Wednesday, October 14, 2009

The Fed Tries to Figure Out How to Control the Money Supply, It's a 'Top Priority'

The Fed Open Market Committee minutes are out. Of note in the minutes:

The Fed discussed the extremely high excess reserves. They clearly expect banks to only start loaning out against these reserves slowly. That could very well be the case, but there is certainly no data, or theory, to back this up. It is probably just as likely that a rapid employment of excess reserves could occur. Bernanke's use of new "tools" to control money growth further complicates the matter. The minutes state:
The staff also briefed the Committee on the likely implications of very high reserve balances for bank balance sheet management and for the economy. The staff's assessment, based in part on consultations with market participants, was that many banks were currently comfortable holding high levels of reserves as a means of managing liquidity risks, and these balances or further increases along the lines implied by the announced programs were not likely to crowd out other lending through pressures on capital positions. As the economy improves, however, banks could seek to lower their levels of reserve balances by purchasing securities, thereby putting downward pressure on market interest rates, or by easing their credit standards and terms in order to expand lending. Such effects, if significant, would provide further impetus to economic growth. The staff analysis indicated that these effects would likely emerge only gradually and that their magnitude could be quite limited. However, some participants thought that declining demand for reserves might already be putting downward pressure on yields. Participants expressed a range of views about the likely stimulative effect of a further expansion of reserve balances on economic activity, as well as the potential impact of elevated reserves on inflation expectations. Some meeting participants noted that the announced decrease in the balance in the Treasury's Supplementary Financing Account (SFA) would increase reserves in the banking system unless it were offset by Federal Reserve actions or by a further reduction in borrowing from the Federal Reserve's various credit and liquidity facilities, and that these increases could be expansionary. Others noted that the decrease in the SFA could well be temporary and, in any event, that the macroeconomic effects of the increase in reserves would probably be limited in the current environment.
The Fed is also apparently uncomfortable with relying on interest rates payments on excess reserves as the sole method of controlling money growth, since the Fed discussed methods of draining reserves to control money growth:

The staff presented an update on the continuing development of several tools that could help support a smooth withdrawal of policy accommodation at the appropriate time. These measures included executing reverse repurchase agreements on a large scale, potentially with counterparties other than the primary dealers; implementing a term deposit facility, available to depository institutions, to reduce the supply of reserve balances; and taking steps to tighten the link between the interest rate paid on reserve balances held at the Federal Reserve Banks and the federal funds rate. Participants expressed confidence that these tools, along with the payment of interest on reserves and possible sales of assets from the System's portfolio, would allow them to remove policy accommodation at the appropriate time and pace. Completing development of these tools would remain a top priority of the Federal Reserve.
In the middle of a crisis, for the Fed to state it is "completing development of these tools" as a "top priority" has to be a scary thought. Shouldn't the Fed simply be operating with tools known to work, such as, the discount rate, the Fed Funds rate and reserve requirements? This tinkering with new tools, in the middle of a crisis, suggests a mad scientist side to Bernanke's personality with the global financial system as his laboratory.

The minutes also point out to the degree government manipulations are impacting the economy, specifically its impact on the auto industry:

The information reviewed at the September 22-23 meeting suggested that overall economic activity was beginning to pick up. Factory output, particularly motor vehicle production, rose in July and August. Consumer spending on motor vehicles during that period was boosted by government rebates and greater dealer incentives, and household spending outside of motor vehicles appeared to rise in August after having been roughly flat from May through July. Although employment continued to contract in August, the pace of job losses slowed noticeably from that of earlier in the year. Investment in equipment and software (E&S) also seemed to be stabilizing. Sales and construction of single-family homes during July and August, while still at low levels, were significantly above the readings at the beginning of the year. The sharp cuts in production this year reduced inventory stocks significantly, though they remained elevated relative to the recent level of sales. Core consumer price inflation continued to be subdued in July and August, but higher gasoline prices raised overall consumer price inflation in August.
Now that this program is over, now what? A major crash in the auto industry? These are bizarre distortions to create.

The notes also show some discussion of the decline in the M2 money supply measure:

After declining in July, M2 contracted more quickly in August. The reduced demand for M2 assets likely reflected low interest rates on retail deposits and money market mutual fund shares, as well as a continued reallocation of wealth toward riskier assets. Small time deposits and retail money market mutual funds fell more sharply in August than earlier in the year. Liquid deposits increased in August, but at a slower rate than in July. Currency expanded less rapidly in July and August than in the first half of the year, as demand from abroad evidently was restrained.
LOL Liquid deposits increasing is not a sign of a move to more risky assets. Further, the Fed seems to want to blame this decline in m2 as a move into risky assets (stocks?) rather than the fact that banks are not lending money out, even though no other period of advancing stock markets has correlated with a decline in M2. Here's the Fed on the decline in lending:
The level of debt of the private domestic nonfinancial sector declined again in the second quarter, as both household and nonfinancial business debt fell. Consumer credit posted its sixth consecutive monthly decline in July; both revolving and nonrevolving credit showed sizable drops. While issuance of consumer credit asset-backed securities decreased in August, a large volume of securities eligible for the Term Asset-Backed Securities Loan Facility was issued in early September. Gross bond issuance by nonfinancial corporations rose in August following a lull in July; the rebound was particularly robust for speculative-grade firms. However, commercial paper outstanding was unchanged and bank loans fell again; as a result, borrowing by the nonfinancial business sector declined, on net, again in August. In contrast, the federal government continued to issue debt at a rapid pace, and gross issuance of state and local government debt was robust, supported in part by issuance of Build America Bonds authorized under the fiscal stimulus program.

Commercial bank credit contracted further in August; all major loan categories declined. Commercial and industrial (C&I) lending again decreased steeply amid reported broad-based paydowns of outstanding loans. At the same time, the latest Survey of Terms of Business Lending showed that C&I loan spreads over comparable-maturity market instruments rose noticeably in recent months. The contraction of commercial real estate loans held by banks also intensified in August. Even though originations of residential mortgages apparently increased during August, banks sold an unusually large volume of loans to the government-sponsored enterprises; consequently, banks' balance sheet holdings of residential mortgages decreased markedly.
The full minutes are here.


  1. My biggest fear: sling-shot inflation. I have no idea if this is a real "economic term" but it seems like this could occur at any point. There is a LOT of money out there (even though the printing press' have eased/stopped) that just isn't being lent out. At some point the government will create an unnatural push on the banks to "get the economy moving" just as the dollar slips even further....BAM! 8% inflation in a matter of weeks.

    Thoughts? Right? Wrong? Crazy?

  2. "Sling shot inflation", I like it.

    It can't be ruled out. Mostly likley, I think it could start by panic selling of dollars by foreigners.