The Back Alley Archives

I have mentioned several times in past weeks that the monetary base is now increasing. You can consider the monetary base to be the bottom most layer of the money supply (the core). It is the base from which banks lend in our fractional reserve system. The monetary base consists of currency in circulation (which is M0), cash held in bank vaults, and cash on deposit with the Federal Reserve as reserves. The Fed obviously has direct power over the monetary base, but only has indirect influence on fractional reserve lending by the banks (and thus the other monetary aggregates). This is why the Fed can "print"/"create" all of the money it wants (assuming that it has an adequate supply of treasuries in the secondary market to buy) and it will not have an impact on inflation if the banks do not put it to use and instead hoard as reserves. Well, this is the problem that the Fed and Treasury are having with the banks. The Fed has funneled all of this new money to the banks (through both lending programs and bailout/injection programs), but the banks are not lending it out as demanded by the Fed and Treasury. They are sitting on it in anticipation of rough times ahead. See http://news.yahoo.com/s/ap/20081028/...ncial_meltdown.

How will we know that the banks have begun lending? We should look at the broader money aggregates, namely M1 and to some extent M2. M1 is M0 (currency in circulation) plus mostly demand deposits and other checkable deposits. Since reserves are not part of the circulating money supply, they are not included in M1. M1 will begin increasing when the banks begin lending in aggregate their now plentiful reserves ... albeit, these are reserves net loaned from the Fed as non-borrowed bank reserves are nearly -$364 billion as of Wednesday 10/24. In last week's Fed H.3 report, the monetary base (not seasonally adjusted) grew to nearly $1.149 trillion, up nearly 14% in just two weeks (see Note: below). This is up 26% since 9/10, approximately when the Fed began its program of quantitative easing. The following chart from the St. Louis Federal Reserve Bank depicts the dramatic rise in the Adjusted Monetary Base (similar to the monetary base cited above, with seasonality factored in) ... http://research.stlouisfed.org/fred2/series/BASE. However, M1 has declined a bit in recent weeks ($1.412 trillion on 10/13 vs. $1.532 trillion on 9/29) and is up only about 3% from 9/8 ($1.368 trillion). Year-over-year, M1 has increased only about 3.5% (using the latest 10/13 figures). The banks are obviously not putting this new money to use in creating new loans and expanding the money supply. The Fed and Treasury are getting desperate as they know that the refusal of banks to lend in aggregate will result in more asset deflation and potentially a deflationary spiral.

How far will the Treasury, Fed, and Executive branch go in encouraging (with force) the banks to lend such that our ever increasing economic problems can be kicked down the road a bit? There are various forms of pressure the Fed can apply to persuade the banks to lend. This could include the Fed/Treasury making an example of a few banks that are not cooperating. This could come in the form of banks being shutout from the bailout funds and/or enhancing rival/competitor banks resulting in takeovers. The Fed could also enact broad measures by draining a specific amount of reserves from the system (while propping up the cooperating banks with targeted funding). These broader measures could be implemented by reversing the quantitative easing program currently being conducted by the Fed. They could also be implemented by the cessation of loan rollovers from the staple Fed lending programs (TAF, TSLF, etc.). This would be yet another example of the Fed/Treasury picking the winners and losers, something that has been a focal point of policy to date.

If the lenders do begin lending again in aggregate off of this vastly expanded monetary base, I think we will likely see serious inflation (monetary and price inflation) and a massive bubble in something (all other things remaining equal, such as the derivatives time bomb). Such a bubble will make the housing bubble seem like child's play. However, if the current deflationary forces win (and bank lending will be a primary indicator), we can fall into a major deflationary spiral. You simply cannot call it at this point and should prepare for both possibilities. I simply keep looking at the numbers for evidence.

As for the Fed cutting the target for the federal funds rate today from 1.5% to 1.0%, this is mostly a non-event. All this did was signal to the market that the Fed will continue the injections of liquidity at the present rate for the intermediate term. The federal funds rate has been trading under 1% for the last two weeks (due to the Fed injecting massive amounts of reserves into the system). So, you will not see any additional liquidity in the system due to a target rate cut today (the target was already being implemented). In fact, the fed funds rate has been effectively trading at the floor set by the rate now paid on excess reserves by the Fed. The rate paid on excess reserves is now 35 basis points (down from 75 basis points) under the target rate for federal funds (this was also a signal that a rate cut was coming). Thus, with a 1.0% target for federal funds, the Fed is now paying banks 0.65% interest on excess reserves on deposit with the Fed. Thus, banks are not going to lend money in the federal funds market for less than they can receive by leaving those reserves on deposit with the Fed. This allows the Fed to engage in quantitative easing (injecting new reserves into the system - expanding the monetary base) without driving interest rates to zero. Allowing the overnight lending rate to fall to 0% did not work out well for Japan.

Note: Bank reserves, averaged throughout last week, increased $20.2 billion to $301.27 billion (this is the number used in the calculation of the monetary base). However, the amount of reserve balances on deposit with the Fed at COB Wednesday 10/22 fell substantially to $220.762 billion (see H.4.1 report). Since the H.3 report calculates the monetary base using an average for reserves, the monetary base number published this week may be a bit inflated when compared to an actual calculation of the monetary base on 10/22.

Brian