Federal Reserve Exit Watch: Part 13

In the summer of 2009, a great deal of concern was expressed about the Federal Reserve and the excessive amounts of Reserve Bank credit that had been pumped into the banking system. The Federal Reserve stated that it had an “exit” plan to withdraw these reserves from the banking system so as not to create an inflationary or hyper-inflationary environment once the economic recovery began to pick up speed.

Here we are 13 months into the “exit watch” and there has been “no exit” of reserves from the banking system. In fact, Reserve Bank credit is now $331 billion GREATER than it was one year ago; it has grown over the past 365 days by 16.7%, as of August 4, 2010.
The stated reason for this “no exit” performance: the economy has remained stagnant and as long as the economy stays very weak the Federal Reserve will keep its low target interest rates which means that the target Federal Funds rate will remain close to zero for an “extended period”.

As I have reported in my blog posts, my belief is that the Federal Reserve is excessively concerned about the solvency difficulties being experienced by the small banks in this county, a concern that I have recently summarized in my post of August 2, titled “No Banks, No Recovery,” http://seekingalpha.com/article/218027-no-banks-no-recovery. There are many small banks experiencing extreme problems and the Federal Reserve is not going to begin withdrawing reserves from the banking system until there is some indication that this solvency problem is over.

Commercial bank Reserve Balances with Federal Reserve Banks has risen by $334 billion over the past year, an increase of 46.6% since August 5, 2009. Note that Excess Reserves at depository institutions rose from a monthly average of $750 billion in June 2009 to $1,035 billion in June 2010, an increase of 38%.

This is a strange “exit.”

And, as the Federal Reserve has pumped these additional reserves into the banking system, the total assets of the commercial banks in the United States fell by 1.7% from almost $12.0 trillion to about $11.8 trillion from June 2009 through June 2010. Loans and leases at these commercial banks declined by 2.6%. Banks got out of a substantial amount of business loans during this time period, as commercial and industrial loans fell by 16.7%, June-over-June, and commercial real estate loans declined by 7.8%, year-over-year.

The reserves the Fed is pumping into the banking system are not going into “pumping up” the economy. The reserves the Fed is pumping into the banking system are just going into excess reserves!

Looking at a shorter period of time, over the past 13 weeks, the last quarter, Reserve balances with Federal Reserve banks rose by $8.0 billion. The primary swings in the Fed’s balance sheet over this time period were operational in nature. There was a $26 billion decrease in the General Account of the U. S. Treasury, a seasonal increase in currency in circulation of about $9 billion and a $7 billion rise in Foreign Reverse Repos. The offsetting transactions of the Fed to neutralize these changes was an increase in Securities Held Outright by the Fed of about $12 billion, the primary increase coming in the Fed’s purchase of Mortgage-backed securities.

In the past 4 weeks, the U. S. Treasury balance reversed itself, increasing by almost $28 billion and there were modest declines in currency in circulation and Foreign Reverse Repos. The Fed offset a portion of these by letting it holdings of Federal Agencies decline by a little more than $5 billion. The net effect of these operating transactions was a $19 billion decline in Reserve balances held at Federal Reserve banks.

Thus, over the past 4 weeks and over the past 13 weeks, Reserve Bank Credit barely changed. Both periods were dominated by operating transactions within the banking system offset by Federal Reserve balancing transactions.

As a consequence, excess reserves in the banking system stayed relatively constant over the last quarter of the year.

Loans and leases at commercial banks continued to decline over the last 4-week and 13 week periods as did commercial and industrial loans and commercial real estate loans.

In summary, the Exit Watch in the thirteenth month of its existence can report little or no action on the exit front over the past month or the past three months. “Exit” is still on hold until either the general condition of the small banks improves or the economic recovery really becomes an economic recovery…or both.

Federal Reserve Exit Watch: Part 11

The basic monetary facts are these: commercial banks aren’t lending and the money stock measures are not really growing. On the surface, it looks as if we have what Irving Fisher called, in the 1930s, the makings of a debt deflation. This is how we can interpret the statistics from the banking sector.

Contrary evidence comes from the performance of the “big banks”, the largest 25 domestically chartered commercial banks in the United States banking system. They are raking in profits right and left and are “making a killing” from the arbitrage and trading opportunities being subsidized for them by the Federal Reserve System.

The other 8,000 domestically chartered commercial banks in the United States are not doing so well. Roughly one out of every eight of these banks is on or very near the list of problem banks of the Federal Deposit Insurance Corporation. These are the banks that the Federal Reserve is trying to preserve through the low target interest rate policy it is following that is the ‘cash cow’ for the largest banks.

The Federal Reserve got us into this position by following a very destructive monetary policy in the early part of this decade. Then, once the financial system began to collapse, Chairman Ben Bernanke and the Federal Reserve threw everything it had against the wall to see what would stick.

We talk about financial innovation in the private sector! No group, organization, or institution initiated more financial innovation over the past fifty years than did the United States government and the Federal Reserve takes the individual prize for financial innovation during this period for what it did over the last three years or so. But, there was no real sophistication to the Fed’s financial innovation: the task of the Federal Reserve was to throw as much money as it could into the financial markets to protect the ‘liquidity’ of the market and its instruments.

Now the banking system (excuse me, the 8,000 ‘other’ domestically chartered commercial banks) is teetering on the brink of a ‘debt deflation’ (while the 25 large domestically chartered commercial banks are cleaning up) and the Federal Reserve cannot remove whatever ‘stuck’ to the wall from the banking system for fear that the rate of failure of the ‘smaller’ banks will accelerate.

The FDIC is overseeing the closure of approximately four commercial banks a week this year and the feeling is that this rate of failure could rise to five banks a week this summer or next fall. Analysts now expect the Fed will continue its “low interest rate target” into 2011.

Wow! The big banks are going to love this!!!

The ‘other side’ question is how is the Fed going to “get the stuff” that stuck on the wall, off the wall? That is, how is the Fed going to ‘exit’ its stance of excessive ease?

We are still waiting. The only ‘trick’ it has applied so far is to get the United States Treasury to
park funds in something called the “United States Treasury, supplementary financing account.” This account has risen by roughly $200 billion since the first of the year, $175 billion over the past 13 weeks, and this has drained some of the excess reserves from the banking system.

Again, no straight, classical monetary policy: the Fed used gimmicks…whoops, financial innovations…to get us to this point. Looks like we are going to use various gimmicks…whoops, financial innovations…to help get “the stuff” off the wall.

