May 6, 2020
In the wake of the economic meltdown caused by the government’s dramatic measures to halt the spread of the corona virus the Fed has leaped into action. It boosted its balance sheet by $2.2 trillion 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 $1.5 trillion in February to $2.9 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 have already been busy. Their loan portfolios have increased by $800 billion in the past two months. To put that in perspective, total bank loans increased $450 billion in 2019. In two months they have lent almost double they did all last year. The recent increase in lending has been almost exclusively to businesses. Commercial and industrial loan growth has climbed at annualized growth rates of 115% in March and 191% in April.
When banks lend to consumers and businesses, they put the proceeds into a checking account. At that point the money supply begins to grow. In March M-2 grew at a 21.0% annual rate. In April it climbed by 46%. Those are funds that businesses can use to pay their workers, pay the rent, and keep the lights on.
The point of all this is that, to its credit, the Federal Reserves has stepped into the credit void to make sure that banks have adequate funds to lend to businesses to keep the economy functioning – however slowly – for a while. If the virus begins to show signs of slowing down, some businesses will be permitted to re-open and the economy can begin a gradual recovery.
Stephen Slifer
NumberNomics
Charleston, SC
Steve, absolutely fascinating. I just worry about my income and expenses and trust that the Feds know what they are doing. It appears that they do. Hope I am right.
Darrel Staat
Steve,
How will the Fed drain the reserves? If the Fed increased the reserved by buying securities, will they decrease the reserves by selling securities from their portfolio? I’m trying to square this with the statements that they’re going to just let the securities in their portfolio mature.
Also, if the Fed is trying to induce inflation, why do they want to neutralize the reserves by raising interest paid on them? Wouldn’t they want to have the banks start to utilize some of those reserves?
Is inflation caused by dumping more money into the system different somehow from (worse than?) inflation caused by a tighter labor market?
Always appreciate your insight.
-Pat
Hi again,
As you point out, the Fed does not intend to sell securities to drain those surplus reserves. But if it lets them mature and does not replace them it can get to the same place — it just takes a lot longer. Given the average maturity of its debt that would probably take about 10 years.
You are right again that the Fed would like to see a bit more inflation. And, in fact, that is probably what is happening right now. It seems like the underlying rate is beginning to pick up. The Fed would love to see the banks utilize some of those reserves by lending money to you and me and various businesses. But the banks are facing requirements to boost equity and, at the same time, every time we turn around they are subject to some new regulation. I think this Dodd Frank law, frankly, has gotten a bit out of hand. The other problem is that they need somebody willing to borrow. Right now consumers are borrowing, but very slowly. And corporations are not interested in investment so they haven’t been showing up on bank doorsteps looking for money. In addition to which they are holding a record amount of cash which they could use for investment if they were so inclined. Bottom line is, I don’t see anybody lining up to borrow. Banks can’t lend if nobody is on the other side.
Having said all this, in our economic nothing ever seems to happen gradually. Right now everybody, myself included, is expecting inflation to pick up gradually. But oil prices are no longer falling. Hence, one thing that has been holding down inflation has disappears. The dollar has stopped rising. When it was rising, imported goods prices were falling. That is not happening anymore. Wages have, at long last, begun to rise. Hence, in my mind, there is a risk that inflation could pick up next year faster than anybody expects. That would force the Fed to speed up the pace of tightening. Not my expectation — but probably more of a fear for me than the economy dropping out of bed.
Thanks for your note.
Steve
Thanks for all the commentary.
I’m still trying to understand why the Fed is paying interest (raising rates) on the reserves, particularly if there is not enough demand to borrow. Seems like the Fed is just wasting money in that case.
Thoughts on that?