Current Analysis of Bank Reserves, Money Supply, Money Velocity, and Monetization

Discussion in 'Economy' started by gonegolfin, Jan 23, 2009.

  1. gonegolfin
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    gonegolfin Member

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    Current Analysis of Bank Reserves, Money Supply, Money Velocity, and Debt Monetization

    Gaining insight into where the economy and financial markets are heading requires, among other things, some knowledge of the monetary system, the various indicators and statistics published on a periodic basis, and the ability to interpret the actions of the Federal Reserve, Treasury, and government in general. Particularly in this environment where the markets are in turmoil and the banking and financial industry is in shambles ... and particularly in an environment where the Fed and Treasury have taken over roles that should be held by the private sector. That is, the undue influence of the Fed and Treasury in these times requires investors to pay particular attention to their actions, whether they are up front and center or they require a bit of unearthing. Several of these types of items were discussed in my essay published last month (included below).

    I have discussed non-borrowed reserves on several occasions, the last time being in October when they were heavily negative reaching over -$360 billion. Non-borrowed reserves are simply the total reserves of all the depository institutions (banks) in the Fed system minus the total borrowings of these same institutions from the Fed. A negative reading means that on the whole, banks actually have negative real reserves. To meet reserve requirements, banks have borrowed vast sums of money from the Federal Reserve in the past year. But the plummeting of non-borrowed reserves took place when the Fed was sterilizing most of its monetary injections (see below article). Now with the Fed engaged in quantitative easing, net reserves are being added to the banking system (new money is being created). The result is that non-borrowed reserves have turned positive, in fact significantly so. Non-borrowed reserves turned positive in December and are $338.633 billion (not seasonally adjusted) as of 1/14, while total borrowings from the Federal Reserve have actually declined modestly to $562.358 billion. The result is a pile of excess reserves held in aggregate by the banking system. Reserves that the Fed feels are required to keep the banking system afloat.

    All of these newly created reserves (remember that only the Fed can create bank reserves) have led to an explosion of the monetary base, discussed here several times in the past. Total reserves of the banking system as of 1/14 are $900.991 billion, with excess reserves totaling $843.508 billion. The result is a monetary base that continues to rise and is now $1.752007 trillion (more than double what it was in September). Meanwhile, the M1 and M2 money supply aggregates are beginning to grow in the last several months, but not alarmingly so. M1 has grown about 7.5% since the beginning of September while M2 has grown 6.6%. The banks are sitting on a pile of reserves, which are needed to cushion their deathly ill balance sheets. Banks are lending, just not near the recent peak levels. Aggregate lending is down, but still near 2006 levels. Real Estate lending has been hardest hit, but loans are still taking place at about early 2004 levels (peak was in 2006). There is also less incentive for the banks to lend at present (also discussed in the article below). It is worthy to note that the monetary base has now exceeded the M1 money supply. This tells us that the money multiplier has been decreasing and is now less than 1. So while lending in aggregate is still happening, lending relative to the amount of bank reserves is extremely low.

    Lending is not the only way the money supply can grow. The Fed can encourage investment of these excess reserves ... such as in treasury bills and bonds (which in this case is lending to the government). But I suspect this will only happen when the Fed unplugs the drain (ceases to pay interest on excess reserves held on deposit with the Fed). I suspect that the Fed intends to encourage treasury investment (by the banks using these excess reserves) when it comes time to float more treasury debt. With the size of the stimulus package and other bailout provisions being discussed by our political leaders, this time will be soon in coming.

    But also a key component in the reversal of falling prices and declining economic output is the velocity of money, which has been declining. Money velocity is the frequency with which a given unit of money is spent, measured in a specified period of time. A typical measure of money velocity can be found in the equation P = M * V. Here, P represents Gross Domestic Product (GDP), M represents a given money supply aggregate (say M1, M2, or TMS), and V represents the velocity of money. Hence, with the velocity of money dropping, a similar increase in money supply is necessary to achieve a constant level of economic output. Money supply has been growing modestly while GDP has been falling, thus the velocity of money has also been falling (at a greater clip than money supply has been growing). Troubling inflation is typically the result of governments attempting to extricate the economy from a deflationary downturn (which we are certainly experiencing). The harder the downturn, the greater the risk of problematic inflation in the subsequent cycle as governments will be more aggressive and typically overreach. Should the banks increase their lending and investment (fueled by their mountain of bank reserves) and money velocity picks up once again, the Fed will suddenly have a serious inflation problem on its hands (in addition to the inflation potential represented by massive amounts of US Dollar reserves being held overseas). Accurate Fed timing in the draining of reserves from the banking system (while not crushing the banks) will be crucial in managing this inflation ... something with which the Fed has had a poor track record. It usually goes like this ... 1) Horses stampede out of the barn 2) Farmer closes the barn door. With the banking system arguably insolvent at present, the Fed may have little option other than keeping the barn door open.

