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.         

Mr. Bernanke and the Fed Don't Know What is Going On!

Recently, the Federal Reserve has held 43 meetings around the country on the financing needs of small business. These meetings began February 3, 2010. Yesterday, Mr. Bernanke hosted a forum on small business lending at the offices of the Board of Governors of the Federal Reserve System in Washington, D. C.

The conclusion of all these meetings about the financing needs of small business?

“Mr. Bernanke’s remarks,” on Monday, “suggested that the Fed was not sure why lending had contracted.” (See “Small-Business Lending is Down, but Reasons Still Elude the Experts,” http://www.nytimes.com/2010/07/13/business/economy/13fed.html?_r=1&ref=business.)

Now there’s a confidence builder.

The Federal Reserve and its Chairman don’t know!

And, they held 43 meetings around the country plus the one on Monday and they haven’t a clue?

I have been writing about the decline in business lending at small banks (in fact at all banks) for 18 months now. Did the Fed just become aware of this fact early this year and are now just trying to understand what is going on?

Go back to your equations, Mr. Bernanke!

The Federal Reserve, the federal government, most economists like Mr. Bernanke, and politicians don’t understand debt. Their models don’t include debt and their thinking doesn’t include debt. They seem to believe that debt is something that can be issued without fear of having to pay it back and if one does get into trouble because of the debt that was issued in the past then they can just issue more debt and that will get them out of their problem.

The banks, particularly the 8,000 banks that are smaller in size than the largest 25 domestically chartered banks in the country, face three factors that are particularly troublesome. First, many of these banks have troubled assets on their balance sheets, especially commercial real estate loans that must be re-financed over the next 18 months or so. Debt can go bad and those that hold the debt must reduce their net worth, their capital, when they write the debt off.

Second, the business environment, both in the United States and in the rest of the world, is very uncertain. The future is very unpredictable and this makes balance sheets extremely fragile. This situation makes banks very unwilling to commit to create more debt on their balance sheets and it also makes businesses, very reluctant to add more debt to their balance sheets. In fact, there are plenty of incentives for these organizations to actually reduce the amount of debt on their balance sheets.

Third, banks need capital, not more debt. About one out of every eight banks in the United States is on the list of financial institutions that are facing severe problems as determined by the Federal Deposit Insurance Corporation. My guess is that maybe three other banks in eight in the United States need a capital infusion. And, with new financial reform legislation about to be enacted, commercial banks will be facing higher capital ratios and a more diligent examination of bank capital positions. Banks are going to be very careful about creating more additional debt that place them in a precarious position relative to the new capital requirements.

What is there not to understand?

And, the headlines read, “Bernanke in call for banks to lend more,” (See http://www.ft.com/cms/s/0/c40445b2-8e07-11df-b06f-00144feab49a.html.)

The Federal Reserve is keeping its target rate of interest between zero and 25 basis points and has injected $1.0 trillion of excess reserves into the banking system! This is to provide incentives to banks to lend.

And, the fundamentalist preacher Paul Krugman shouts at the top of his lungs about “The Feckless Fed” who is “dithering on the road to deflation.” (http://www.nytimes.com/2010/07/12/opinion/12krugman.html?ref=paulkrugman)

Krugman and his whole fundamentalist crowd not only believe that additional spending and more debt on the part of the government is needed at this time but that we need the forgiveness of consumer debt so that consumers can start borrowing and spending again, and we need the Fed to force commercial banks to support more borrowing on the part of businesses so that they can invest in inventories and plant and equipment. Then we inflate the real value of the debt away so that issuing debt is not so painful.

Isn’t this just the attitude that got us into the situation we are now in?

Unfortunately, this attitude seems to have prevailed in history as arrogant governments over time have lived off of issuing more and more debt and then inflating their way out of their responsibility to pay it off. On this issue see the books by Rogoff and Reinhart, “This Time is Different,” (http://seekingalpha.com/article/171610-crisis-in-context-this-time-is-different-eight-centuries-of-financial-folly-by-carmen-m-reinhart-and-kenneth-s-rogoff) and Niall Ferguson, “The Ascent of Money,” (http://seekingalpha.com/article/120595-a-financial-history-of-the-world).

There was another time, in the spring and summer of 2008, when Mr. Bernanke and the Federal Reserve didn’t seem to know what was going on. The consequence of this ignorance has been pretty severe.

To think that people can say that Mr. Bernanke and the Federal Reserve don’t know what is currently going on in the banking system they oversee and regulate is downright scary. The American people deserve better!