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
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?