Where is the US Consumer?--Part 2

Two pieces of news today that go along with my earlier post about the pressures families are facing in the United States. (http://seekingalpha.com/article/328252-where-is-the-u-s-consumer).   

First, “Home Prices Tumble.” (http://professional.wsj.com/article/SB10001424052970204652904577194752102528744.html?mod=WSJ_hp_LEFTWhatsNewsCollection) “For November, the Case-Shiller index of 10 major metropolitan areas and the 20-city index both fell 1.3% from the previous month. David M. Blitzer, chairman of the index committee at S&P Indices, also noted that 19 of the 20 major U.S. metropolitan markets covered by the indices in November saw prices decline from October…

The 10-city and 20-city composites posted annual returns of negative 3.6% and negative 3.7%, respectively, compared with November 2010.”

Second, “Consumer Confidence Unexpectedly Declines.” (http://blogs.wsj.com/economics/2012/01/31/consumer-confidence-unexpectedly-declines/)  “U.S. consumer confidence in January gave back some of the huge gains posted in the previous two months, according to a report released Tuesday. Views on labor markets darkened.

The Conference Board, a private research group, said its index of consumer confidence retreated to 61.1 this month from a revised 64.8 in December, first reported as 64.5. The January index was far less than the 68.0 expected by economists surveyed by Dow Jones Newswires.

Perceptions about the job markets worsened this month. The survey showed 43.5% think jobs are “hard to get” up from 41.6% saying that in December, while only 6.1% think jobs are “plentiful” down from 6.6% in December.”

These data are consistent with the material presented in the earlier post.  The United State consumer has lots to worry about and, for a large portion of this consumer base, spending is not expected to be very robust in future months.  And, their situation cannot be turned around soon by either monetary or fiscal policies. 

Mr. Bernanke Gets His Way

Well, Mr. Bernanke has moved the Federal Reserve to a position of greater transparency. 

We now have projections of interest rates out until the end of 2014.  It is now believed by most members of the Fed’s Open Market that the Federal Funds rate will remain close to zero until the end of 2014.

What is the probability that the Federal Funds rate will be close to zero for the last six months of 2014?

In my mind, zero or close to it!

What is the probability that the Federal Funds rate will be close to zero for the first six months of 2014?

In my mind, zero or close to it!

What is the probability that the Federal Funds rate will be close to zero for the last six months of 2014?

You guessed it!

And, so on…

Seems like I don’t have a lot of confidence in these forecasts. 

What are these forecasts for, then?

I have already written my answer to this question.  These forecasts are to make Mr. Bernanke feel better. (http://seekingalpha.com/article/317453-bernanke-transparent-about-his-lack-of-self-confidence)

Mr. Bernanke doesn’t want to be misunderstood.  Apparently, in the past, Mr. Bernanke feels that he has been misunderstood.  Now, with the “new transparency” there should be no doubt where Mr. Bernanke and the Fed stand…and Mr. Bernanke should feel justified.

This is the first time in my mind that the Federal Reserve has done something of this magnitude so as to make the Chairman of the Board of Governors feel better.

I hope it achieves its goal because as far as I am concerned this new transparency program does absolutely nothing for me in terms of understanding where interest rates are going to be for the next two to three years.  It does absolutely nothing for me in terms of understanding what the monetary policy of the Federal Reserve is going to be for the next two to three years. 

If anything this new transparency program will assist, in the shorter-term, speculators in making lots of money.  George Soros, and others like him, loves a situation in which a government says it is going to maintain a price for as long as it can.  This type of government activity creates “sure thing” bets. 

The economy is in the condition it is in because there is still a lot of insolvency around.  By keeping short-term interest rates as low as they are helps financial institutions and other private or public organizations remain open hoping that they will be able to work themselves out of their insolvency. 

According to a report released Wednesday put together by the American Bankers Association and State Bankers Associations, thirty percent of the commercial banks reporting were under some form of written agreement with regulators.  A total of 1000 banks responded to the survey, so the study should be fairly representative.  Extrapolating this to the total number of banks in the banking system we would get some 1,900 banks under some kind of agreement with the regulators.   

