Monetaray Policy in 2011: Looking Back

Total reserves in the banking system rose by almost 50 percent in 2011 to average around $1.6 trillion.  The increase during the year was slightly more than $511 billion. (Remember in August 2008 when total reserves in the banking system averaged less than $45 billion?)

Excess reserves in the banking system rose by about $490 billion from December 2010 to December 2011 to a total of about $1.5 trillion. (Remember in August 2008 when excess reserves in the banking system averaged less than $2 billion?)

The Federal Reserve continued to pump reserves into the banking system in 2011 and about 95% of the reserves going into the banking system went into excess reserves. 

Bank loans fell during the year by approximately $50 billion.  There was a pickup in business loans (commercial and industrial loans) of about $122 billion, but real estate loans (primarily commercial real estate loans) fell by $150 billion and consumer loans dropped by $22 billion. 

Note that the pickup in business loans was predominately located in the largest 25 domestically chartered banks in the United States.  The increase here was approximately $95 billion. 

One can conclude from this that the reserves that the Fed pumped into the banking system did not, on balance, go to support an increase in lending.

Yet, the growth rate in both measures of the money stock rose during the year.  For the M1 measure of the money stock, the year-over-year rate of increase rose from 7.5 percent in December 2010 to 19.1 percent in December 2011. (This is using the 13-week average of the measure.)  The year-over-year rate of growth of the M2 measure of the money stock rose from 3.3 percent in December 2010 to 9.8 percent in December 2011. (Again using the 13-week average.)

The increase was highlighted by a whopping 45% rise in demand deposits!

But, this increase in demand deposits did not come from an increase in bank lending because the bank lending that might have resulted in an increase in demand deposits and hence the M1 money stock actually declined!

The reason for the huge increase in demand deposits seems to be that people are moving assets from short-term investment vehicles to demand deposit accounts. 

For the past two years or so I have been arguing that this movement into demand deposits is coming for two reasons.  The first reason is that interest rates on short term investments are so low that people do not believe that it is worthwhile to keep their money in interest bearing assets rather than demand deposits. (For example, Federal Reserve data record a drop of almost $90 billion in Institutional Money Funds over the past year.)

The second reason is that many people are still is difficult financial condition.  Hence, they are keeping what funds they have in transaction-type accounts so as to pay for necessary living expenses.  Additional information that supports this argument is that the currency component of the money stock rose by more than 9 percent this last year.  This is, historically, an extremely high number.  People in tough economic situations also hold more cash.

The evidence from the banking system is not very encouraging with regards to a pickup in economic activity.

How did the Federal Reserve inject more than $500 billion reserves into the banking system this last year?

First, the Federal Reserve increased its holdings of securities by roughly $442 billion.  Actual acquisitions of Treasury securities amounted to about $640 billion but these purchases were offset by a $43 billion decrease in the Fed’s holdings of Federal Agency issues and a $154 decline in the Fed’s holdings of mortgage backed securities. 

One should also note that there was a net decrease in funds associated with the bailout actions of 2007 and 2008 of approximately $140 billion. Also, primary borrowings from the Fed’s discount window declined by $36 billion.  One generally assumes that these “operating” factors are offset by the Fed’s purchase of securities.  Thus the “net” addition of funds from the increase in the Fed’s outright holdings of securities totaled about $266 billion. 

Second, the United States Treasury also played a role in the increase in bank reserves.  At the end of 2010, the Treasury held almost $200 billion in something called the U. S. Treasury Supplementary Financing Account. (I have mentioned the use of this account many times in 2010…here is one post: http://seekingalpha.com/article/256497-qe2-watch-version-4-0-fed-is-tone-deaf-and-spaghetti-tossing.) These funds were injected into the banking system this past year…the full $200 billion of them.  This can be added to the $376 billion mentioned in the previous paragraph to account for $466 billion of reserves going into the banking system. 

Third, the currency being demanded by the public mentioned above is supplied to the public by the Federal Reserve “on demand”.  That is, the Federal Reserve generally replaces the currency flowing out of the banking system into general circulation, dollar for dollar.  This past year, currency in circulation rose by about $93 billion.  Thus the $466 billion of the previous paragraph drops to $373 billion.

