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Monetary policy update and overall outlook summary




The point of this chart is to put into proper perspective the Fed's efforts to inject dollar liquidity into the global economy. It uses a semi-log scale because the change in the amount of bank reserves has been extremely large in the past two years or so. The first stage of Quantitative Easing saw bank reserves soar from about $100 billion to almost $1.3 trillion, and the Fed accomplished this by purchasing MBS and Treasury securities by the bushel, in addition to extending credit to the financial system through swaps, repos and special loans. As the latter injections began unwind, bank reserves shrunk from a high of $1.28 billion in Feb. '10, to $1.07 trillion in Oct. '10. Concerned that they might inadvertently be allowing a tightening of monetary policy at a time when deflation concerns were (allegedly) meaningful and the economy was (allegedly) still struggling, the Fed launched QE2 in Nov. '10. Those purchases have now pushed reserves up to a new high of $1.42 trillion.

Since Oct. '10, bank reserves have increased by $350 billion as a direct result of the Fed's purchases of Treasury securities. But since there has been no unusual growth in the other components of the money supply (e.g., currency and M2), and no huge increase in required reserves (reserves that need to be held against bank deposits) we can conclude that almost all of the increase in bank reserves has served merely to satisfy the economy's and the financial system's demand for bank reserves. And as I've explained before, since bank reserves are essentially obligations of the U.S. government and pay an interest rate similar to that of T-bills, which are considered to be the safest way to hold money in the world, the world was apparently eager to increase its holdings of safe money by $350 billion in recent months, and the Fed was happy to oblige.

If the world (and the banks) had been unwilling to accumulate additional stores of safe money that yields almost nothing, then we would have seen a significant increase in required reserves, a corresponding decrease in excess reserves, and a big increase in the growth of money (currency and M2). Instead of holding excess reserves in growing quantities, banks would have been putting those reserves to work by using them to generate new loans, increased deposits, and more currency. Loans would have generated a yield significantly higher than the yield on bank reserves—a virtual money-making machine. But this is not happening, because banks are satisfied with holding onto more safe, low-yielding cash, and the world in aggregate is apparently unwilling to increase its leverage. M2 is growing at close to a 6% annualized rate, and this is the rate of growth that has prevailed for the past 15 years on average, as the next chart shows. Currency in circulation is up about 7% in the past year, and has only risen at a 5.4% annualized rate in the past two years; again, no sign of any unusual expansion.


In short, the Fed has dumped a ton of reserves into the banking system, but banks have been either unwilling to make new loans, or the economy has no desire to take on more debt, or both. There is still a great deal of uncertainty out there that would explain why reserves have been hoarded instead of utilized: e.g., huge fiscal deficits that raise the specter of huge increases in future tax and regulator burdens, and of course the Fed's own potentially inflationary monetary policy.

The result of all this is that to date the Fed's actions have not been overtly inflationary (i.e., there is no sign that the amount of money in the economy has increased by enough to provoke a significant rise in inflation). However, there are several sensitive and leading indicators that suggest the Fed is in fact making an inflationary mistake: e.g., rising gold and commodity prices, the very weak dollar, and the very steep yield curve. At the same time, there have been numerous signs in the data in the past few months that strongly suggest the economy is picking up speed: e.g., the ISM surveys, rising commodity prices, manufacturing production, car sales, and the decline in unemployment claims. In addition, measures of confidence are starting to perk up, and C&I Loans are picking up, which further suggests that the economy's demand for money is beginning to decline (which would allow 6% money growth to fuel much higher growth in nominal GDP). The biggest positive on the horizon is the likelihood that Congress will finally begin to tackle our out-of-control fiscal policy trainwreck-in-the-making without raising taxes.

I think there is enough smoke out there to be worried about an inflationary fire, but I don't yet see a reason to call for a calamity in the making, as some are (e.g., a dollar collapse, hyperinflation, and another recession/depression). I do think that the risk of deflation is now virtually nil, and that therefore Treasury yields are exceptionally low and at risk of rising significantly. Measures of credit risk are still priced to higher-than-normal default risk, which is unlikely to prevail if money is indeed easy and the price level is set to rise meaningfully. Equity markets are priced with a good deal of fear built in (the Vix is still substantially above its long-term average), PE ratios are about average despite NIPA earnings being at record highs, and earnings yields are higher than corporate bond yields. So I think it still pays to be bullish on the economy, the equity markets, and corporate bonds, but bearish on Treasuries and cash.

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