This is when there are still some 864 commercial banks on the FDIC’s list of problem banks, which we know does not include all the banks under some kind of agreement with the FDIC. 

Many home owners still find the market values of their homes below the amount of the mortgage that exists on the property.  Commercial real estate loans are still defaulting at a very rapid pace and many businesses are declaring bankruptcy or are near filing for bankruptcy, especially small ones.

It is understood that the Federal Reserve must continue to protect against further economic deterioration and must continue to protect those individuals and institutions that are insolvent or near insolvency. 

Because of this and the consequent slow pace of economic growth the Fed must continue to keep the economy excessively liquid.

I don’t know that publishing interest rate forecasts for the next three years will convince us any more that the Fed is attempting to protect the banking system and the economy.  I guess it must help Mr. Bernanke to sleep better to know that he is releasing all this information even if it does little or nothing for anyone else.           

Post QE2 Federal Resserve Watch: Part 3

I didn’t post a “Post QE2 Federal Reserve Watch” last month because I was on vacation.  You have to go back to September 12 to get Part 2 of the “Post QE2” watch. (http://seekingalpha.com/article/292986-post-qe2-federal-reserve-watch-not-much-banking-system-activity)

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

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

Federal Reserve policy for the past two years has basically been to throw all the “spaghetti” it can against the wall and see what sticks.  So far, very little of the “spaghetti” has stuck as total bank loans have not increased that much over the past year although business lending has picked up some at the larger banks (http://seekingalpha.com/article/303929-business-lending-is-increasing-especially-at-the-largest-u-s-banks)

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

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

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

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

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

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

   

Over the past six months, the required reserves at commercial banks have risen by just under $19 billion. 

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

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

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

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

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

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

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

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

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

Oh, My Gosh! We Now Need "Forward Guidance"!

Poor Ben Bernanke. 

To me, the kindest thing that can be said about him is that he is suffering the fate of those who are in charge of large institutions with little or no practical experience in administering any other organization of consequence.  He just does not seem to understand how to lead such an organization and he does not seem to have the capacity to adapt how he does things so as to achieve a better performance. 

Where one can criticize Mr. Bernanke and the Fed, as I have done in the past, for claiming that solvency problems are just liquidity problems, one can also criticize Mr. Bernanke and the Fed for claiming that their problems with the market are ones of the appropriate information flow and not one of credibility.

Now we are presented with the specter of something called “Forward Guidance.”  To quote Mr. Bernanke, “forward guidance and other forms of communication about policy can be valuable even when the zero lower bound is not relevant (short-term rates are not around zero).  I expect to see increasing use of such tools in the future.” (http://www.federalreserve.gov/newsevents/speech/bernanke20111018a.htm)

Mr. Bernanke came into the position of Chairman of the Board of Governors of the Federal Reserve System promising to provide greater openness and transparency to what the Federal Reserve is doing.  He has been consistently more available to the press and others than any previous Fed Chairman.  His latest effort has been to talk directly with the press after four regularly held meetings of the Federal Reserve Open Market Committee to explain what the Fed is doing.  The first such meeting was less than rousing. 

Yet, apparently, Mr. Bernanke is unsatisfied with the results of this accessibility.  Why else would we need to have something dangled in front of us like this so-called “Forward Guidance.”

Roughly, “Forward Guidance” provides banks and financial markets with an explicit idea of what the Federal Reserve is attempting to achieve in the future in much the way that the August 2011 statement that the Fed would keep short-term interest rates low until mid-2013.

And, there are other forms the “Guidance” could take.  For example, Mr. Bernanke has been an advocate of “inflation targeting” something other central banks in the world have adopted.  For example, the Fed, during the regime of Mr. Bernanke, has had an informal target for inflation of 2 percent.  Under the new effort to keep the public better informed, this policy effort, tying interest rate levels to an inflation target, would be made more formal and explicit.

One could also do the same thing with respect to an unemployment goal. 

When this effort of communication does not work, I wonder what Mr. Bernanke will try next.  His increasing attempts to inform the public about how the Fed will operate given the policy parameters it is watching seems to be constantly falling short of what Mr. Bernanke and the Fed have expected.  Hence, the need to try different things.

