Where Does the Fed's Stimulus Money Go? The Obscure, Convoluted and Scary Story
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The single worst cholera outbreak in England's history happened in 1854 in the Soho district of London. It left hundreds dead, although the broader cholera epidemic around London claimed tens of thousands of lives. At the time, the world did not know that microorganisms caused many diseases (Louise Pasteur would not discover what has become known as "germ theory" until several years later). In fact, the prevalent common knowledge was that diseases like cholera where caused by "bad air."
So when physician John Snow eventually traced the outbreak to a single public water pump (the infamous Broad Street pump), he had to make an overwhelming data argument to convince public officials to shut down the water source by removing the pump's handle. The thoroughness of his study and his hypothesis that people could get sick from drinking contaminated water made Snow a seminal figure in the fields of public health and epidemiology. He's also a hero figure in entry level texts about water treatment.
The parallels to today's seemingly infinite "pump priming" by the Fed (and other central banks) are ironic, to say the least. Snow didn't understand what was going on in the water to make people sick - he just knew he had to get people to stop drinking it. In the same way, most investors and traders don't really understand the inner workings of money creation in today's world, but they can sense that our central bank's "money pump" could lead to an economic epidemic. In a real last turn of irony - after the cholera epidemic of 1864 had waned, government officials put the handle back on the Broad Street pump, allowing the flow of dangerous water to continue… Does that ring a bell to anyone who listened in last week to the Fed's "keep the spigot flowing" decision? Let's dig in to see what the addition of $2.2 trillion dollars has bought us in terms of liquidity and economic growth so far.
The Obscure Part: Has All the Stimulus Been Helping?
Lots of stimulus has been tossed into the system. In fact, let's take a quick look at the M1 chart, one many of you will be familiar with -
But has any of this trickled down to Main Street? Spoiler alert - the velocity of money (the financial lubricant that our credit-driven system so badly needs to thrive) has actually dropped and the bulk of the stimulus money has found its way into risk assets like the stock market, not into growth areas of business and real estate loans. Alas, Main Street is left holding the bag - taxes and deflated dollars are paying for the largess that allows large institutions to play with the Fed's exponentially expanding balance sheet as if it were Monopoly Game money.
Let's look at perhaps the most disturbing picture first. Trillions of dollars of stimulus is put into the system while household incomes are actually dropping - by a lot. Below is a graph of the Census Bureau's latest data.
Since 2007 (not the highest point on the chart, mind you), Real Median Household Income has dropped more than 8 percent. Not exactly a victory for Joe or Jane Sixpack, but at least all this stimulus has helped out the employment picture, right? The Fed's infamous dual mandate includes fighting inflation and maximizing employment. So what kind of jobs growth does TRILLIONS of new dollars buy you? Let's head back to the Fed's own database:
Ouch - this one is still startling. Despite all the bluster from Washington, the U.S. employment picture is pretty darn flat (and at an unacceptably low level) since late 2009. It's also one of the reasons cited last Wednesday by the Fed for keeping the handle on the stimulus pump.
But at least some things have been getting better - namely risk assets:
Who knew that the Fed kept stock price charts on their site? Here you have one of the main locations where all the Fed stimulus has landed. How it got there takes a bit of explaining.
The Convoluted Part: How Fed Stimulus Gets Into the Markets
Here's a very insightful chart that I couldn't get from the St. Louis Fed site. It looks at that big rise in stock market cap divided by the Fed's burgeoning balance sheet (source: Haver Research and Gluskin Sheff):
As you can see, since the beginning of the stimulus, the market's capitalization has essentially kept pace with the Fed's money pump. This gives us some hints about stimulus money and the market but we are missing an important piece of the path. Let's dig deeper.
In a very illuminating Working Paper entitled Collateral and Monetary Policy, Manmohan Singh of the International Monetary Fund gives a mind-numbing look into the new money creation paradigm that the Fed has created (more details on that will have to wait for a later article). For our purposes today, let's cut straight to how QE money from the Fed winds up in the stock market instead of going out as new business or real estate loans. Let's start with an astonishing chart from the folks at Zero Hedge. They have taken data straight out the Fed's H-8 report and made some simple bar graphs showing U.S. bank balance sheets before the stimulus hit the fan up to now:
Here you can see that the banks' balance sheets have grown by $2.2 trillion as the Fed buys Treasuries or Mortgaged Backed Securities from them. As Singh describes in great detail - the immediate effect is to increase bank deposits (as shown above). It's up to the bank to decide how to handle these new deposits; it can loan them out or use the "deposit to loan gap" for other purposes.
Again, Zero Hedge (with an assist from JP Morgan) gives us some insight into what one commercial bank did with its newly acquired deposits last year:
The red lined blue box in the center column above represents JP Morgan's $423 billion deposit to loan gap. On the left, the yellow portion of the red lined box is $323 billion labeled as "CIO AFS securities" (Chief Investment Office Available for Sale securities). What happened next is well known to anyone following the financial news; the so-called London Whale in JP Morgan's CIO group (with full knowledge of the company executives) took on huge positions that cost the company billions of dollars in losses in a truly excruciating proprietary (prop) trade gone bad. The whale story may be intriguing but its details hide a significant point highlighted by the chart above. Most importantly, it lets' us see the inner workings of how stimulus money goes from the Fed to the securities market without ever leaving the bank's balance sheet (it is marked as a liability - essentially lent to itself). The underlying deposits can then be leveraged and used by prop trading desks to return outsized gains (in theory and usually in practice, though not in the case of the London Whale) versus what could have been made through loans to real estate investors, businesses, and consumers.
What's scary is that this is not even the scary part.
The Scary Part?
I'll leave you with these departing thoughts and one more chart: the current usage of all of this extra money has DECREASED the velocity of money, the speed of its movement through the economy while it has INCREASED the systemic risk.
First for monetary velocity: more money is doing less (being loaned out, etc.) since the stimulus has started. Singh estimates that collateral turnover has dropped from 3x in 2007 to 2.2x in 2012. And the Fed's own measure of velocity shows a clear drop:
The importance of the velocity of money can be found in the definition from the FRED site, "The velocity of money is the frequency at which one unit of currency is used to purchase domestically-produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy."
Velocity of money tells us how much money in circulation is being used as a lubricant - reducing the friction for economic transactions. As we can see above, we are well past the point of diminishing returns.
Now about that systemic risk - banks' balance sheets have swelled thanks to the Fed's ever-present purchases. These additional reserves would seem to provide added safety for banks until you look at their nature. In a vast over-simplification, the Fed has been buying the banks' highly liquid AA+ rated securities (e.g. Treasuries, etc. - which are very easily traded on the open market) and has been replacing them with bank reserve deposits at the Fed - which are only available for interbank trade.
Peter Stella of Stellar Consulting LLC wrote a detailed and illuminating piece on the implications of the current bank reserve situation just last Friday. Stella points out that the massive shift in bank holdings from liquid US Treasury securities to Fed bank reserve deposits does not pose a credit risk issue; Fed reserves and treasuries are equally safe. Fed reserve deposits, however, are marketable only to a very select audience, namely US banks. The shift in trillions of dollars of bank holdings out of very liquid securities to much less liquid Fed reserve deposits has injected a new systemic risk into the economy. This money supply / bank reserve relationship will be the subject of our next article.
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