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As reported in my last review of Federal Reserve actions, all remains quiet on the monetary front. Right now, as far as monetary policy is concerned, there is not much for the Fed to do ... and, to me, this is good.

Things are quiet in the banking system -- except for the complaints of top bankers about new rules and regulations that are being discussed. The FDIC closed only one bank this week, bringing the total for the year up to 23. But, closers are going “smoothly”.

Economic growth, year-over-year, continues to be in excess of two percent, although not by much. And, other data being reported contain some good information -- and some not-so-good information.

The European crisis continues along, with more stress being placed on the creation of growth rather than continuing “austerity.” The question is how much the elections of the weekend will change the near term future for the eurozone.

And, with the presidential election in full swing, the Fed seems to be content with the above scenario. There is little or nothing it can do between now and the election to change the trajectory of the economy before November. It “stands by” in case there is any “fire” that needs to be put out in the meantime. (For more on this see my post.)

Furthermore, it seems as if we have had the last of the “education” sessions put on by Professor Bernanke for a while. Thank goodness!

In terms of the actions of the Federal Reserve over the past month, most changes that occurred on the Fed’s balance sheet seem to be “operational”. That is, the Fed was just responding to general “operating” factors impacting the banking system.

The largest “operating” factor that occurred in April was connected with the yearly tax collections. Deposits at Federal Reserve banks rose in April by almost $80 billion. This is a seasonal swing as funds are collected at tax time in “tax and loan accounts” at commercial banks. Then, the Treasury transfers these balances to its account at the Fed -- the account the Treasury writes checks on. This movement absorbs bank reserves at the same time the Treasury writes checks, which will then go back into the banking system as the recipients of those checks deposit them. This procedure minimizes disruptions to the amount of reserves in the banking system. Hence, these actions are called “operational”.

Two other factors can catch our attention. First, over the past four weeks, the Fed has increased its holdings of mortgage-backed securities by $11 billion. This is the first increase in mortgage-backed securities for more than a year. In total, this account declined by almost $80 billion from May 4, 2011 to May 3, 2012. Some support for this sector of the financial markets?

The second factor is the decline in Central Bank Liquidity Swaps. This account increased over the past year as the European sovereign debt crisis expanded into the fall of 2011. But these liquidity swaps began to decline since the second Greek bailout was accomplished. Central bank liquidity swaps declined by about $19 billion over the last four-week period, and declined by over $77 billion during the last 13-week period. As of May 3, 2012, there were slightly more than $27 billion swaps still on the Fed’s books.

Reserve balances with Federal Reserve banks on May 3, 2012 stood at $1,481 billion ($1.5 trillion rounded off), only $8 billion more than existed on May 4, 2011. Excess reserves in the commercial banking system, a two-week average, were $1.458 trillion, just about what was in the banking system one year ago, $1.452 trillion.

This relative stability on the Fed’s balance sheet was achieved despite substantial changes taking place within the banking system itself.

Although the total reserves in the banking system only increased by a little less than 4%, required reserves in the banking system rose by about 32%. The reason for this difference is that demand deposits at commercial banks, deposits that have the highest reserve requirements, increased by more than 41%. Time and savings deposits at commercial banks, which have lower reserve requirements, rose by a little more than 8%. Thus, there was a shift in the banking system from deposits with lower reserve requirements to deposits with substantially higher reserve requirements.

This shift from time and savings deposits to demand deposits has been going on for a long time. I have been reporting on this for more than two years now. The shift is taking place, not only because of the low interest rates being paid by banks (and thrift institutions), but because of the weak economy. People out of work or on the edge financially transfer the wealth they have to “transaction” type of accounts so that they can live and pay their bills. They don’t have the resources to “manage” their wealth across a spectrum of assets. Thus, the growth in demand deposits, to me, is a sign of weakness in the economy and not a sign that monetary policy is working.

Another piece of evidence supporting this claim is the strong demand for currency outside the banking system. Currency in circulation is increasing at a 9%, year-over-year, rate of growth. This is an extremely high growth rate and a sign of a weak economy and not a strong one.

As a consequence of these demands, money stock growth continues to increase at a very rapid pace. The M1 measure of the money stock remains in the high teens, growing at an 18% rate for the past year, while the M2 measure is growing at a pace slightly under 10%.

Both of these rates of growth are high, historically, but can be explained by the shift in assets toward more liquid and more transaction-based accounts. Only recently has loan growth started to increase and this may provide some reason for the money stock to continue to increase in the future. If loan growth does continue to increase and if this creates a reason for the money stock to grow, this would be a healthy sign for a recovering economy.

So, not much has changed on the monetary front from last month. I believe that this is a good situation for the monetary authorities. It doesn’t mean that the future will be easy. The Fed is still going to have to deal with almost $1.5 trillion in excess bank reserves when the economy begins to expand more rapidly; the threat of rising inflation is real. Yet the past is past and we are where we are right now ... and, to me, where we are right now is hopeful.

Source: All Quiet At The Fed ... And That's Good