In my mind, Mr. Bernanke and the Federal Reserve have followed one basic policy since late 2007.  This policy can be described as throwing as much “stuff” as possible against the wall to see how much of the “stuff” can stick to the wall.

The term “stuff” can apply to many things.  An early example of “stuff” was the Term Auction Credit (TAC), which first showed up on the Fed’s balance sheet on December 26, 2007.  During 2008, the Fed became the banker to the world lending to the European Central Bank and the Swiss National Bank, among others, through swap lines of credit.  The Fed’s line item, Other Federal Reserve Assets, which includes these central bank transactions, rose from about $56 billion on December 26, 2007 to $105 billion on August 27, 2008.  Added to this was the Fed’s assumption of assets from the Bear Stearns transaction, which first showed up on July 2, 2008.  Then in the fall of 2008, the door swung wide open. 

Whereas the earlier efforts did not expand Federal Reserve credit appreciably during most of 2008 (this measure rose from about $874 billion on December 26, 2007 to $884 billion on August 27, 2008 as the Fed reduced other categories of assets to expand credit where it seemed to be needed) by December 31, 2008, Federal Reserve credit reached $2.250 trillion!

On October 12, 2011, Federal Reserve credit stands at almost $2.845 trillion!

We have had QE1, and QE2, and now we have “Operation Twist.”  Excess reserves in the commercial banking system have risen from less than $2.0 billion in December 2007 to about $770 billion in December 2008 to over $1.550 trillion in September 2011.

Bank lending remains anemic, at best, and economic growth stays modest. 

What is the Fed’s monetary policy?  The Fed’s monetary policy is to flood the banking system with “cash”.  What else needs to be explained? 

“Operation Twist” and “Forward Guidance” and “QE2” and whatever do not change the general thrust of the Fed’s monetary policy.  The Fed is throwing as much “stuff” against the wall as it possibly can.  And, it will continue to do so for as long as Mr. Bernanke and the Fed feel that it is necessary.

But, Mr. Bernanke does not feel that this is enough.  And, so he tries this and tries that to increase the “openness and transparency” of the Fed to the rest of the world.  I believe that he is concerned about this more to calm his own mind than to calm the mind of the banking system and the financial markets.

The problem is that people are attempting to reduce their debt loads.  The fifty years or so of credit inflation released on American families and businesses by the United States government since the early 1960s has resulted in a situation where these same families and businesses feel that they are burdened by too much debt.  Consequently, they are attempting to reduce their debt loads. (See my post, “The US economy will continue to grow”: http://seekingalpha.com/article/300450-the-u-s-economy-will-continue-to-grow.)

However, de-leveraging takes time.  Unfortunately, given the current circumstances, the only thing that would stop the de-leveraging is a rapid build-up of inflation making debt “economically valuable” again.  In one sense, this is what it looks as if Mr. Bernanke and the Fed are trying to do.

But, with modest economic growth and tepid inflation, families and small- and medium-sized businesses will continue to reduce the amount of debt on their balance sheets.  These people will not come back into the debt market for some time.  This is  consistent with the research published by Reinhart and Rogoff in their book, “This Time is Different.” 

Even if this is true, Mr. Bernanke and the Fed, for the history books, do not want to look as if they did not do everything in their power to combat a second Great Recession…a double dip, if you will.  Consequently, they will stand ready to throw as much “stuff” as they feel they need to against the wall and will continue, in an open and transparent way, to tell the world that they are doing everything within their power to get the economy moving again.  To me, this is a lack of confidence that does not enhance their credibility.

Wil Bernanke Policy "Destroy Credit Creation"? Bill Gross is Worried It Will--The Role of Financial Innovation

Yesterday I discussed the concern Bill Gross, founder and co-chief investment officer of PIMCO, has about the current Federal Reserve policy of keeping short-term interest rates low for the next two years.  The concern extends to the possibility that the Fed will attempt to “twist” the term structure of interest rates by buying more and more long-term government securities in an attempt to bring longer-term interest rates in line with the very low short-term interest rates.  Gross sees the efforts extending to the seven- and eight-year maturity range.