Excess reserves have declined about $80 billion from January, a little over $70 billion in the last 13 weeks, primarily due to the buildup in the Treasury’s supplementary financing account. Excess reserves, however, still are in excess of $1.0 trillion, averaging $1.048 trillion in the banking week ending June 2.

The only thing that the Federal Reserve has continued to do over the past quarter is to continue to increase its holdings of Mortgage-Backed securities. Over the last 13 weeks, the portfolio of Mortgage-Backed securities rose by $87 billion, $16 billion of the increase came over the past 4 weeks.

And, what impact does this seem to be having on the monetary aggregates. Well, the M2 money stock measure is hovering around a 1.6% year-over-year rate of growth. If the expected real rate of growth of the economy is around 3.0% then this monetary growth is certainly deflationary.

But, note this. The rate of growth of the non-M1 part of the M2 money stock measure was only 0.3% in May, on a year-over-year basis. The M1 year-over-year growth rate is 6.8% which shows that people are still transferring their wealth into transactions balances in order to have cash to pay for their daily needs. Given all the unemployment, foreclosures, and bankruptcies, the concern is that this movement will continue putting additional pressure on the 8,000 other domestically chartered commercial banks in the country.

The United States banking system does not seem to be healthy (except for the biggest banks). The monetary system is stalled. Ben Bernanke has traveled to Detroit, Michigan to hold a discussion about getting loans out to small businesses: see his “Brief Remarks at the Meeting on Addressing the Financing Needs of Michigan's Small Businesses, Detroit, Michigan” (http://www.federalreserve.gov/newsevents/speech/bernanke20100603a.htm). The Fed doesn’t seem to understand what is going on.

This is my eleventh post relating to the Federal Reserve’s Exit Strategy. I started these posts 10 months ago because of the concern expressed over how the Fed was going to “get the stuff” off the wall. The Fed wanted to be totally transparent about how it was going to “exit” its position of extreme ease and so it started talking about what it was going to do.

The concern is still there. As far as I can see, there is little confidence that the Fed can safely lead us to the “promised land”, the land of low unemployment, strong economic growth, and little or no inflation.

The Fed has acted with very little subtlety and sophistication over the past decade. Why should we expect it to act any differently over the next ten years, let alone over the next year?

Federal Reserve Exit Watch: Part 8

Looking at the Federal Reserve statistics these days is rather boring. As has been reported over the past month or two, the Fed has gotten its balance sheet in position for the “great undoing.” And, now it is just waiting.

One can divide the Fed’s balance sheet into three components: the “regular” portion which is roughly equivalent to the asset side of the balance sheet of the Fed in the “good old days”; the portion of the balance sheet that consists of line items related to the “new” facilities created to combat the financial collapse; and the “liability” side of the balance sheet which includes Treasury deposits and reverse repos, the account the Fed has stated it will use in the “undoing” of the excess reserves it has injected into the banking system.

The “regular” portion of the Fed’s statement now represents over 90% of the assets of the central bank. Almost $2.0 trillion of these assets are in the form of securities that the Fed has purchased on the open market and holds outright. The only real movement here is in the Fed’s holding of mortgage-backed securities which, on March 3, 2010, amounted to slightly more than $1.0 trillion. The Fed has stated that this account will reach $1.25 trillion by the end of March.

The Federal Reserve has added, net, $175 billion of the mortgage-backed securities to its portfolio over the last 13-week period, roughly $70 billion in the last four weeks.

In terms of the “new” facilities, the Fed is letting these items run off as the assets run off, are written off, or are sold. Over the last 13 weeks, since December 2, 2009, these accounts have declined by slightly more than $100 billion. Over the past month, since February 4, 2010, they have declined by $30 billion.

Overall, therefore, the Federal Reserve has supplied roughly $76 billion to the building of reserve funds over the last 13 weeks and slightly more than $30 billion over the last 4 weeks. Rather a non-event if you ask me.

In terms of factors absorbing reserve funds, the interesting item here is the Supplementary Financing Account of the United States Treasury. I wrote about this account on February 24, 2010 for it seems to be something that the Fed/Treasury is also planning to use during the “undoing”. For more on this see my blog post: http://seekingalpha.com/article/190404-the-treasury-s-latest-maneuver-with-the-fed.

What has happened in this account is that it has been increasing. It reached a low early this year at $5.0 billion, as the Congress had to approve an increase in the federal debt limit. Since February 4, 2010 this account has increased by $20.0 billion. The Federal Reserve announced that an agreement had been reached with the Treasury Department that the Fed will borrow $200 billion from the Treasury and leave the cash on deposit at the central bank. As explained in my post, this borrowing will be used by the Fed to help it “undo” excess reserves in the banking system. It seems as if the Fed is starting to build up this facility slowly so as not to be disruptive to the banking system.

If we combine all the factors supplying reserve funds to the banking system and factors absorbing funds from the banking system we find that commercial bank’s Reserve Balances with Federal Reserve Banks increased by roughly $70 billion in the last four weeks and over the last 13 weeks: thus, very little changed in the banking system over the last quarter of a year.

If we look at the statistics from the banking system itself, we see that excess reserves in the banking system rose by about $110 billion.

What the Fed did, as it has for an extended period of time now, went directly into the excess reserves of the banking system. Commercial banks, as a whole, are just sitting on their hands and doing nothing. This allows the Fed to do all its repositioning in order to prepare for the “great undoing” without throwing any more uncertainty into financial markets.

The Federal Reserve is still “sitting on the fence”. Its dilemma is that the banking system still remains extremely week…except, of course, for the big banks. For more on this see two of my recent posts: “The Struggles Continue for Commercial Banks”, http://seekingalpha.com/article/190191-the-struggles-continue-for-commercial-banks, and, “The Banking System Continues to Shrink”, http://seekingalpha.com/article/188566-the-banking-system-continues-to-shrink. The Fed cannot move too fast to remove excess reserves from the banking system for fear that this “undoing” may result in many more bank failures among the small- to medium-sized banks.

Of course, the economy remains weak and the Fed has used this excuse for not removing reserves from the banking system and raising short-term interest rates. This may be a cover for their real concern over the systemic weakness of the small- and medium-sized banks in the United States.

