The Fed's security purchases are down to $25.0 billion per month. Only two months left until tapering ends in October.
Get ready for the paradigm shift.
We don't really know what the shift in the Fed's monetary policy will be. But, the steady acquisition of open-market securities will cease…at least, for the time being.
And, a part of this paradigm shift includes the possibility that short-term interest rates will begin to rise. There is more evidence of a growing movement within the officials of the Fed to begin to cause short-term interest rates to rise.
Still there is a noted weakness on the demand side of the market, the economy is just not that strong, and there are an ample supply of bank liquidity available to meet needs. There is absolutely no pressure for the federal funds rate to rise through market pressures and the effective federal funds rate remained around 9 and 10 basis points throughout July…a level that it has roughly remained at all year. See my latest thoughts on this topic.
The issue of rising short-term interest rates generated some press this week. The topic has been one that I have written about constantly over the past five years…the movement of funds into transactions "money" from other short-term assets that are not quite as liquid or from other short-term assets that are paying hardly any interest.
This has caused the M1 measure of the money stock to rise at historically high levels, while broader measures have shown only modest increases. For example, the M1 measure of the money stock rose by almost 12.5 percent from July 2013 to July 2014 while the M2 measure rose by 6.5 percent.
This has been the case throughout the current recovery. For example, in late 2011, the M1 measure of the money stock was rising, year-over-year, by more than 20.0 percent. During this time period the non-M1 components of M2 were only increasing at around a 7.0 percent year-over-year rate.
These high rates of growth were not a sign of potential economic health but were actually a sign of weakness as under-employed people and people with debt problems moved money into assets they could use for transactions. The funds movements did not come from new loans that were going into productive paths that would stimulate economic growth.
This movement continues. The growth of transaction assets continue to rise rapidly: currency in circulation is still growing by about 8.0 percent, year-over-year; and demand deposits are rising by almost 19.0 percent, year-over-year.
Savings deposits at financial institutions have only increased by about 7.0 percent, year-over-year, while small time accounts have dropped by almost 8.0 percent; and retail money funds have fallen by about 3.5 percent; and institutional money funds have declined by almost 1.0 percent.
This has been the basic pattern for the last five years.
What some people are starting to worry about is that as short-term interest rates begin to rise, won't at least a part of these funds move back in the opposite direction? If so, this could mean major outflows of deposits from the banking system and into other short-term assets.
If this outflow were to take place, what would the Federal Reserve do? This could certainly cause some demand pressure to build up in the federal funds market as commercial banks moved to cover deposit outflows.
But, this raises another question to me. Recently, I have written in other places that the commercial banking system is perhaps not as healthy as we might think. Again, I have argued over the past five years that one of the reasons the Federal Reserve has pumped so much liquidity into banking has been to keep troubled banks sufficiently liquid so that they could stay open until they found someone to acquire them or until they could be smoothly closed by the FDIC.
If there is a deposit outflow due to rising short-term interest rates, might it be the case that the Federal Reserve and the FDIC might have another liquidity problem to deal with?
As I mentioned above…get ready for the paradigm shift. We are going to need to keep our eyes on a bunch of things.
As far as the Fed's tapering, the central bank keeps right on target.
Over the past five-week period, the Federal Reserve added a net $32.3 billion to its securities portfolio…pretty much on target.
Reserve balances at Federal Reserve banks, a proxy for excess reserves, rose by almost $160.0 billion in this five-week period.
The major cause of this large increase was the Fed's paying back of its special term deposit offering of $92.7 billion. As these funds were paid back to depository institutions, bank reserves increased. These special term deposits began appearing on the Fed's balance sheet on May 28, 2014 and reached a high of $153 billion on July 16. On July 23, the total was down to zero.
There was also a $38.0 billion reduction in the Treasury's General Account at the Fed. This Treasury deposit account increases during tax time as tax revenues come to the Treasury. This causes bank balances at the Fed to decline.
As the Treasury writes checks, the General Account falls…and most of the check payments end up back in the commercial banking system.
These latter two movements are called "operational" and are seasonal in nature and so become less important over time.
Bottom line: nothing really new in terms of what the Federal Reserve is doing and what is happening in the short-term money markets.
The problem for the future is that we are going to have to be looking at a lot of things to try and understand what is going on in the financial markets, what the Federal Reserve is doing, and what this means for the economy and our investment portfolio. I expect that next 12 months or so to be very interesting
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