Recent Monetary Policy and the Growth of the M1 Money Stock

Since the end of June 2011, excess reserves held by commercial banks have declined by about $107 billion. (Remember in August 2008 when excess reserves in the banking system totaled only $2.0 billion…for the whole banking system!) For the two-week period ending November 30, 2011, excess reserves averaged almost $1.6 trillion.

Reserves balances held at Federal Reserve banks dropped by about $110 billion over the same period of time. On December 7, 2011, reserve balances were slightly under $1.6 trillion.

Excess reserves held by the banking system and reserve balances at the Federal Reserve tend to move in the same direction and in about the same magnitude. The reason for focusing on reserve balances held at Federal Reserve banks is that this number comes from the Fed’s balance sheet and can be related the movements of line items that appear on the balance sheet.

This decline in reserve balances has not been overtly driven by Federal Reserve actions. In fact, three factors have dominated this decline, and each of the three is independent of what the Federal Reserve might be overtly doing.

The first two factors relate to components of the Federal Reserve’s portfolio of securities. After the Fed’s holdings of U. S. Treasury securities, the largest part of the portfolio is made up of mortgage-backed securities. From the end of June through the current banking week, the amount of mortgage-backed securities on the Fed’s balance sheet dropped by $82 billion and represented maturing securities.

The Fed’s holdings of Federal Agency securities also feel by almost $11 billion during this same time period again from the run-off of maturing issues.

The third factor that helped to decrease reserve balances was a $31 billion increase in currency in circulation outside the banking system. That is, when currency is drawn out of the banks and moves into the hands of individuals, families, and businesses, bank reserves go down…unless these outflows are offset by other actions of the Federal Reserve.

Just these three factors alone resulted in a $124 billion reduction in bank reserves. Some open market operations as well as other operating factors offset this decline, but the net result, as mentioned above, was that overall excess reserves in the banking system decline by more about $110 billion over this time period.

While these excess reserves were declining, however, we observed during the same time period, a sizeable change in the speed at which the money stock was growing. For example, in June, the year-over-year rate of growth of the M1 measure of the money stock was about 6 percent. In July, the rate of growth increased to 16 percent, in August it was slightly more than 20 percent where it has stayed.

The M2 measure of the money stock did not show such dramatic increases, since the M1 measure is a subset of the larger total, but it, too, increased during this time period. In June, the year-over-year rate of growth of the M1 measure was about 6 percent. In July the growth rate of this measure rose to 8 percent and then jumped to 10 percent in August where it has remained.

In July and August, the banking system experienced huge gains in demand deposits while in June, July, and August savings deposits at depository institutions rose dramatically.

These movements along with the continued strong demand for currency in circulation can still be used as evidence that the economy remains very weak. The $31 billion increase of currency in circulation mentioned above has resulted in the currency component of the money stock measure showing a year-over-year rate of growth by the end of October of almost 9 percent, which is a very high figure historically.

The movements taking place in the money stock figures point to the weak economy in two ways. First, with people under-employed, with people trying to stay away from debt, and with businesses trying to build up large stashes of cash, the demand for currency and for transaction balances at financial institutions rises. Weak economies cause economic units to keep more of their wealth in a form that is readily accessible and spendable.

The second piece of evidence, however, is the extremely low interest rates associated with the weak economy. With interest rate so low, it just does not pay for people to keep funds in interest-bearing accounts. Over the past five months, savings deposits at financial institutions have dropped by almost $75 billion and funds kept in institutional money funds have dropped by $160 billion over the same time period. A large portion of these funds has apparently gone into currency and transaction balances.

People are still getting out of short-term assets and placing their funds, more and more, in transactions-type accounts. This is a sign of the weak economy and not of economic growth or a successful monetary policy.

This is “debt deflation” type of behavior. It is a type of behavior that the Federal Reserve has not yet been able to over come. And, having the Fed toss more “stuff” against the wall does not seem to be the policy to turn things around.

Federal Reserve officials keep talking about up the fact that they have not run out of things that they can do to continue to try and stimulate the economy. Unfortunately, it seems to me that fewer and fewer people are listening to their pleading.

With a banking system that is still much weaker than the authorities are willing to talk about; with a consumer sector and business sector that, for the most part, are still trying to reduce their debt load; and with a public sector that is sorely out-of-balance and doesn’t seem to know where it wants to go; people are confused and uncertain about their future and about what to do.

In this kind of environment, people want to hold onto what they have and want to avoid as much risk as they can. They don’t want to borrow if they don’t have to and they want their assets to be as liquid as possible.

This is what the Federal Reserve is facing.

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