On the other side there is the continuing fear over the possibility that sooner or later the excess reserves in the banking system will turn into bank loans which will result in an expansion of the money stock measures which will result in a worsening of inflation. With over $1.1 trillion in excess reserves in a banking system that used to carry less than $100 billion in excess reserves there is substantial doubt that the Fed can smoothly remove all of these reserves thereby preventing possible inflation or even hyperinflation. Nothing like this has ever been experienced in history before.

So, we sit and wait.

The good news is that things within the banking system seem quiet now. The FDIC continues to close banks without major disruptions to banking markets or local economies. The focus of financial markets seems to be on Greece, Spain, Italy, the Euro, and California, New York and other political entities. That is good for the banking system!

Some have pointed to a potential problem arising from the sale of assets recently conducted by the FDIC. The argument is that now that these assets have a price, will other banks have to “mark-to-market” similar assets that they carry on their balance sheet? And, if they have to mark these assets to market, will this speed up the number of banks actually failing or force banks that seem to be doing OK into insolvency?

In the circumstances we now find ourselves, boring is good! Let’s hope it stays boring. Or hope that the situation becomes even more boring.

Bernanke's Testimony: Reading Between the Lines

Chairman Ben Bernanke gave testimony this past week on the Fed’s semiannual report on monetary policy to the United States Congress. I believe that Mr. Bernanke’s report can be summarized in two sentences. First, the United States economy is recovering, but the recovery will be quite slow. Second, the Federal Reserve will continue to keep its interest rate target at current levels.

This testimony came during a time in which the Federal Reserve has been attempting to reveal and explain how it plans to exit from its current position, a position that includes a banking system with almost $1.2 trillion in excess reserves. Fundamentally, the Fed is ready to begin to “undo” what it has done over the last year and a half. (See, for example, my posts http://seekingalpha.com/article/189547-back-to-business-at-the-fed, and http://seekingalpha.com/article/189547-back-to-business-at-the-fed.)

The implicit contradiction in all of this is that the Fed’s “undoing” is to take place as the economy recovers, but, the Chairman in not willing give a hint as to when the economy will be strong enough to allow the Federal Reserve to start raising its current target level of the Federal Funds rate.

To me, the message that is being conveyed between the lines is that there are still some things so wrong with the economy (that the Federal Reserve is aware of) that the Fed cannot take a chance, even give a hint of a chance, that the target Fed Funds rate will be raised.

And, what is the basis of this fear?

Will, we can start with the state of the banking system. The Federal Deposit Insurance Corporation (FDIC) produced its quarterly report last week and indicated that 702 commercial banks were now on the list of problem banks at the end of 2009. This is up from a total of 552 banks that were on the problem list at the end of September 2009. And, the FDIC closed 2 to 3 banks per week during the fourth quarter of the year.

Given the current list, the expectation is that about 235 banks, one-third of the current total on the problem list, will close over the next 12 to 18 months, a rate of 3 to 4.5 banks per week for this time period.

Remember that there are about 8,000 commercial banks in the United States, with the top 25 accounting for well over one-half the assets in the banking system. Thus, the banks that are failing tend to be small and they tend to be “local” in nature and a failure can cause quite a disruption on “Main Street.”

The problems in the banking system go deep. The insured banks charged off 2.9% of outstanding loans in the fourth quarter of 2009. This is the largest charge off rate in the 75-year history of the FDIC.

At the end of the fourth quarter, 5.4% of all loans were at least 90 days past due, a near-term high. Specific areas of the loan portfolios are showing a large amount of stress. For example, data on construction loans to build single-family loans indicate that about 40% of the loans are either delinquent or have totally been written off. Mortgage loans still remain a problem where about 12.5% of the loans outstanding are past due.

Commercial real estate loans are the looming giant in terms of providing dark clouds for future bank loan performance. Elizabeth Warren, head of the Congressional team that oversees the TARP funds has stated that about 3,000 commercial banks face the possibility of a “tidal wave” of commercial real estate loan problems. At the end of the fourth quarter of 2009, over 6% of these loans were classified as a problem in some way.

Before these problem loan areas can be resolved, the economy must begin to get stronger, people must return to good paying jobs, and real estate values must cease falling. Discouraged workers must return to the workforce and manufacturing firms must increase the utilization of their resources. There is little evidence to indicate that these factors are, in fact, improving to the extent needed to strengthen the loan portfolios of commercial banks.

The Fed, obviously, has a good seat to observe all of these facts. And, I believe, they are very, very concerned. And, I also believe, that bankers are very, very concerned.

Why?

Because the bankers are sitting on their hands and holding onto any type of asset that will not deteriorate in value…cash or deposits at Federal Reserve banks and short term government securities.

Yes, we can say that businesses and homeowners with very good credit are not borrowing. And, we can say that consumers are not borrowing.

I don’t think this is the answer.

I believe that this situation is more like the one that was experienced in the period around 1937. Commercial banks were holding a lot of excess reserves at that time too. Also, there was no lending to speak of during that period. And, the Federal Reserve raised reserve requirements to “sop up” those excess reserves.

And, what did the banks do at that time? They withdrew even further. The banks wanted those excess reserves. They did not want to lend them out. They just wanted the protection and security of having those reserves in their hands. By taking the reserves away, the Fed caused the banks to restrict credit even further in order to return excess reserves to a level more consistent with the safety the banks wanted on their balance sheets.

Ben Bernanke, the student of the 1930s, knows what happened back then. He is, therefore, fighting on two fronts in the current climate. First, there are those that are afraid that the excess reserves the Fed has injected into the banking system will eventually be lent out and this will cause the money stock to expand and this, given the size of the $1.2 trillion level of excess reserves, will result in a higher than desired level of inflation in the United States economy.

Bernanke and the Fed must do enough, talking and maneuvering, to satisfy this crowd. Hence the exit strategy and the efforts to get Federal Reserve’s operations back into a more normal environment.

Second, however, is the fear that the excess reserves in the banking system are “desired” by the banking system and any effort to substantially reduce them in the near future could lead to a further contraction in the banking system that would ensure a “double-dip” Great Recession.

My guess is that Bernanke is not willing to take a risk on generating a further contraction in the banking system by removing bank reserves at this time. This, to me, is the message between the lines of the Chairman’s testimony in front of Congress this past week.

The Fed is ready for the great “undoing” of its balance sheet, but is not going to begin this “undoing” until it is sure that the commercial banks are willing to let go of the $1.2 trillion in excess reserves.

The Fed and the Treasury Maneuver

Yesterday, the Treasury announced that it will borrow $200 billion from the Federal Reserve and leave the cash on deposit with the Fed. As it initially goes on the Fed’s balance sheet the transaction is a wash.