The concern Gross has is that a flat yield curve will cause banks and other financial organizations to de-leverage even further and faster than they would under conditions the of un-sustainable debt levels created by the previous fifty years of credit inflation.  Gross, in his Financial Times article (http://www.ft.com/intl/cms/s/0/04868cd6-d7b2-11e0-a06b-00144feabdc0.html#axzz1XGri4Us6), argued that the Federal Reserve consistently maintained a positive slope to the yield curve throughout this fifty year period (with the exception of periods of tight monetary policy) so that the banks and other financial institutions would continually provide “credit creation” so that the economy would continue to expand and create jobs. 

The positive slope to the yield curve provided the mechanism for this credit creation through three channels that I have written about on a regular basis.  First, the positive slope to the yield curve meant that banks and other financial institutions could borrow short at relatively low interest rates and lend long at higher interest rates.  The mis-matching of maturities increases interest-rate risk but then if the yield curve, on average, remains positive, the positive yield spread can be maintained over time.

Second, credit inflation “bails out” riskier loans so the banks and other financial institutions could lend money on riskier deals and thereby earn an even larger interest rate margin.  To paraphrase Warren Buffet…if credit inflation tide is rising, it is hard to tell bad assets from good assets.  Only when the credit inflation tide recedes and the water level drops do we discover who is not wearing a bathing suit.   Tell me about the sub-prime mortgage mess…

Third, narrow interest margins can be turned into substantial returns on equity by the use of financial leverage.  And, if competition brings net interest margin levels down, banks and other financial institutions can maintain the levels of return on equity they had previously earned by adding more and more financial leverage to their balance sheets. 

This third component of the growing risk exposure of a period of credit inflation can only succeed if the banks and other financial institutions are “liability managers”.  In terms of the last fifty years, financial institutions became liability managers through the process of financial innovation.  Most financial institutions were locked into their balance sheets before the 1960s because money and capital markets were not developed to the extent that banks and others could buy or sell all the funds they wanted a the going market interest rate.

Commercial banks, at this earlier time, could only obtain funds through “local” markets and these funds were not very interest sensitive.  Hence, these organizations were “asset managers” limited to what Leo Tilman calls “Balance Sheet Arbitrage”.  (See a review of Tilman’s book “Financial Darwinism” at http://seekingalpha.com/article/221607-making-money-in-the-21st-century-financial-darwinism-create-value-or-self-destruct-in-a-world-of-risk-by-leo-tilman.) Balance sheet arbitrage is the “old” way of commercial banking where banks are “local” in nature and obtain funds from demand deposit accounts and savings accounts which pay very low interest rates and lend the funds out to borrowers, many of whom have no other sources of funding so that the interest on these loans are relatively high.  Thus, the banks worked with nice interest margins that were relatively stable and reliable. 

Liability management came into pay through the financial innovation of the 1960s.  Negotiable CDs and Eurodollar deposit along with holding company issue Bankers Acceptances became the innovation of choice in the larger banks and this freed up the balance sheets of banks so that they were no longer limited to “local” constraints on the choice of funding sources.  Funding sources became world wide and the understanding was that, at most times, banks could now buy or sell as many funds as they wanted at the going market interest rate. 

In essence, commercial banks could now “leverage up” as much as regulation…or accounting rules…would allow!

And, as regulation eased up, banks and other financial institutions got into other financial and organizational innovations.  Tilman lists these as moves into “Principal Investments” (private equity and venture capital, investments in hedge funds, or, capital allocations to internal proprietary trading desks) and “Systematic Risks” (which included interest rate risks, credit risks, currencies, commodities, and equity indices). This created an environment I have called the “New Liquidity.” (See http://seekingalpha.com/article/289579-let-s-move-on-from-keynes-and-accept-the-new-liquidity.)

The result? Bill Gross nails it in his article: “Thousands of billions of dollars were extended…” It seems as if capital requirements were non-existent.  Credit could expand almost without limit.