Fourth, the Federal Reserve has “pumped” dollars into the European banking system due to the sovereign debt crisis in Europe.  For example, Central bank liquidity swaps have increased by about $100 over the past year, most of the increase coming in the past six months.  This is not the only way the Fed influences what is going on internationally as the Fed holds other assets denominated in foreign currencies and also engages in reverse repurchase agreements with “foreign official and international accounts”.  If one roughly nets out the accounts associated with all of these type of transactions, we can say that the Fed roughly added another $104 billion to bank reserves which brings the total injection to $477 billion 

One final operating factor influences this total figure, payments into and out to the general account of the United States Treasury.  This fluctuates with tax payments and actual government expenditures.  The year-over-year drop in this account is about $28 billion and this brings the total increase in “reserve balances at Federal Reserve banks to $505 billion, which matches very closely with the $490 increase in excess reserves mentioned in the second paragraph of this post. (The difference is due to minor operating factors that we do not need to discuss.)

In summary, the Federal Reserve (and the U. S. Treasury) put a lot of reserves into the banking system this past year.  As usual, the Fed needs to take care of other operating factors that constantly impact the banking system, but in general, the injection of reserves came from the securities the Fed purchased as a part of the QE2, the dollars being advanced to European central banks to help relieve the pressures of the sovereign debt crisis, and the injection of funds into the banking system from the fiscal activities of the United States Treasury.

As of this time, the reserves going into the banking system have not been lent out…they are just sitting on the balance sheets of the commercial banks.  The extraordinary increase in the money stock measures are the result of the low interest rates that people can earn on their money balances and the need of people who are economically distressed to hole transaction accounts.

The efforts of the monetary authorities are not being felt, yet, by an increase in economic activity.

Interpreting the Recent Behavior of the Monetary Aggregates

All research seems to indicate that, over time and everywhere, inflation is a monetary phenomenon. If this is true then we need to take some account of monetary aggregates in the short run so as to better understand what is taking place and what the current situation implies for the future. Also, it seems as if interest in the monetary aggregates might be surfacing once again. (See my post, http://seekingalpha.com/article/217598-monetary-targets-a-fresh-take.)

Let’s look at the current situation beginning with the quarter that followed the start of the Great Recession, the first quarter of 2008. If one looks at the year-over-year growth rate of the M2 measure of the money stock, things look relatively benign. Growth remained modestly above 6% through the first nine months of

the recession, but rose to over 10% by early 2009. However, this did not signal that monetary policy was working even though the end of the recession has been dated as July 2009. In fact, in looking at all the other monetary measures one could discern some troubling behavior that might indicate a deeper recession and a very slow recovery.

For example, the behavior of this measure certainly did not track the performance of bank reserves or the monetary base. Through the first nine months of 2008, total reserves in the banking system averaged a little under 5%, year-over-year. In the second quarter of 2009, the rate of increase was over 1,800%! The monetary base performed in a similar fashion. For the first nine months of 2008, the monetary base grew around 2.5% year-over-year. This increased to more than 100% in the beginning of 2009.

Of course, we know the reason why these reserve aggregates grew so rapidly while the money stock measure picked up only modestly. Excess reserves in the banking system went from less than $2 billion in the second quarter of 2008 to over $800 billion in the first quarter of 2009. The Federal Reserve was supplying funds to the banking system. However, the banking system was just holding onto them!

There was another movement within the monetary aggregates that was also of interest during this time period. The growth of required reserves, the reserves the banks had to hold behind their deposits, rose throughout 2008 but not nearly at the pace of total reserves or the monetary base. Note, however, that the growth rate of the non-M1 component of M2 remained relatively constant throughout 2008 and 2009 which indicated that a lot must be happening within the M1 measure of the money stock.

Here we see that through the first six months of 2008, the M1 money stock hardly grew at all. However, starting in September 2008 which marked the beginning of the financial crisis, this measure took off and was growing by almost 17% in early 2009. Growth was mainly in the demand deposit component of M1.

Two things were happening here. First, interest rates fell dramatically in 2009; keeping money in interest bearing accounts at banks and thrift institutions did not make much sense. Second, as people lost jobs and the economic environment became more and more uncertain, people and businesses moved assets from less liquid vehicles to transaction balances (demand deposits and other checkable deposits) so as to be able to buy necessities and to pay bills.

It is very important to identify this behavior because it explains a lot about how people were using their wealth at this time and what kinds of pressures they were feeling. This information helps us understand why the economy is performing the way it is and what implications this kind of behavior has for the future.