The Treasury has two accounts that show up on the Federal Reserve sources and uses statement. (These data can be found on the Federal Reserve release H. 4.1, Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.) The first is called the U. S. Treasury, General Account, and this is primarily used to manage the Treasury’s cash position and flow of expenditures and tax receipts.

When taxes are collected, the funds flow into government tax and loan accounts at commercial banks. This transfer of funds from the private sector to the public sector causes no disruption to bank reserves because the funds stay in the banking system. (The data on U. S. Government deposits at commercial banks can be obtained in the Federal Reserve release H.6, Money Stock measures, Table 7.)

The Treasury does not draw funds out of its accounts in the commercial banking system until it begins to make payments out of its balance in the General Account at the Federal Reserve so as to cause as little disruption to the reserves held in the banking system. That is, government funds come out of the banking system and go into the Fed account, but the Fed account is being drawn down with payments to the private sector that will be deposited into commercial bank deposits.

For example, government demand deposits at commercial banks averaged $1.3 billion in December 2009. However, in January, as tax collections flowed into the government, these balances rose to $1.6 billion in the banking week ending January 4 and increased to $2.3 billion, $4.3 billion, and $5.1 billion, in the next three weeks, respectively. In the banking week ending February 1 the balances fell to $1.8 billion and then dropped to $1.3 billion in the following week as the Treasury paid out funds to the private sector.

These movements just represent operational procedures that have been established over the years to avoid major movements of funds into and out of governmental accounts. Hence, this is called the “General Account.”

On September 17, 2008, the Treasury Department announced something called the “Supplementary Financing Program”. Under this program the Treasury was to issue marketable debt and deposit the proceeds in an account that would be separate from the General Account of the Treasury at the Fed.

Thus, the Fed’s holdings of U. S. Treasury holdings would go up on the “asset” side of the balance sheet (this being a debt of the Treasury) and the U. S. Treasury Supplementary Financing Account would rise on the “liability” side of the balance sheet (this being an asset of the Treasury).

In September 2008, this account averaged almost $80 billion. In November 2008 it was above $500 billion. The account dropped to just below $200 billion in January 2009 and remained around that level into September 2009. The figure drops precipitously from there as the issue about the debt limit of the Federal Government had to be dealt with. In January and February 2010, the account averaged just $5 billion.

Now that the Congress has raised the debt limit on the government, the plan has been revived.

The original purpose of the Supplemental Financing Account was to get cash into the hands of those that needed funds and not have to go through the market system which would take more time and, perhaps, a greater amount of trading, to meet the peak liquidity demands in the financial crisis. That is, the Treasury had cash to spend out of this account that could go directly to those that needed the stimulus spending. This program allowed the Treasury to issue securities without going directly to the market and perhaps keeping interest rates from falling.

In the present case, the Treasury says that it is going to keep the cash proceeds from the borrowing on deposit at the Federal Reserve. If this is true, then it seems that what the arrangement is providing is more Treasury securities to the Fed to be used as the central bank reduces the amount of excess reserves in the banking system.

On February 17, 2010, the Federal Reserve had a little less than $800 billion of U. S. Treasury securities on its balance sheet. Commercial bank reserve balances, mostly excess reserves, with Federal Reserve banks stood at slightly more than $1.2 trillion.

If the Fed is going to remove reserves from the banking system by open market sales of U. S. Treasury securities, then it needs to have a sufficient amount of them on hand to be a credible seller of these securities.

Although the Federal Reserve is expected to have $1.25 trillion of mortgage-backed securities in its portfolio in March, it is expected that the Fed will not want to sell these off in any large amounts because it does not want to destabilize the mortgage market and force mortgage rates to rise too fast.

Also, the Fed’s portfolio of Federal Agency debt securities is too small, about $165 billion, to help much in any exit strategy.

Thus, adding $200 billion to the Fed’s portfolio of U. S. Treasury securities will bring the total Treasury securities on hand to approximately $1.0 trillion and this may be sufficient to allow the Fed to “undo” its portfolio and reduce the amount of excess reserves in the banking system without having to sell mortgage-backed securities. That is, if the Treasury does not write any checks against its Supplementary Financing Account.

The Fed is attempting to get as much ammunition in place before the “battle to exit” begins. Over the past several months and weeks, the Federal Reserve has moved to position itself to “undo” its massive injection of reserves into the banking system. Last week it announced that it was returning the “primary loan” function to its pre-crisis operating procedures. (See my “Back to Business at the Fed”: http://seekingalpha.com/article/189547-back-to-business-at-the-fed.) This week, the Treasury is pumping up its Supplemental Financing Account. Next week, well who knows.

This process will continue over the following weeks as the Fed does all it can to prepare for its “undoing.”

"Fed to Bare Tightening Plan"

I would recommend reading the article by Jon Hilsenrath with the title “Fed to Bare Tightening Plan” which appeared on the front page of the Wall Street Journal February 8. (http://online.wsj.com/article/SB10001424052748703427704575051442884515742.html) In this article Hilsenrath discusses the issues and possible actions the Fed may face in “credit tightening…once the Fed decides the economy has recovered sufficiently.” This is a good follow-up piece to my post of February 7 titled, “Everything is in Place: Federal Reserve Exit Watch Part 7.” (http://seekingalpha.com/article/187265-federal-reserve-exit-watch-part-7)

The problem facing the Fed?

Hilsenrath lays it out: in the financial crisis “the Fed took extraordinary action to prevent an even deeper recession— pushing short-term interest rates to zero and printing trillions of dollars to lower long-term rates. Extricating itself from these actions will require both skill and luck: If the Fed moves too fast, it could provoke a new economic downturn; if it waits too long, it could unleash inflation, and if it moves clumsily it could unsettle markets in ways that disrupt the nascent economic recovery.”

This week in testimony before the House Financial Services Committee, Chairman Bernanke is expected to begin laying out a blueprint of how the Fed expects to undo this “extraordinary action.”

The Fed has a major new tool to use in this “undoing”. This tool is something called “interest on excess reserves” which the Congress gave the central bank in October 2008. In essence, this is interest paid for doing nothing! Right now, just for holding the $1.1 trillion in excess reserves the Federal Reserve has freely given the banking system, the banks receive the interest rate of 0.25%, which is above the effective Federal Funds rate that has been around 12 basis points for a very long time.