    Recent Fed actions indicate that bank reserves will continue to grow. The Fed recently (1/5) commenced purchases in its Agency Mortgage-Backed Securities (MBS) Program (New York Fed Begins Purchasing Mortgage-Backed Securities - Federal Reserve Bank of New York). That is, the Fed is now monetizing agency backed mortgage-backed securities (Fannie Mae, Freddie Mac, Ginnie Mae, and Federal Home Loan Bank). This shifts more risk from the lending institutions to the Fed ... and by extension our currency. Through 1/21, $52.627 billion in MBS purchases have been made by the Fed (Agency Mortgage-Backed Securities Purchase Program - Federal Reserve Bank of New York) and this number will be growing as the program cap is $500 billion. These are outright purchases (permanent open market operations) where the Fed creates new money by crediting the selling primary dealer reserve account held at the Fed (Federal Reserve Bank of New York - Permanent Open Market Operations). These are not part of one of the Fed lending programs (Ex. TAF), nor are they temporary open market operations that will shortly be unwound. The Fed feels this is necessary due to a significant drop in foreign ownership. China has been a net seller of agency debt and agency mortgage-backed securities in recent months, although total US Dollar reserves held by the Chinese continue to increase.

    Finally, there have been rumors that the Fed may shortly begin the outright purchase of longer dated US Treasury bonds. This would be the Federal Reserve monetizing the debt of the Treasury. The Fed has not monetized treasuries during this financial crisis (in fact, it has sold treasuries from its portfolio). It has merely accepted treasuries as collateral in its various lending facilities and in temporary open market operations. The outright purchases of mortgage-backed securities and treasuries adds these specific assets to the asset side of the Fed balance sheet, thus increasing bank reserves and the monetary base. As for the targeting of long term treasuries, 1) the Fed is under more pressure to keep a ceiling on long term interest rates and 2) will likely need to support large amounts of newly issued treasury debt in the near future. Its goal is to keep mortgage lending cheap and these programs would do just that, though in an artificial manner that devalues the currency once this money works its way into the economy. This pressure comes as there is evidence China is de-emphasizing long term US treasury debt in its US treasury holdings. While overall Chinese purchases of US treasuries continue to rise, the increases are coming at the short end of the yield curve. Meanwhile, China has recently been a net seller of longer dated treasury bonds as they fear a fall in the value of the long bond. This may force both the Fed and the banks to purchase longer dated treasuries (more purchases in the case of the banks) to cover the shortfall. Might the average maturity of outstanding US Treasury debt held by foreign official institutions be declining in the future? I think it will.


    Reference statistical releases:
    FRB: H.4.1 Release--Factors Affecting Reserve Balances--January 22, 2009
    FRB: H.3 Release--Aggregate Reserves of Depository Institutions--January 22, 2009
    FRB: H.6 Release--Money Stock and Debt Measures--January 22, 2009
    FRB: U.S. Reserve Assets and Foreign Official Assets Held at Federal Reserve Banks--December 2008
    Agency Mortgage-Backed Securities Purchase Program - Federal Reserve Bank of New York
    Federal Reserve Bank of New York - Permanent Open Market Operations
    FRB: G.20 Release--Finance Companies--December 23, 2008
    FRB: H.8 Release--Assets and Liabilities of Commercial Banks in the US--January 23, 2009
    Institutional - Announcement & Results Press Releases


    Previous essay ...
    http://www.usmessageboard.com/economy/66033-interpreting-fed-policy.html#post947243

    Brian
     
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  2. Toro
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    Toro Diamond Member

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    Brian

    Excellent article, thanks. Please continue commenting in the future on what you are seeing in the Federal Reserve System. I usually don't learn much of consequence in forums, but these posts are certainly substantive.

    A few things. First both gold and silver continue to act well. Gold appears to be running into resistance at these levels but silver appears to be forming a good base. This may be indicative of future inflation.

    Also, I thought I had read in Grant's recently that Chinese reserves were declining, though perhaps I am remembering incorrectly.
     
  3. editec
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    editec Mr. Forgot-it-All

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    Why does the FED want to keep banks afloat? The ONLY people the FED should be keeping afloat are the DEPOSITORS in those banks. FDIC style.

     
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  4. RodISHI
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    RodISHI Gold Member

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    It is falling on deaf ears ed.

    The final solution you have there though is an interesting one. If we can be patient enough though this too will come to pass. That is if the people do not rise up in the mean time.
     
  5. Neubarth
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    Neubarth At the Ballpark July 30th

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    The Fed can move money all it wants. What we need is to put people to work so they can spend their paychecks. One program that I can see would work would be to employ a million ORCS.

    Whatsa ORC you say?

    An ORC is a ten dollar an hour laborer who is responsible for Outside Refuse Control. Just like in Mexico, they can be given a 50 gallon can with wheels on it, a welded handle so the can can be moved down the street like a dolly. The individual would then have a street broom and a flatblade shovel (Coal Shovel), and they would be tasked with sweeping the streets in a specified ten block area. If they can not keep the streets clean in their ten block area, they will be fired, but if they are doing a good job, they can receive regular bonuses of a dollar an hour for each year of service up to $15 an hour.

