February 15, 2022

In the wake of the economic meltdown caused by the government’s dramatic measures to halt the spread of the corona virus the Fed  leaped into action.  It boosted its balance sheet by about $3.0 trillion in March and April primarily via purchases of U.S. government securities.  When it purchases government securities the proceeds of the transaction are put into a bank’s “reserves” account at the Fed.  Think of this as that bank’s checking account.  Excess reserves in the banking system have jumped from $1.75 trillion in February 2020 to $4.2  trillion.  This measures the ability of the banking system to make additional loans.  Banks are awash in funds just waiting to be lent to needy businesses.

Banks were busy in those two months.  Their loan portfolios increased by $700 billion in March and April 2020.  To put that in perspective, total bank loans increased $450 billion in 2019.  In two months they lent almost double they did in the previous year.

Most of the March/April increase in lending was to businesses.  Commercial and industrial loans climbed by $600 billion in that 2-month period of time as businesses wanted to be sure they had enough liquidity to stay afloat during the crisis.  However, the recovery happened much more quickly than anticipated and with more vigor, so businesses did not need all the funds that they borrowed and C&I loans have fallen steadily until October of 2021 when they finally began to grow again.

When banks lend to consumers and/pr businesses, they put the proceeds into a checking account.  At that point the money supply begins to grow.  In March 2020 M-2 grew at a 42.0% annual rate.  In April 2020 it climbed by 77%. The Fed flooded the economy with liquidity in an effort to get it out of the deepest recession ever recorded.  It worked.  After declining 31% in the second quarter GDP growth surged in the third quarter by 34% and it has been growing fairly rapidly since, registering 5.5% growth in 2021.  M-2 growth has subsequently slowed and in the past year it M-2 has climbed by 13.1%  Those are funds that businesses can use to pay their workers, pay the rent, and keep the lights on.

But with its purchases U.S. Treasury securities and mortgage-backed securities in March and April 2020 and additional monthly purchases every month since, the level of M-2 is far higher than it would have been had it grown at its steady trend rate of 6.0%.  In fact, it is now $4.1 trillion higher than it should be.  Those are funds slopping around in the economy that allow businesses and consumers to spend freely.  Given that the economy is now at full employment, that additional spending is what is causing the inflation rate to rise quickly.  Inflation will not decline significantly until the Fed shrinks the money supply back into link with long-term growth path.  That is unlikely to happen any time soon.

The point of all this is that, to its credit, the Federal Reserve stepped into the credit void to make sure that banks had adequate funds to lend to businesses to keep the economy functioning during the 2-month 2020 recession.  But it should have begun to remove some of that surplus liquidity long ago.

Stephen Slifer


Charleston, SC