The Federal Reserve doesn’t want the banking system to lend out this $1.1 trillion so the idea is, when the Fed is ready to start its “undoing”, it will raise the interest rate paid on excess reserves. This would, hopefully, make it more desirable for the banks to retain the excess reserves than to lend them out to businesses or consumers, thereby inflating credit and the various measures of the money stock.

In essence, the Fed has printed $1.1 trillion in bank reserves and it will subsidize the banking system whatever it takes to keep them from becoming too aggressive in their lending.

Let’s see…the government wants the banks to begin lending again…but, the Fed doesn’t want them to be lending.

Makes a lot of sense!

As Randy Quaid stated in “National Lampoon’s Christmas Vacation,” this is “the gift that keeps on giving.” Suppose I give you $1.1 trillion dollars and then let me pay you 25 basis points, 50 basis points, or whatever it takes for you not to go out and use that $1.1 trillion in any other way. Sounds like a pretty good deal. But, as we know, the Fed has lots and lots of profits from which it can pay this interest.

What is it we are doing for Main Street amongst all the deals we are giving Wall Street?

What about the Fed’s portfolio of securities purchased outright? As of Wednesday, February 3 the total portfolio amounted to $1,912 billion. Of this total, $777 billion were in U. S. Treasury securities. In the near future, this account will bear the burden of asset sales to reduce bank liquidity. Initially, the proposed methodology to achieve these sales is through “reverse repurchase agreements” or “reverse repos.” This is discussed in my post mentioned above.

But, the Fed hopes to have$1.25 trillion in mortgage-backed securities on its balance sheet by March 2010. Last Wednesday, it held $970 billion in its portfolio. It seems as if these securities are NOT going to be available for sale for a while because of the precariousness of the mortgage market and the housing market. The Fed certainly doesn’t want to do anything either in terms of dramatically higher interest rates or lack of liquidity in the mortgage market to disturb a recovery in housing. Don’t count on these securities being used to reduce the $1.1 trillion in excess reserves in the early stages of Fed tightening.

The Fed also has $165 billion in Federal Agency debt securities. Don’t expect these securities to be an active part in the Fed’s “undoing.”

Thus, it seems as if the prescription for the “undoing” is to sell U. S. Treasury securities, first through “reverse repos” and then through outright sales if the banks are congenial with a reduction in reserves and to pay interest on excess reserves to keep banks from lending out their “excess reserves” should loan demand increase or if the banks are not congenial with a reduction in reserves.

How much comfort does this “blueprint” give me?

Not a whole lot!

The Greenspan/Bernanke Fed gave us excessively low interest rates from late 2001 into 2005 (the effective Federal Funds rate was below 2.00% for all of this time period); “measured” rate increases ran into 2006 (Hilsenrath introduces one of the problems with this approach in his article. Rate increases that are “too” predictable can “fuel a borrowing boom” because of the predictability of the rises.); Bernanke publically claimed that there were no problems in the housing market and in subprime mortgage lending during this time period; the Bernanke Fed failed to foresee the economic downturn which began in 2007, but also had no clue to its potential severity; and, to combat the financial crisis, the Bernanke Fed followed one rule and that was to throw everything it could into the financial markets so as to err on the side of providing too much liquidity.

I see very little understanding of financial markets in this performance and no exhibition of “touch” in these actions. It does not leave me with a great deal of confidence that the “undoing” will proceed smoothly. My guess right now is that the Fed will wait too long to begin the “tightening” and that will put them into a world in which none of the actions that are available to them are desirable…much like the fiscal policy stance of the U. S. government right now. This is a problem, however, that one experiences because of the excesses in the past.

Everything is in Place: Federal Reserve Exit Watch Part 7

Looking at the Federal Reserve figures for Wednesday, February 3, 2010, one could argue that just about everything seems to be in place for the Fed to execute its exit plan. The Fed will still purchase some more Mortgage-backed securities and there are some other residuals left from the world financial crisis that still remain, but these are now relatively minor parts of the picture.

On Wednesday, February 3, 2010, the Total Factors Supplying Reserves to the banking system totaled $2,231.3 billion or a little more than $2.2 trillion. The Securities held outright by the Federal Reserve amounted to $1,911.6 billion or approximately 85.7% of the total factors supplying reserves.

To put these numbers in perspective, on Wednesday, December 5, 2007, Total Factors Supplying Reserves to the banking system equaled $920.4 billion and Securities held outright amounted to $779.7 billion or 84.7%. The Fed did have outstanding $46.5 billion in repurchase agreements which, if included, made about 89.8% of their balance sheet related to securities.

On February 3, 2010,the Federal Reserve had no repurchase agreements outstanding.

I go back to December 2007 because one has to go back that far to get to a Fed balance sheet that does not include “special” line items that were constructed to combat the financial crisis. In December 2007, the Term Auction Facility (TAF) was initiated. During the time the TAF existed total funds supplied through this facility reached several hundred billion dollars. On Wednesday February 3, 2010, funds supplied to the banking industry through the TAF were only $39 billion, down $37.4 billion over the past four weeks and down by $101 billion in the last 13-week period.

In preparing to remove excessive amounts of reserves from the banking system the Federal Reserve has been allowing the “special” facilities that have supplied reserves to banks to “run off” while the Fed has replaced these funds with open market purchases.

Another area in which this has taken place has been in central bank liquidity swaps. This facility was also started in December 2007. At one time central bank liquidity swaps were in the hundreds of billions of dollars. On Wednesday, February 3, swaps totaled $100 million.

In the last four weeks and the last 13-weeks, the other items on the Federal Reserve statement did not change dramatically. To me what I have presented in the last three paragraphs pretty well sums up what the Fed has been doing to get itself ready to begin removing excess reserves from the banking system…when it decides it is time to do so.

Over the past 13-week period, reserves have been removed from the banking system by a reduction in funds available through the TAF ($101 billion) and through a decline in central bank liquidity swaps ($32 billion) or a total of $133 billion.

During this time, the Federal Reserve has purchased open-market securities of $214 billion. Thus, total factors supplying reserves during this time rose by $81 billion from these factors.

Over the past 4-week period, the TAF has been reduced by $38 billion and central bank liquidity swaps declined by $10 billion or a total of $48 billion.

Federal Reserve purchases of open market securities totaled $66 billion. Total factors supplying reserves from these factors rose by roughly $18 billion.

