Fed's Easy Money Policy Ignores an Important Warning Sign

 |  Includes: BAC, C, JPM, WFC
by: John Tobey, CFA

A key indicator is flashing a warning for the Federal Reserve Open Market Committee (FOMC) to back off its easy money policy. But the signal goes unheeded.

How important is the indicator? Very.
Here’s the situation…
The Fed does not have complete control over the money supply
There is another party that can expand and shrink the money supply: Banks. After setting aside part of their deposits as reserves (for liquidity and safety), banks are free to lend out the rest. This lending creates new money (deposits) for the borrowers.
Although the Federal Reserve can regulate banks, it cannot prevent the volatility that comes with business cycles. Therefore, the Fed must adjust its activities, meshing with the banks’, so that the whole monetary system is operating properly. Namely,
  • When the banking system shrinks lending, the Fed must be ready to expand. Not doing so means the economy can be hit by a monetary tightening and even a "liquidity crisis."
  • When the banking system expands lending, the Fed must be ready to back off any expansionary policy they are pursuing. Not doing so means the adverse effects of a ballooning money supply can occur: inflation, rapid/unhealthy growth, and excess speculation/risk-taking.
So, clearly, the Fed needs to watch and respond to what the banks are up to. Alan Greenspan did it – twice. But Bernanke has not on his first chance.
The indicator the Fed is ignoring: Bank commercial and industrial loans
Commercial and industrial lending is important because it reflects bankers’ views of the economy and business world. They will only make loans if they believe they will be repaid in the future, and that means making a judgment about what’s in store.
During a recession, lending dries up and, as loans are paid off or written off, the total shrinks. The Fed needs to expand to counteract this tightening in the money supply.
Following a recession, the loans at first shrink less; then they start expanding. With expansion, the Fed needs to decrease its easy money policies to prevent a doubling up of money supply growth.
Now look at the graph below. Shown are the two key indicators, the Federal Funds rate and bank lending. Also shown is continuing claims for unemployment insurance (Bernanke often mentions unemployment as a reason for the easy money policy).
Bank lending & Fed Funds rate - long-termClick to enlarge
Greenspan, in control during the previous two recessions, began raising the Federal Funds rate as soon as bank loan growth started. However, Bernanke has yet to act even though that growth began last December.
Focusing on recent events
Let’s now focus on the recent period, starting with 2007 (Bernanke became chairman in early 2006). In the graph, the unemployment claims line is gone, and a new one is added: the 13-week (three month) percentage change in loans. This line allows us to see how quickly the loans are expanding or shrinking.
Bank lending & Fed Funds rate - short-termClick to enlarge
Remember, bank lending is a lagging indicator. Bankers need to see improvement before they will commit to new loans.
Note that the 13-week line turns up even as loans continue to shrink (the red area). This means the rate of decline is lessening. This improving period lasted about a year, from late 2009 to December 2010, when positive loan growth started.
Signs that something is amiss
Now, here’s why things look amiss. Bernanke and the FOMC should used that year to prepare for backing off the easy money policy. Instead:
  • The words, “…exceptionally low levels for the federal funds rate for an extended period” continued to be put into the FOMC’s statements
  • QE2 was created
  • Bernanke continued to say the economy wasn’t strong enough
  • Dissension on the FOMC began and became public
And now the most disturbing of all: We are four months past the lending indicator’s signal and everything remains the same. The only change is that Bernanke has said he will speak more frequently to help the public understand what the Federal Reserve is up to.
The “public” is concerned
Many are now worried about what the outcome is going to be.
So, the Fed’s lengthy easy money policy is now producing an ironic twist: Increasing worry instead of raising confidence.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.