And, why are we interested in credit inflation and not price inflation?  Why do we focus on credit creation and not money? Focus, in the past, was placed on money because people were concerned about what was happening with consumer prices…”flow” prices.  “Flow” prices relate to the prices paid for goods and services that are consumed in a relatively short period of time.  “Flow” prices are to be differentiated from “asset” prices. 

“Flow” prices are in many ways “constructed” prices.  For example, in the construction of the Consumer Price Index, the price of a house is not included because that is the price of an asset.  The “flow” of housing services is what people consume and the “price” of this flow of services is called “rent”.  In the construction of the CPI, the “rental price” of housing services is, to a large extent, estimated.  And, as it turns out, since the consumption of housing services is such a large component of consumer expenditures, the “rent” component turns out to be the largest part of the CPI.

Theoretically, the price of an ‘asset” (the price of a house) should be equal to the discounted present value of the future cash flows relating to the purchase of the housing services provided by the house (the rent or rental value of the housing services).  In the world these two prices can differ from one another for a substantial amount of time as they did during the 2000s where housing prices were severely inflated and estimates of rental values lagged far behind. 

This is true of other asset categories like equity shares that are traded on the stock markets (take for example the Internet bubble of the 1990s).

Thus credit and credit inflation are of crucial interest to the behavior of prices…all prices…in the economy.  And this is why we must be interested in cumulative credit inflations that become unsustainable and turn into cumulative debt deflations that create a “formidable headwind” (thank you Mr. Bernanke) that must be overcome by any fiscal or monetary policy hoping to stimulate growth in the economy. 

The problem seen by Mr. Gross, however, is that the monetary policy now being followed by the Mr. Bernanke and the Federal Reserve that promotes a flat yield curve will just exacerbate the situation because it will accelerate the debt deflation taking place.  One could also argue (ala Mr. Gross) that the situation created by recent financial innovation, the “new liquidity”, will further add to the volatility of the whole situation. 

The Current State of Monetary Policy

At the top of my Financial Times this morning reads the blurb: “Did Ben Bernanke Drop the Ball Over QE3?”  This is reference to an editorial by Clive Cook. (http://www.ft.com/intl/cms/s/0/7f55246e-cf2d-11e0-b6d4-00144feabdc0.html#axzz1WPnzI9CU)

In examining the speech given by Fed Chairman Bernanke, Cook takes on the Financial Times essays published last week by Michael Woodford (http://www.ft.com/intl/cms/s/0/aa41c0f2-ce78-11e0-b755-00144feabdc0.html#axzz1WPnzI9CU) and Mohamed El-Erian (http://www.ft.com/intl/cms/s/0/0472f1ea-cd89-11e0-b267-00144feabdc0.html#axzz1WPnzI9CU) that argued against the Fed implementing a QE3.  Cook contends that Bernanke missed a chance…a “chance to jolt ailing America.”

I don’t believe that Bernanke dropped the ball.  I don’t believe that a declared QE3 is necessary.  Whereas Cook believes that a QE3 would “shock” America, I believe that a QE3 would be taken as ho-hum, more of the same. 

In this, I don’t believe that QE1 and QE2 were understood. 

Michael Woodford, the “good” academic states in his essay: “The economic theory behind QE has always been flimsy.”

Get real…this is the “real world”!

QE1 and QE2 were not a result of economic theory.  QE1 and QE2, in my mind, were a response of real people to a desperate real world situation.  In the first case, the financial markets were falling apart.  In the second case, the economy was not growing. 

In both cases, the response of Mr. Bernanke and the Fed’s policy makers were to throw whatever they had against the wall to see what would stick.  There is little in the way of theory behind this.   Some of us believe that in the first case this was not one of Mr. Bernanke’s finest hours. (See my post, “The Bailout Plan: Did Bernanke Panic,” http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)

In my mind, what was behind these actions was not theory…but history. And, Mr. Bernanke is one of the premier students of the history of the Great Depression and the 1930. 

So, what was behind QE1 and QE2?

In the case of QE1, Mr. Bernanke was aware of the massive monetary history written by Milton Freidman and Anna Schwartz.  The famous conclusion drawn from the Friedman/Schwartz history is that the Federal Reserve allowed the money stock of the United States to decline by one third over the 1929-1933 period. 

