Fixed Income Weekly

The process of money creation is complex. Flooding the market with cash to keep Fed Funds low is a very traditional way to stimulate an economy, and the Fed is all in on that front with Fed Funds at zero. They took it a step further this year and moved into longer assets to bring down longer term interest rates on things like mortgages. All of this buying has left banks flush with cash and rates low, hoping to spur lending and economic growth. Fed funds has been at 0-.25% for 11 months, they have purchased $300 billion in Treasuries notes, over $1 trillion in Agency MBS and over $100 billion in Agency debt in addition to $43 billion in TALF and billions more in other confusingly named programs. So why isn’t there any real growth?

The graphs below show the decline in credit since late 2008. The first graph shows Commercial Loans, the second shows Consumer Loans.

Banks are required to hold a certain amount of cash at the Fed, called required reserves. Excess reserves, cash that banks chooses to hold at the Fed in excess of the required amount, have grown since the Fed began pumping the system with cash. The reason for this is lack of demand for funds by both households and businesses – basically banks have nothing to do with all the liquidity. The graph below shows the level of reserves, both required and excess, that banks currently hold at the Fed.

True money creation is more than just Fed induced liquidity. Money creation will only happen if there is adequate demand for money, and right now there isn’t. Excess liquidity has a track record of producing high levels of inflation, but the lack of demand for loans is keeping inflation in check right now.

The public can ridicule banks all they want for not lending, but that is not the problem. Businesses are not expanding and households are still trying to repair the damage done to their home values and/or from their lost income. Stimulus, whether it is monetary or fiscal, still relies on true demand to foster a recovery, and risky asset rally that has been labeled an “economic recovery” has some difficult times ahead unless we get some.

Cliff J. Reynolds Jr., Investment Analyst