Since the start of Quantitative Easing, which was better described by Bernanke in his famous Oct.8, 2009 speech as ‘Credit Easing’, we have seen the Federal Reserve balance sheet grow to $3.42 Trillion last week in the assets side of the balance sheet. This growth in assets from the inception of QE has been in the following categories:
(1) Short-term lending programs (up to 90 days) that provide backstop liquidity to financial institutions such as banks, broker-dealers, and money market mutual funds: These lending programs had full collateralization and constituted a small part of the total monetary base.
(2) Targeted lending programs, which include loans to nonfinancial borrowers and are intended to address dysfunctions in key credit markets: Commercial Paper Funding and Term Asset backed securities are the primary ones, when the securitization market almost fell off the cliff, this provided the necessary fillip and backstop. This component has also come down as percentage of the total.
(3) Holdings of marketable securities, including Treasury notes and bonds, the debt of government-sponsored enterprises (GSEs) (agency debt), and agency-guaranteed mortgage-backed securities (MBS). Agency backed MBS forms the bulk of this and Bernanke mentioned that “30-year fixed mortgage rates, which responded very little to our cuts in the target federal funds rate, have declined about 1-1/2 percentage points since we first announced MBS purchases in November, helping to support the housing market”, was one of the key benefits that accrued. This category includes Fannie and Freddie amounting to $1.18 Trillion alone and holding of Treasuries have increased to $1.178 Trillion. This component is the bulk of the Fed Balance sheet assets and is growing constantly.
(4) Emergency lending intended to avert the disorderly collapse of systemically critical financial institutions: This mainly constituted the emergency measures related to Bear Sterns and AIG. This component currently is virtually very small.
The second and fourth categories were more aimed at bringing the credit markets back on track immediately after the crisis and have now tapered off. The real increase has happened in the categories 3 and 1 as far as the assets are concerned.
On the other hand if one looks at the liability side of the balance sheet, very little attention has been drawn to it and Bernanke has been candid about it, “Although the Federal Reserve’s approach also entails substantial increases in bank liquidity, it is motivated less by the desire to increase the liabilities of the Federal Reserve than by the need to address dysfunction in specific credit markets through the types of programs.”
The fact remains that the liability side of the balance sheet consists of more than $1.96 Trillion of the excess reserves that the commercial banks have parked in the Fed (this is above the mandatory 10% reserves that they already hold on their own balance). The purpose of increasing the monetary base was to allow commercial banks to lend but we have seen a slower speed of M2 growth (currency, checking accounts, savings deposits, small time deposits, and retail money fund shares).
Bernanke did hint on the lowering of interest on excess reserves as a means to tackle the problem of the bloating liability side, but going by what has happened in the ECB, very little changed in decreasing the excess reserves, so perhaps this instrument is more of an academic discussion than anything real happening on the ground, although the subject has come up many times in Bernanke’s speech.
Bernanke, apart from his reference to working on interest on excess reserves had hinted on four other areas as his exit strategy:
-Wind-down of short term lending
-Reverse re-purchase agreement
-Time deposits for depository institutions
-Run-offs and Assets sales
Even after three and half years from making these presentations, Bernanke has not yet initiated anything remotely close to these statements as given in his speech on Oct.8, 2009.
Why there is so little attention on the excess reserves problem on the liability side of the balance sheet and so much attention on the monetary base and the asset side of the balance sheet? With mounting excess reserves which would attract interest payments and with rising interest rates Fed would be sitting on a liability of Billions of dollars of IOERs. This money which is not in circulation while creating the illusion of expansion of the monetary base needs a greater scrutiny.
The chart of St. Louis Fed shows the M1 Multiplier at much less than 1, while the same in the period 2004-2006 was at 1.7, this is at the wake of almost negligible excess reserves in the same period.
The expansion of the monetary base to $3.1 Trillion includes the impact of the excess reserves, which does precious little to move to goods and services, which is what it was originally meant to do. In fact the monetary transmission @$85 Billion a month has $50 Billion moving to excess reserves if one sees the development of these reserves since the time the expansion started.
The entrapment of some sorts was unwound by the Scandinavian countries, Sweden in particular, by putting a negative interest rate on reserves to discourage commercial banks from parking those reserves in the central bank. ECB reduced the rate and Fed had been constantly toying with the idea, but Bernanke has been on record stating that it could discourage the small investors away, thus the stalemate continues and the tax-payers indirectly are bearing the costs which could be rising as the reserves keep piling and the interest rates eventually rise.
The excess reserves, coupled with the excess cash that S&P 500 hold are two very strong reasons why further easing makes no sense till the excess reserves are drained from the system into activities that produce goods and services; Capital invested in production, not money in circulation for consumption, is where the attention needs to be diverted and any excess liquidity which could distort markets (as it has been the case) should be taken out of circulation expeditiously.
Procyon Mukherjee, 29th May 2013