Mr. Bernanke and the modern Fed was not going to allow this to take place.  As a consequence, they, Bernanke and the Fed, threw everything they had at the wall.  There was no theory in this.  They were just human beings re-acting in a situation in which there was extreme uncertainty and in which things seemed to be falling apart around them. 

In terms of QE2 we can also go back into the history of the 1930s to get some instruction that might help us understand what the Federal Reserve has been attempting to do over the past year.  The specific case here comes from the period 1937-1938.  The United States economy had been modestly recovering since 1933 but bank lending had not really picked up.  Excess reserves at commercial banks became, for the time under review, excessive.  Since the Federal Reserve’s policy makers did not want to have all these excess reserves around because they felt this reduced their control over the banking system they raised reserve requirements so as to get rid of these “superfluous” reserves.

The consequence? 

There was another collapse of the money stock because the commercial banks “wanted” those excess reserves due to the uncertain times and the slow pickup in business activity.  So, when the Fed took away the excess reserves, the banks reduced their lending activity even more to recover their “excess” reserves and the financial system declined once again.  There was another depression following up on the “Great” one!

Mr. Bernanke, the historian, and the Fed did not and does not want a repeat of the 1937-38 depression.  As a consequence, QE2 was created.  The thought behind QE2 was to throw enough against the wall so that something would stick!  Economic growth was sluggish at best; bank lending was still declining in the summer of 2010; debt loads of businesses, and families, and governments were huge; foreclosures and bankruptcies were at record levels; and under-employment were at levels reached only in the 1930s.  Banks had excess reserves, yet, nothing much seemed to be moving.

Mr. Bernanke and the Fed wanted to escape a replay of 1937-38!

There was little or no theory behind QE1 and QE2.  These two programs were put into place by real people facing extreme situations who did not want to err on the side of not doing enough.  They were people that would let history decide whether or not they acted correctly…and let the theorists debate all they wanted to in their own little worlds. 

And, what are we left with right now?

A commercial banking system that has around $1.6 trillion in excess reserves and about $2.0 trillion in cash assets on its balance sheets.  And, we are told that the central bank is poised to act in the future in anyway needed to shore up the banking system and the economy.  Furthermore, we are told that short-term interest rates are to stay around where they are for two more years. 

Mr. Bernanke, who has overseen both QE1 and QE2, is not afraid to throw more “stuff” against the wall if needed.  This, to me, is current state of monetary policy at the present time.        

The Merger Binge and the Economy

We wondered what Microsoft was up to when it started issuing long-term debt last year, something that it had never done all the rest of the time it has been a public company. 

This money was not going to go to expand operations.  It already had tons of cash to do that!

The best bet was that Microsoft was going to go acquiring…but, what.

Now we have a partial view…Microsoft…and Steve Ballmer…is buying Skype!  The estimated cost?  More than $8 billion.

What about all the other money Microsoft raised in the bond market?  My best guess is that we will see more acquisitions in the future!

But, Microsoft is not alone in this.  Hertz is going after Dollar Thrifty and outbidding Avis.  Southwest Airlines acquired AirTran Holdings to get into the Atlanta airport, the world’s busiest. 

And the beat goes on.

AT&T is intent on acquiring T-Mobile for around $39 billion; Johnson & Johnson has a $21.5 billion deal in the works for Synthes; Duke Energy plans to merge with Progress energy, the deal totaling a little less than $14 billion; and there is the bid for NYSE Euronext for more than $11 billion.

I have been arguing for at least a year now that much of the cash being built up at many large corporations was going to contribute to a major acquisition binge…worldwide. 

And, this binge would include companies from more and more nations.  The Chinese are looking to put $200 billion into corporate acquisitions globally.

Roger Altman, Chairman of Evercore Partners, Inc., argues that the deal making will be at an all time high in 2011, surpassing the $4 trillion record total that was achieved in 2007. (http://www.bloomberg.com/news/2011-05-06/altman-sees-dealmaking-recovery-surpassing-record-4-trillion-of-2007-boom.html)

Some analysts argue that the growing stability of the economy is contributing to this.  Others attribute this movement to the strength in the stock market. 