    That should keep a million people at work and get our cities a lot cleaner while we try to work our way out of this looming Depression..
     
  6. editec
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    editec Mr. Forgot-it-All

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    Giving money to people who DO SOMETHIGN USEFUL for it make a hell of a lot more sense than giving it to people who do nothing but leand it AT INTEREST to people who plan on doing something useful with it, don't you think?

    The banker class, as it is currently set up, is a class of PARASITES.

    It fucking amazes me that we bitch and whine about welfare mothers when the real recepients of welfare are the banking class which screwed up our economny.

    And it fucking amzes me even more that those same assholes are being saved when giving them more momney doens't put ANYBODY to 3
    work, too.

    WORKING PEOPLE ARE THE SOURCE OF ALL REAL WEALTH.

    Not money in banks, the work of people is what makes the world go round.

    The bankers have so bamboozled most of you that you honest think MONEY is wealth.

    Sheer fucking nonsense, of course.

    Money is a way keep score, at best.
     
  7. gonegolfin
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    gonegolfin Member

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    Thanks Toro. That is kind of you.

    The resistance I have been watching in Gold is the $888 -> $890 level. I think that if we can close above that level for a few days, Gold will break further to the upside. It is above all of its major daily and weekly moving averages. It will have some resistance to deal with at the $930 level.

    I agree that Silver seems to be forming a base. It decisively broke out over the $11.50 level that has been giving it trouble for a couple of months. There is some good resistance at the $13.50 level.

    The interesting thing is that Gold and Silver have been performing well in the last week or so amidst a strongly rising Dollar (and falling equity markets). My best guess here is that there has been more flight to safety and more bets that the stimulus and bailouts will be inflationary in the not too distant future (I have been of the opinion that we will be mired in a downturn for a while). And now, flight to safety has been including more precious metals in addition to the typical short term treasuries.

    I did not read Grant's. But everything I have been reading for a while has the Chinese trade surplus growing as their imports are declining much faster than their imports. Chinese holdings of agency debt and agency MBSs have certainly been falling. But the Chinese have drastically stepped up their short term treasury purchases to cover this shortfall as well as the declining purchases of long term treasuries. I think that if you look at the 10-year and 30-year recently, it makes sense.

    Brad Setser (economist for the CFR that previously worked for Roubini) covers this extensively on his blog as he specializes in international money flows.

    Brad Setser: Follow the Money

    A particular article of interest that covers money flows through November (before a significant rise in long term treasury yields) ...
    http://blogs.cfr.org/setser/2009/01/16/a-few-quick-words-on-the-november-tic-data/#more-4509


    Brian
     
    Last edited: Jan 24, 2009
  8. editec
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    editec Mr. Forgot-it-All

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    I thought we stopped issuing 30 year T-bills.

    Or am I not understanding what you're talking about or are you talking about the secondary market for those that are extant?
     
  9. gonegolfin
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    gonegolfin Member

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    Because the banks are the Federal Reserve System.

    Yup. But I would not say "given". The Fed purchases assets from the primary dealers (at discount based on the quality of the collateral) and credits the proceeds in the reserve account of the selling primary dealer at the Fed. This is how bank reserves are created. As for the interest being paid on excess reserves, this is another form of sterlization that the Fed utilizes. See my December essay again (linked at the bottom of this essay) which discussed this. You may have missed it the first time around.

    I think the Fed is attempting to get the bank balance sheets healthy by adding massive reserves to the banking system (which is not inflationary in and of itself). I think they are also attempting to recapitalize the banks while minimizing inflation. These disincentives prevent the banks from lending and investing immediately and in mass (which would cause severe inflation). I also think that they want to time it such that these reserves are used to purchase tremendous amounts of treasury debt that must be purchased in upcoming auctions. Especially in light of waning foreign participation.

    Some time ago, yes.

    You crack me up sometimes.

    To attempt to unconfuse you ... I am sure that you realize that the Treasury will need to auction significant amounts of debt in the coming months to fund the remainder of the TARP (for the parts that have not been funded by auction yet) as well as the stimulus bill and any other bailout provisions. The Treasury needs buyers, else interest rates will soar. Foreign official institutions such as China are already beginning to net sell their longer dated maturities (treasuries). The 10-year and 30-year bonds are down significantly since the middle of December (yields are up significantly).

    The $850 billion in excess reserves constitute a nice pool of cash with which the banks could use to invest in treasury bonds (with the implicit promise by the Fed that they will also work to keep intermediate to long term interest rates low by monetizing debt as needed). This would give the banks additional yield with which they could use to recapitalize. As opposed to riskier lending to the consumer. But to encourage the banks to do so, they would need to lift the free yield the banks are getting on their excess reserves (which was instituted last Fall).

    Brian
     
    Last edited: Jan 24, 2009
  10. gonegolfin
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    gonegolfin Member

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    Yes. 30-year treasury bonds trade in the secondary market and are held by foreign official institutions.

    BTW, the 30-year treasury bond was brought back in February of 2006. For obvious reasons ...

    Brian
     

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