I have not discussed the factors that have been absorbing bank reserves over the past 4-week and 13-week periods because they have been impacted by some wide swings in the deposits of the federal government, much of which are technical in nature. And, these factors should not play any important role in how the Fed removes reserves from the banking system.

The bottom line in this discussion is that it seems to me that the Fed has basically eliminated or reduced most of the facilities that it created over the past two years that can have a major impact on the creation or destruction of bank reserves. The two major facilities are, of course, the TAF and central bank liquidity swaps.

The Federal Reserve now has one thing to work with in withdrawing reserves from the banking system: its portfolio of open-market securities. The Fed’s balance sheet is composed of roughly 85% open-market securities held outright. (A shown above, as a percentage of the balance sheet this is not too far off what the composition of the balance sheet was in early December 2007.)

The Fed has already had some recent test runs using “Reverse Repurchase Agreements” (reverse repos), or, selling securities to securities dealers under an agreement to repurchase. The idea here is to test the market’s reception to the withdrawal of funds from the banking system. Since the reverse repos are only temporary, the funds withdrawn will be put right back into the system avoiding any disruption that might be caused by the sale of the securities.

In this way, the Fed can “feel” its way toward withdrawing the excess reserves from the banking system. On one side is the question about is how the Fed will react to a pickup in bank lending and a rapid rise in the growth rates of the money stock. On the other side, the Fed wants to avoid a catastrophe like the 1937-1938 period in which reserve requirements were raised at a time when banks seemed to have had a lot of “excess reserves” on their hands, but really wanted to keep excess reserves on their balance sheets.

Bernanke, a historian of the Great Depression knows this lesson all too well. That is why a suggestion like that of Andy Kessler, a former hedge fund manager, which appeared in the Wall Street Journal last Thursday morning, “Bernanke’s Exit Strategy: Tighten Reserve Requirements” (http://online.wsj.com/article/SB20001424052748703699204575017462822204340.html#mod=todays_us_opinion) seems a bit absurd.

My belief is that Mr. Bernanke and the Fed are going to, at least initially, take things slow. When they begin to exit they are going to engage in some reverse repos and see how the banking system reacts. Then they will do some more…and then some more. The strategy: basically stepping out into the river to see how deep the water is. And, then stepping out a little further…and then a little further. The hope is to avoid falling in over their head, causing a further contraction in the banking system that would lead to another financial crisis.

In doing this the Fed keeps the reserves in the banking system if the economy remains slow or if the banking system wants to hold onto the funds. However, in this plan they start to remove the reserves, testing the market all along the way, so as not to pull the reserves out too quickly.

The problem is on the “up-side”. If bank lending does start to accelerate then the banks will want those “excess reserves” for loans. And, the funds are already on their balance sheets. In such a case the questions will be “How fast will the Fed sell the securities on its balance sheet?” and “How high will the Fed drive up interest rates in order to avoid a credit inflation from breaking out in the United States?”

As we have seen in other periods of time, we can simultaneously be in a period of economic stagnation and still experience a credit inflation. Bernanke has not earned his “star” yet! He still has $1.1 trillion of EXCESS RESERVES in the banking system that must be removed.

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.

Building the Exit Strategy at the Federal Reserve

Interest continues to grow about how the Federal Reserve is going to remove all of the reserves that it has injected into the banking system. The articles are getting personal now. See, for example, the article in the Wall Street Journal this morning that actually brings us a name, Brian Sack, who is the head of the markets group at the Federal Reserve Bank of New York and the person responsible for developing the “exit strategy” that the Fed will use to remove the $1.0 trillion, more or less, excess reserves that reside on the balance sheets of the country’s commercial banks. (“Brian Sack Engineers Big Moves at Fed,” http://online.wsj.com/article/SB125720947716624249.html#mod=todays_us_money_and_investing.)
The basic problem facing the Federal Reserve is that the Fed has pushed an enormous amount of funds into the banking system and, at some time, is going to have to remove those reserves so as to avoid the possibility of stimulating a massive amount of inflation in the United States. Thus, the Fed needs to go back to where it was once, or, at least, somewhere around there.

The first question that arises is exactly what date do we go back to? Do we go back to the week before the week of September 15, 2008 when the financial collapse became paramount? Or, do we go back to the middle of December 2007 when the Bear Sterns deal was cut? Around this latter date we get the creation of the Term Auction Facility (TAF) that was a first innovation of the Fed to meet the financial crisis that was in its early stages. Let’s use both dates to see if there is any substantial difference between the two.

I have made three, rough calculations about the “excess” funds that the Fed needs to remove from the banking system if we are to get back to a Fed balance sheet that looks something like either the ones that existed on either December 19, 2007 or the September 10, 2008. I use the actual Wednesday data and not the averages of daily figures for the banking week ending on those dates.

The three rough numbers are $1.3 trillion to get back to the balance sheet of the earlier date and $1.1 trillion to get back to 2008 date. My third estimate is generated by assuming that the Federal Reserve balance sheet would grow from December 19, 2007, at a (generous) 10% annual rate up to the current reported figure for October 28, 2009. This third figure is $1.1 trillion. All these numbers are rounded off so as to produce general targets so that we have a rough idea of the magnitude of the task.

So, given these estimate the Federal Reserve needs to remove approximately $1.1 to $1.3 trillion from its balance sheet.

Now, there are two parts to the removal of these funds from the balance sheet. The first has to do with very specific responses to the crisis, either in terms of particular markets or in terms of particular institutions. In terms of particular institutions, I am referring to the “line items” on the balance sheet that relate to the Bear Sterns and the AIG deals. In terms of particular markets, I am referring to the facilities set up for Primary Dealers and Broker-Dealers, Commercial Paper Funding, Money Market liquidity funding, Central Bank liquidity swaps and so forth.

The current strategy of the Federal Reserve with respect to these specific “line items” is to let the dollar amounts decline at their own speed as the need for them dissipates or as the assets are worked off. This strategy is already reflected in the balance sheet results examined in my series on the Federal Reserve Exit Watch: see http://seekingalpha.com/article/167300-federal-reserve-exit-watch-part-3, and, http://seekingalpha.com/article/162274-federal-reserve-exit-watch-part-2.

The total of these accounts, as of October 28, 2009, is $412 billion. These accounts seem to be declining on a regular basis and there is really little or nothing that the Fed can do to speed this decline along. In fact, you want these accounts to be reduced at their own pace because as the need for the assistance goes away, the accounts will fall to zero. True, some of the accounts could remain on the books for an extended period of time, but these will be minor relative to the whole balance sheet.