Whereas these support the cumulative rise in the amount of M & A activity taking place, I still believe that this record-breaking rise in acquisition activity is being subsidized by the monetary policy of the Federal Reserve System. 

The first to benefit from this subsidy are those companies that came through the Great Recession with little or no debt on their balance sheets. 

The second group to benefit have been those that have been able to use leveraged loans and junk bond issues to refinance billions of dollars of debt borrowed during the credit inflation of the past decade or so. 

These companies are now buying other companies and strategically positioning themselves for the future.  And, in a real sense, the big are getting bigger…and more complex.  Industry is following the banks on this as the larger firms are getting greater market share and expanded market space. 

And, in my experience, there is only one way to really make acquisitions work.  The acquirers, after the deal is made, must become the biggest “bastards” in the world.  That is, the acquirers must become ruthless in rationalizing their purchase…otherwise…the acquisition just won’t pay off.

The effect on the economy?  In the longer-run…good…very good!  In the short run…continued pain.  Jobs must be cut, un-economic facilities must be disposed of, and, in general, spending must be reduced. 

“In AT&T’s pending deal for T-Mobile USA, the companies estimate cost savings of $40 billion over time, including expected layoffs, starting from the third year after the merger is completed.” (http://professional.wsj.com/article/SB10001424052748704810504576305363524537424.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

But, this gets into another point I have been trying to make for the past two to three years.  During this time I have argued that about one-in-four to one-in-five people of working age are under-employed.  Forget the unemployment rate as it is measured…there are a lot of individuals that have either left the labor market or are not fully employed but would like to be.  And, this has been a growing problem over the past half-century. 

The merger and acquisition binge is not going to help this situation…one bit!

David Brooks in his New York Times column this morning emphasis this problem. (http://www.nytimes.com/2011/05/10/opinion/10brooks.html?_r=1&hp)  Brooks reports that 80 percent of “all men in their prime working ages are not getting up and going to work…there are probably more idle men now than at any time since the Great Depression and this time the problem is mostly structural, not cyclical.”

And, the primary factor that distinguishes the unemployed?  Not sufficient educational training.  “According to the Bureau of Labor Statistics, 35 percent of those without a high school degree are out of the labor force.”  Not unemployed…but, “out of the labor force”!  And, while this number goes down the more education one has, there is still a close correlation between the number of individuals “out of the labor force” and the amount of education that an individual has.   

And, as the mergers and acquisitions take place, the trend will just worsen.  For too long a time, when unemployment arose, we have tried to put people back into the jobs they had formerly held, even though those jobs became less and less economically justified.  The expectation was that the government would stimulate the economy and people would get their old jobs back.

Now we are going through a transition in which those “old jobs” are no longer there. 

And, the monetary stimulation coming from the Federal Reserve System is now resulting in a continued reduction in the less productive jobs through the merger and acquisition banquet going on and is doing very little toward helping these people get back into the work force.

This is consistent with the argument that I have continuously made in these posts that the credit inflation created by the monetary and fiscal policy of the United States government over the past fifty years has done a very good job in splitting the labor force into two segments, the less educated and the more educated, and the society into a much more highly skewed income distribution than earlier.

The acquirers have the cash, they can still borrow at ridiculously low interest rates, and these conditions are expected to stay in place for “an extended period.”  Continue to watch all the M&A activity taking place.  I think this will be a time to remember.

Federal Reserve QE2 Watch: Part 5.0

On March 30, 2011, reserve balances with Federal Reserve banks, a good proxy for the amount of excess reserves in the commercial banking system, almost reached $1.5 trillion!

This total is approximately $450 billion more than was on the Fed’s balance sheet on September 1, 2010 which was soon after Chairman Ben Bernanke announced the advent of Quantitative Easing 2, or QE2, at a Federal Reserve conference in Jackson Hole, Wyoming.