Taking this analysis into 2010 we see that the growth rate of M2 drops off drastically to less than 2%, yet M1 continued to incease at rates in excess of 5%. This is because people continued to transfer funds from interest-bearing accounts into transaction accounts. This is supported by the information on the growth rate in required reserves which was still above 10%. Note, that because of this the Federal Reserve has needed to continue to supply more reserves into the banking system to handle this increase in required reserves yet maintain the extraordinarly high levels of excess reserves in the banking system, reaching more than $1.0 trillion in the fourth quarter of 2009.

What this indicates to me is that the behavior of people and of the business community has not changed much over the past two and one-half years. People are still scared. Because of the tepid economy, high unemployment, and the uncertainty about the future, economic units still prefer to put their funds into transaction accounts so that they can facilitate their needed expenditures. This kind of information does not give one much confidence.

Furthermore, this kind of behavior is not what is seen before economic recoveries pick up steam. And, with the M2 measure of the money stock growing below 2%, year-over-year, one can only conclude that money is not entering the economy in a way that will stimulate future business expansion. Only when bank loans begin to increase and, consequently, M2 begins to expand more rapidly, then, maybe, confidence in the recovery will grow.

To me, monetary information is very valuable in trying to understand what is happening in the economy and where the economy might be going. However, the analysis of monetary aggregates must not be the kind of “cookie-cutter” analysis done in the 1970s and 1980s. Good analysis of the monetary aggregates is very complex and must include some historical analysis with it.

What Banks Aren't Telling Us?

I am still worried about what banks aren’t telling us.

Why?

Total Reserves in the banking system have increased by $857.8 billion over the twelve month period ending in May 2009. Excess reserves in the banking system have increased by $842.1 billion in the same time period.

The Federal Reserve System has overseen a 1,900% increase in total reserve in the banking system, year-over-year, for the year ending May 2009, and banks have chosen to sit on the injection almost dollar-for-dollar!

These figures come from the Federal Reserve statistical release H.3 “Aggregate Reserves of Depository Institutions and the Monetary Base.” I have used the “not seasonally adjusted” data.

This is unheard of! In May 2008, excess reserves were $2.0 billion and stood at 4.5% of the total reserves in the banking system. In May 2009, excess reserves totaled 93.7% of the total reserves in the banking system.

Unless someone can convince me otherwise there are, in my mind, only three reasons for this behavior. The first is the volume of bad assets currently on the balance sheets of banks that have not been recognized. The second is the volume of bad assets that banks anticipate will be forthcoming over the next year or so. The third has to do with how the banks have funded themselves in the past several years.

If these assumptions are correct, the recession cannot be called over yet and any economic recovery that might be forthcoming is going to be relatively tepid or postponed for some time. I obviously hope that I am wrong but something just does not “foot” with the data that I have reported above.

In the first category, current bad assets on the balance sheet, one would think that we know a fair amount about them. Their volume was sufficiently large so that the government put into place the TARP program and then followed that up with the idea of the P-PIP. Several banks feel sufficiently strong that they are returning their TARP money and it appears as if the P-PIP will never be actually implemented.

Financial markets have responded favorably to these events. Yet, we know that there still remain a large number of bad assets in the banking system. The current confidence has allowed some banks to return the TARP funds wanting to get the “Feds” out of their buildings and out of their compensation committees. In addition, with the relative calm in both financial and economic markets, confidence has risen within the banking system that maybe they can ride out the rest of the way to recovery, hoping that many of the remaining bad assets will turnaround or be refinanced or be worked with.

In my experience working in the banking sector, “hope seems to spring eternal” when it comes to believing that bad assets will eventually become good assets. The attitude is that “with time” the borrowers will come through.

But, what kind of confidence is it that sits on $844.1 billion in excess reserves, funds that are earning no return to the banks? Required reserves in the banking system in May only totaled $58.8 billion. What am I missing?

Let’s look at the second category, that about debt coming due or repricing in the future. We have seen more and more reports in recent weeks about the Option Mortgages that are coming due over the next 18 months or so; we read about all the commercial mortgage debt that is on the edge and this was accentuated this week with the bankruptcy filing of Six Flags; and we know that credit card delinquencies are still rising. What we don’t know is the extent of the fallout from the bankruptcies in the auto industry and how this will impact those industries and regions that have depended upon a healthy car business. In addition, personal bankruptcies and small business bankruptcies continue to rise and there is really no firm information about when the increase in these will moderate and what the effect on the banking system will be.