If you remove these numbers from the shrinkage that needs to take place on the Federal Reserve balance sheet you are left with numbers in the $700 to $900 billion range. The total of Mortgage-Backed securities on the balance sheet as of October 28, 2009 is $774 billion. Federal Agency securities totaled $142 billion on that date. Thus, the “active” strategy for reducing the Fed’s balance sheet relates to these specific security portfolios.

This is where the proposed program called “reverse repos” comes into the picture. Obviously, the Fed cannot just dump $774 billion in mortgage-backed securities on the financial markets. (There is even some concern that Congress may want the Federal Reserve to hold onto a large portion of these securities so as to continue to support housing in the United States. That, however, raises other issues.)

Furthermore, the Federal Reserve is very cognizant of the events of 1937. The United States economy had recovered from the Great Depression (or Great Contraction) and was experiencing relatively satisfactory growth at that time. The commercial banking system, however, was holding onto a large amount of excess reserves (not unlike the current situation). In order to tighter their control over credit, the Federal Reserve, in all its wisdom, raised reserve requirements.

The result was disastrous! The bankers wanted those excess reserves and the removal of them caused the banking system to contract even more and the amount of credit and money in the economy contracted as well. The 1937-1938 depression was the result.

The Federal Reserve does not want to duplicate such a mistake. Consequently, they are going to try and “ease” the funds out, not “yank” them out. This, seemingly, is the reason why the Fed is looking at the “reverse repos’ program as an alternative. Because “reverse repos” would represent the “temporary” removal of funds from the banking system and because they would be undertaken through market transactions, the Fed would not get “ahead of the curve” in removing reserves from the banks. That way, they would constantly be “in the market” and be able to determine if there was any resistance to the removal of funds. In that way, they could proceed incrementally toward selling the securities and then, as the markets allowed, actually sell them outright from their securities portfolio.

The Federal Reserve is in a delicate position. They know that they will need, at some time, to remove the excess reserves from the banking system. However, they don’t want to move too fast and create another financial crisis, as happened in 1937. But, the Fed knows that at some time it is going to have to remove the excess reserves as quickly as it can.

Let me repeat, the Federal Reserve is in a delicate position! In talking about “exit strategies” in the public domain, Fed officials hope to keep the financial community informed and prepared for what might be done and at the pace it at which it will be done.

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!

No "Green Shoots" in the Banking Sector Yet

Although analysts have detected “Green Shoots” in the economy signaling the possibility that there may be a recovery occurring sometime soon, it is my belief that we will need to see some signs of life in the banking system before we can get too excited about any sustainable upswing. Right now, I don’t see any “Green Shoots” in the area of commercial banking.

The only indication that something might be starting to happen in the banking sector is the apparent “credit thaw” in the money markets. An article in the Wall Street Journal touts the “voracious demand for short-term debt issued by U. S. and European banks.” We are told by one New York trader that “bank commercial paper ‘flies off the screen.” (See “Credit Thaw Is Spurring Appetite for Bank IOUs” at http://online.wsj.com/article/SB124890956451491803.html#mod=todays_us_money_and_investing.) The London interbank offer rate has dropped and relative interest rate spreads have fallen indicating that confidence is returning to this sector of the money market.

Yet commercial banks are not lending. They are not lending to each other and they are not lending to businesses. Commercial banks are still reducing their own debt or just holding onto the cash! The only lending that seems to be happening is on pre-approved home equity loans and on pre-approved credit card balances and other revolving consumer credit. Year-over-year, the change in total commercial bank lending and leases is roughly zero.

In terms of banks lending to other banks, from June last year to June this year, the decline in Fed Funds lending and reverse repurchase agreements with other banks has dropped 15%. These loans have dropped another $60 billion in the four week period ending July 15 from a total of $319 billion!

Credit risk is not the reason that the commercial banks are not lending to each other. In normal times, commercial banks lend to each other through the Federal Funds market or through using repurchase agreements in order to manage their reserve positions at the Federal Reserve. However, these are not normal times.

Commercial banks really don’t need to lend to each other in order to manage their reserve positions at the Federal Reserve because they are over-whelming liquid!

Note that in the two weeks ending July 15, the Federal Reserve reported that excess reserves in the banking system totaled $743.9 billion dollars! This is up from $1.9 billion in July 2008. Commercial banks have no concerns with meeting their reserve requirements because they are holding reserves at Federal Reserve banks that are far in excess of what is required. And, why should there be any trading of Federal Funds when there are such excesses within the system.

The commercial banking system is recording cash assets, as of July 15, 2009, of $958.7 billion which is up from $320.0 billion in the month of June 2008.

Right now, the lending market seems to be compressed on both sides of the market, supply as well as demand. Not only do banks seem to be reluctant to make loans, there seem to be a dearth of borrowers at this time.

The argument on the supply side is that commercial banks still have two major concerns on their minds. The first is the value of assets on their balance sheets. In terms of asset values, there still is the problem of mortgage foreclosures. We are starting a period of re-pricing of Alt-A and Option mortgages at a time when unemployment impacts are growing. Next year there is apparently another round of re-pricings of subprime mortgages. Credit card losses continue to rise. And, there are still big problems expected in commercial real estate loans. This says nothing about the securitized loans that are still on the books of the banks. The second concern of the banks is who to lend to if they were to make loans. Given the uncertainties with respect to the strength of the recovery and the state of the labor market commercial bank lending practice has reverted to the principles of the “good old days” which begin with “don’t lend to anybody that needs to borrow.”

The demand for loans is tepid at best. De-leveraging and saving are the primary focus of a large portion of the business and family population. Small businesses and individuals are scared enough that they are shrinking their needs for outside funding and are looking more and more to greater self-reliance. Experts in the field don’t see this new behavior pattern changing soon. More larger firms that possess some degree of financial strength seem to be moving to take advantage of the economic distress of others and so they are borrowing more, but not from the commercial banks.

The consequence of this? Commercial and industrial loans at commercial banks have declined by more than $120 billion this year. Consumer loans have declined by $30 billion since February 2009. Real estate loans have remained roughly constant this year.

There is still one more factor that is weighing on the minds of commercial bankers. The Federal Reserve has created a situation in which commercial banks have ended up with well over $700 billion in excess reserves. The question on the minds of commercial bankers is when and how will the Federal Reserve remove these excess funds?