The Fed’s basic plan was to purchase $900 billion in United States Treasury securities during QE2, $600 billion of the purchases were to be a net addition to the Fed’s portfolio of securities held outright and $300 billion were to replace maturing Mortgage-backed securities and Federal Agency securities.

Between September 1, 2010 and March 30, 2011, the Fed has achieved a net addition of about $550 billion to its holdings of Treasury securities which has resulted in a net addition of around $360 billion to its securities held outright. About $190 billion has run off from the Fed’s portfolio of Mortgage-backed securities and Federal Agency securities.

The plan was that the Fed would add about $2 in bank reserves to it’s balance sheet for every $3 it purchased in U. S. Treasury securities. Since September 1, the Fed has added about $3 for every $5 in Treasuries it has purchased.

However, over the past four weeks, the Fed has added about $4 for every $5 in Treasuries it has purchased.

In the first three months of this year the Fed has added, on average, approximately $100 billion in United States Treasury securities to its balance sheet every month.

However, securities purchases are not the only thing changing on the Fed’s balance sheet. Since September 1, 2010, the Fed’s net purchases of securities have supplied almost $325 billion in reserve funds to commercial banks.

The other $125 billion of the total $450 billion increase in reserve balances has come from the other side of the balance sheet. Here the primary contributor to the increase in reserve balances has been a $195 billion decrease in the Supplementary Financing Account of the United States Treasury.

In effect, the Treasury had $200 billion in deposits at the Fed in this account on September 1, 2010. The Treasury has withdrawn $195 billion of this $200 billion and when the Treasury spends out of its account at the Fed it creates bank deposits…or reserve balances at the Fed.

About $70 billion of this decrease has been offset by an increase in currency in circulation which draws funds out of commercial bank accounts and an increase in the Treasury’s General Account at the Fed. Currency in circulation rose about $55 billion since September 1 and the General Account of the Treasury rose by about $15 billion.

After about two years of almost total turmoil, the Federal Reserve’s accounts have settled down and are very open and straight forward. About all that is going on at the Fed right now is the activity related to QE2. And, the Fed is doing exactly what it said it was going to do.

The reason for QE2, we are told, is that the Fed is creating this excessive amount of liquidity to spur on bank lending in order to get the economy growing at a faster pace.

We are told that QE2 will be over by the end of June, 2011.

The average year-over-year growth of real Gross Domestic Product over the past three quarters has been 3.0 percent. Analysts have predicted that economic growth will probably end up around 3.0 percent for the whole year of 2011. Usually the American economy comes out of a recession at a faster rate of growth than this, but this rate of growth is very consistent with the compound rate of growth of real GDP over the past fifty years.

The point is, the economy is growing. It is not a spectacular rate of growth but it shows that the economy is growing at a rate that is close to its long run average. The growth rate is not rapid enough to cause a dramatic decrease in the unemployment rate, but this may be a result of the fact that the United States economy needs to restructure and restructuring a large economy takes time.

Does the fact that the economy is only growing around 3.0 percent warrant the injection of $1.5 trillion in excess reserves into the banking system? Will all this liquidity really cause economic growth to accelerate and with this acceleration bring down the unemployment rate?

It is here, I believe, that we have a disconnect between the story the Fed is trying to tell and the way that the economy is performing. To me, the facts just don’t seem to mesh with the urgency of the Fed’s expressed concern. And, this disjunction of words and economic behavior is made even muddier by the contradictory statements made by members of the Fed’s own Open Market Committee this past week.

But, Chairman Bernanke is going to make things exceedingly clear in the future by holding a press conference after four future meetings of the Open Market Committee.

The results of QE2 to this point: in terms of the purchase of U. S. Treasury securities, the Federal Reserve is doing exactly what it said it was going to do; in terms of economic activity, the economy is behaving just about the way it was behaving at the time QE2 was introduced.

Lots of activity on the part of the Fed and little or no reaction on the part of the economy.

In terms of understanding what the Fed is doing and what it hopes to accomplish…confusion.

Up to this point, the walk and the talk just don’t seem to coincide. My problem is that I was taught to watch the hips…not the lips. What the hips are doing, in this case, however, don’t make a lot of sense.