Finally, there is the problem of financing the banking system itself. I recommend that you take a look at the article by Gretchen Morgenson in the June 14 New York Times, “Debts Coming Due at Just the Wrong Time.” (http://www.nytimes.com/2009/06/14/business/14gret.html?ref=business.) Morgenson writes about the debt of the banking system and the need for bank balance sheets to shrink. The banking system, itself, needs to de-leverage and may have to do so unwillingly.

In this article, Morgenson refers to a study by Barclays Capital that discusses the amount of debt of financial companies coming due over the next year or two. The figures, roughly $172 billion of debt will mature in the rest of 2009 and $245 billion will mature in 2010. This means that financial institutions will have to refinance about $25 billion a month for the next 18 months or so. Part of the problem in refinancing this debt is that “many of the entities that bought this debt when it was issued aren’t around any more.” Furthermore, in general, “few buyers of short-term bank debt are around now.”

Raising equity capital is fine, but, over then next few years, the banks may have a larger hole to finance in terms of the debt that it must try to roll over. This, of course, will put more pressure on the policy makers. The policy makers have gone out on a limb in attempting to protect the need to write down bad assets. The policy makers have provided capital for some of the banks that were in the worst financial shape. The next issue has to do with the need for the purchase of bank liabilities. This may be a very tough balancing act to complete successfully.

But, maybe the government has already provided the funds to meet these emergencies. Maybe that is why banks are holding such large amounts of excess reserves. They know that over the next 18 months that they are going to have a severe funding problem. Excess reserves are the perfect answer to paying off the debt as it runs off, leaving the banks with a lot of funds that still can buy them time to “work out” the bad assets that remain on their balance sheets.

When Will the Banks Start Lending Again?

The Federal Reserve, as we know, has been pumping all kinds of reserves into the banking system. For the banking week ended May 2, 2009, Federal Reserve Bank Credit stood at $2.041 trillion. This is up from $0.894 trillion for the banking week ending September 3, 2008, an increase of $1.147 trillion.

Total reserves in the banking system jumped from $44.1 billion in the month of August 2008 to $881.8 billion in the month of April 2009. This is an increase in total reserves in the banking system of $837.7 billion.

Note that the difference between the amount of credit the Federal Reserve extended to the economy and the increase in total reserves in the banking system is $309 billion, the amount of Federal Reserve credit that ended up in coin and currency outside the banking system.

This massive growth in total bank reserves can be picked up in the year-over-year growth in total reserves as represented in the accompanying chart. Note that the year-over-year rate of growth in total reserve for April 2009 is 1,924%.














The crucial point I want to make here, however, is that in the banking week ending September 3, 2008, Federal Reserve credit stood at $894 billion. The increase in total reserves at ALL commercial banks from August 2008 through April 2009 was $838 billion. In eight months the Federal Reserve added just about the same amount of dollars to commercial bank balance sheets that it had accumulated on its own balance sheet in the 94 years beginning in 1913!

And, what did the commercial banks do with the funds the Federal Reserve forced into the banking system. It sat on them. In the next chart we get a picture of the excess reserves of all commercial banks in the United States. We see the commercial banks are holding $824 billion in excess reserves. That is, in August 2008, the commercial banking system held between $1.0 and $2.0 billion in excess reserves. So, almost all of the increase in total reserves in ALL of the commercial banking system between the first of September 2008 and the end of April 2009 went into excess reserves! There was next to no lending going on in the whole banking system.

What happened to loan growth in the United States banking system? Well, in the fall of 2008 the year-over-year rate of growth in the loans and investments held on the balance sheets of all commercial banks was over 10%. In April 2009, the year-over-year rate of growth in loans and investments held on the balances sheets of all commercial banks was just over 2%. Loans in the commercial banking system increased by a little more than this number but, the decline in the loan series was even greater than what took place in loans AND investments.

The bottom line is that the banking system was putting out next to nothing in loans or in investments in securities. The banking system basically has sat on the reserves that the Federal Reserve has pumped into the economy.

There is only one conclusion that I can draw from the analysis of these data. Commercial banks are so petrified at their condition that they are not putting any money out into the business or financial community!

I don’t care what the stress tests show. Behavior speaks louder than stress tests! Commercial banks aren’t lending because they can’t take the risk that they will put any more bad loans onto their books. At least cash holds its nominal value and is not subject to default risk!

When will banks begin to lend again?

Unfortunately, I don’t like any of the answers I come up with that would account for them lending more in the near term.