It is obvious from his testimony in front of Congress last week that Chairman Bernanke does not have an “exit strategy” for the Federal Reserve to remove these reserves from the banking system.

My question to you is, “Would you lend out these reserves if you had no idea when the central bank was going to take them away from you?” I certainly would not! I think any banker that wanted to put these excess reserves to work under the current leadership of the Federal Reserve would be foolish!

There may be indications that money markets are warming to the commercial banking sector and this is good. However, this is not putting money out into the economy. We need to keep looking at the commercial banking sector to see when lending starts to pick up. Until it does, consumers and businesses will just have to rely on their own resources to finance a recovery. This does not bode well for a rapid turnaround.

The Future of Monetary Policy: The Exit Strategy

The recession seems to be ending. However, many people do not feel that the recovery will be very robust. (See my post “Is the Recession Over?” http://maseportfolio.blogspot.com.)
The crucial claim in the near term though is that the recession seems to be ending.

Because of this the issue that seems on the minds of many people is: how is the Fed going to remove all the bank reserves it has pumped into the banking system over the past ten months? The obvious concern is that the recessionary downdraft would turn into an inflationary nightmare. In other words, these people are asking for an explanation of the “exit strategy” the Federal Reserve plans from its policy of preventing a major economic collapse?

Chairman Bernanke spoke to Congress last week to give some assurance that the Federal Reserve knew what it was doing and would, therefore, do what it needed to do as the economy recovered to keep country from experiencing a wicked bout of inflation. I did not sense a lot of confidence that the hypothesized “exit strategy” would unfold as Bernanke stated that it would.

Bernanke also claimed that the United States economy, although it would begin recovering from the recession soon, would not emerge rapidly. Consequently, the Federal Reserve would have to keep its target Federal Funds rate at the present levels for an extended period of time.

There are two immediate concerns with Bernanke’s presentation. First, the Federal Reserve always tends to react to the economic situation. It does not lead economic events. Simply put, the Federal Reserve will not move in advance of any evidence that inflation is picking up. It will follow such evidence. Furthermore, can you see this Federal Reserve taking on Congress by saying that it is tightening up on monetary policy when economic growth is still moderate or just tepid and unemployment rates are above 8% and inflation has not began to accelerate? This Fed does not have that independence from the political side of the government.

Second, even if inflation does begin to pick up speed increasing rapidly enough to cause some concern in financial markets, can you see Congress accepting an inflation target versus a target for faster economic growth. At no time in post-World War II history has the Federal Reserve crossed a presidential administration or a Congress in the early stages of an economic recovery to follow an anti-inflationary period. This starts right with the “Accord” of 1951 to the present. (The Volcker reign at the Fed does not qualify for this as its timing in the economic cycle was not the same.) The Employment Act of 1948, and as modified, still rules as far as Presidents and Congresses are concerned.

Plus there is the concern over the federal deficit. There will be some form of health care coming along, and an energy policy, and other policy initiatives that will continue to put pressure on the budget of the government. The prospect for further large deficits and a rapidly growing national debt is still a reality that must be faced in the next few years. How is the Federal Reserve going to stay independent of all the Government bonds that are going to be coming to market?

This kind of environment will also encourage private borrowing again, both from businesses as well as the consumer. This kind of environment is inflationary like the early 2000s even if price indices like the Consumer Price Index do not rise dramatically. With private debt soaring along with the debt of the government we will have another period of “credit inflation.”

When the growth of credit exceeds the possible real growth of the economy or if the growth of credit in a particular sector of the economy exceeds the possible real growth of that sector, there is a “credit inflation.” This “credit inflation” can result in an asset bubble as occurred in the housing market earlier this decade where asset prices rose even if “flow” prices, like rents, or, implied rents as estimated for the Consumer Price Index, do not reflect this inflation. In addition, it can result in a substantial deficit in the trade balance and lead to a massive flow of dollars into world financial markets and whether these imbalances in the United States trade deficit will find happy recipients of the dollars, as China gladly seemed to receive dollars earlier on, is a question no one can answer at this time.

There is too much debt already in the financial system and it needs to be reduced. The Fed is trying to do the best it can and I don’t question the “good intentions” of the people that are attempting to get us through this mess. However, the problems are huge and I am not convinced that having good intentions is sufficient to lead us through these times. There is plenty of evidence that there is plenty of pain ahead of us. I am not convinced that Ben Bernanke is the person to create this pain and then lead us through the restructuring of the economy.

The Reappointment of Ben Bernanke to the Chair

There are two reasons I am not in favor of re-appointing Ben Bernanke as Chairman of the Board of Governors of the Federal Reserve System. First, I don’t believe that Bernanke has a plan on how to move the country into the future and I don’t believe that he ever did have a plan to move the country into the future. He was an advocate of “inflation targeting” and a student of the Great Depression. It is not the right time in history to pursue “inflation targeting” and the only thing Bernanke learned from the Great Depression is that if you are going to do something to try and combat a major economic downturn, do it in sufficient magnitude so that no one can say that you erred on the side of doing too little effort.

Second, I believe that the economy is going to have to go through some pain in the near future, a pain that results from the problems related to having too much debt in the economy. To restructure the balance sheets of American finance and industry there are still tough times to go through. I don’t see Ben Bernanke as the inflictor of pain. Paul Volcker was capable of acting in that way and had the personal strength of character to carry it through. Bernanke, in my mind, has neither the ability to inflict discipline on the economy nor does he have the weight of personality to carry it through.

Let’s look at Bernanke’s history. He was complicit with the Greenspan easy money policy that kept interest rates at historically low rates for too long a period of time and created the “credit inflation” that resulted in the housing bubble, the dramatic decline in the value of the United States dollar by about 40%, and the massive flooding of dollars into the world economy. He had no feeling at all for the lending practices in the mortgage sector or for the mess that was evolving in the area of credit derivatives and banking governance. Later on, he continued to follow a policy of fighting inflation when the financial markets were beginning to fall apart. He seemed to react hastily in September 2008 and was not a consistent guide through the bailout of Fannie Mae and Freddie Mac, the collapse of Lehman Brothers, and the strange subsidization of AIG. (See my post of November 16, 2008: http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)

I do not know who should replace Bernanke at this time. All I do know is that we have a new administration and a new economic team. Bernanke, I believe, does not have what it takes to get the financial and monetary situation straightened out. I believe that President Obama needs to appoint his own choice as Chairman of the Board of Governors of the Federal Reserve System.