011, the year-over-year rate of increase rose to almost 3%, the highest level it had been in several years.



The reason is that the rate of decline in small time accounts and retail money funds slowed dramatically. In the first quarter of 2009, each of these accounts were falling at a 25% rate. In January 2011, the rate of decline in small time accounts was 21% and the rate of decline in retail money funds was around 13%. So, the non-transactions account part of the money stock measures have not declined…have even picked up…but the accounts associated with savings have experience a decline in their rate of decline.



So where are we? About where we have been for two years or so. The Fed keeps trying to push on the accelerator…and the private sector continues to scramble for survival.



What is amazing is that consumer spending and consumer sentiment seem to be picking up. Again, I can only argue that the American society has split. The wealthier, those that are still employed, still live in their own homes, and still have sufficient cash flows are spending. Those that are not fully employed, that have lost their homes or businesses, and those that must rely on their past accumulations of savings are in pretty poor shape. This is the only way I can explain the statistics I see on a daily basis.

How People are using their Money

It is instructive to take a closer look at how people seem to be handling their money. Obviously, people are not spending much, although the Federal Reserve sure cannot be faulted for not trying to jump start consumer and business spending. The monetary base, the sum of all bank reserves and money that can serve as bank reserves has gone from a year-over-year rate of increase of about one percent at the end of 2007, to a 101%, year-over-year, rate of increase at the end of 2008, to a 102%, year-over-year, rate of increase through the third quarter of 2009.

The unwillingness of banks to lend and/or the unwillingness of people to borrow shows up in how fast this base money turns over in the economy, that is, in the velocity of use of this base money. Whereas, velocity was increasing by about 4% through 2007, it declined by 101% in 2008, and was declining at a 104% rate through the third quarter of 2009.

The consequence of this was a build-up in excess reserves in the banking system. For a current review of this result see the column of Peter Eavis, “The U. S. Economy’s $1 Trillion Question”, in the Wall Street Journal (http://online.wsj.com/article/SB20001424052748703300504574565991276510968.html#mod=todays_us_money_and_investing).
If we look at broader measures of the money stock, we see similar results, but with some interesting shifts between money stock measures. The year-over-year rate of growth in the M1 measure of the money stock was roughly flat through the end of 2007, about 16% at the end of 2008, and approximately 19% through the third quarter of 2009. The turn-over, or, velocity, of the M1 money stock increased by about 5% in the earlier period, but fell by 16% through the year of 2008 and by 20% through the first three quarters of 2009.

The M2 measure of the money stock grew at a 6% year-over-year rate of increase in 2007, a 10% growth in 2008 and an 8% rise through the first three quarters of 2009. The velocity of the M2 money stock was roughly constant in 2007, but fell at annual rates of about 10% in both 2008 and through the first three quarters of 2009.

The difference in the performance of the M1 and M2 money stock measures tell of something very interesting in terms of how people are handling their money, but, it does not tell us much about how banks are lending because all measures of bank lending have been declining throughout the summer and fall months of 2009.

First of all, people have demanded more and more currency, a symbol of not only a move to security, but also an indication that people are paying for more of the things that they are buying with cash. The year-over-year rate of increase in currency outside of the banks was relatively flat through all of 2007 and through August 2008. In September 2008, however, the currency component of the money stock began to increase and was rising in the range of 10% to 11% by the end of 2008 through the September of 2009.
The other interesting thing about the growth of the M1 measure of the money stock was the rise in demand deposits at commercial banks. These are primarily “transactions” balances and serve much the same purpose as currency, reflecting the need to keep funds available for cash purposes. Also, people seem to feel more secure with funds in checking accounts than in other forms of bank accounts.

Demand deposits at commercial banks were actually decreasing all through 2007 and through the summer of 2008. In September 2008, the year-over-year the growth rate dramatically turned positive (16%) and then rose to a 54% rate of increase by December of that year. Demand deposits continued to grow at a 30% to 40% annual rate through most of 2009, falling off to about a 20% rate of increase in September and October 2009.

The interesting thing about this movement is where it is coming from. Primarily the movement into currency and demand deposits is coming from thrift institutions and retail money funds. The growth in savings deposits and small time deposits at thrift institutions turned negative in 2008, although the latter actually started to decline in late 2007. Since October 2008, the year-over-year rate of change of savings deposits at thrift institutions decline in the 7% to 9% range and the rate of decline in small time deposits at thrift institutions was in the teens for most of late 2008 before reaching 20% in the fall of 2009.

The biggest turnaround came in retail money funds. In late 2007 and through July 2008, the year-over-year rate of growth of money in retail money funds was in the 25% range. However, by the end of 2008, the increase was less than 10% and in March 2009, money was actually leaving these funds! In September 2009, the year-over-year rate of decline in these funds was over 16% and dropped further to -22% in October.

The bottom line of all this activity is that people have moved a massive amount of funds from time and savings accounts to demand deposits and currency. They have also moved massive amounts of funds from thrift institutions and retail money funds into commercial banks. There appear to be two main motives for this movement. The first is for people to have access to their funds for spending and to avoid the use of credit, if possible. The second is for people to feel that their funds are safer.

The consequences of this movement of funds are that the growth rate of the M1 money stock rapidly accelerated while the rate of increase of the M2 money stock only increased modestly. In recent weeks, however, the growth rates of both measures of the money stock have been slowing. Hopefully, this is a sign that fewer and fewer people are moving their funds into assets for use in transactions.

The next thing we need to look for in this area is a movement out of these “transaction” assets and back into time and savings accounts. It may take several more months for this to happen. When this movement begins we can gain greater confidence that people are feeling better about their financial circumstances and that the economy is, in fact, recovering.

Just a little aside on regulatory issues: A suggestion for restructuring the banking industry and its regulatory agencies would be to completely eliminate thrift institutions and the regulatory agencies overseeing thrift institutions and allow those thrifts that now exist the choice of either becoming a commercial bank or becoming a credit union.