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One of
the chief mandates of the U.S. Federal Reserve is to manage the nation's
monetary stock. This essay analyzes the historic growth of the American
monetary stock (or aggregates) since 1960 and looks at some recent
developments revealing a marked adjustment in policy. These changes are a
direct response to the on-going worldwide financial crisis that escalated in
September 2008 following the collapse of Lehman Brothers.
U.S. Monetary Aggregates
The U.S.
Federal Reserve regularly publishes Money Stock
Measures showing a breakdown for the
different components of each measure. Data from this source was used to
produce the following chart.
M1
includes the most liquid forms of money. Higher order monetary measures include
money acting more as a 'store of value' as opposed to a 'means of exchange'.
The U.S.
Federal Reserve stated that it would cease publishing the M3 monetary
aggregate as of May 23, 2006 and all of its
components except for that of Institutional Money Market Mutual Funds (MMMF)
citing that "...the costs of collecting the
underlying data and publishing M3 outweigh the benefits."
The
reason for continuing MMMF is that it is a component of the recently devised
Money-Zero-Maturity (MZM) monetary aggregate. This measure includes M2 less Time Deposits plus all
MMMF and is deemed by many as best representing the money available within an
economy for spending and consumption. Some economists oppose the inclusion of
money market mutual funds as 'money' because, while liquid and eligible to be
sold without incurring a capital loss, they are still technically an asset
that first must be sold in order to be spent.
Controlling
the Money Supply
The
Federal Reserve primarily controls the U.S. monetary stock through three
mechanisms:
1.
Setting the Federal Funds Rate
By
decreasing interest rates and effectively making money less expensive to borrow, the Federal
Reserve increases the demand for money. Conversely, the Federal Reserve can
lower the demand for money by targeting a higher interest rate, as Paul
Volcker did early in his tenure as Federal Reserve Chairman from August 6,
1979 to August 11, 1987. At present, the effective federal fund rate is being
targeted to remain between 0 - 0.25%, the lowest in its history in response
to the current financial crisis.
2.
Buying U.S.
Government Treasuries
When the
Federal Reserve purchases U.S.
treasuries it loans money to the U.S. government. In addition to
the money created by the Fed to purchase these treasuries, the assets of the
Federal Reserve increase allowing them to lend more to their clients under
the fractional reserve banking system. Previously, the weekly release of the
U.S. Federal Reserve balance sheet, known as the Factors
Affecting Reserve Balances of Depository Institutions and Condition Statement
of Federal Reserve Banks, was a complete
non-event, showing a slow and steady increase over the previous week's
release. This has since changed following the Fed's historical response to
the global financial crisis. A wide variety of assets now back the U.S.
Dollar in addition to U.S. Treasuries. Many of these assets, such as Term
Auction credit, loans to American Insurance Group, and commercial paper
holdings, Mortgage Backed Securities (MBS) are of questionable value due to
their illiquidity when previously within the public domain.
3.
Adjusting the Reserve Ratios
All
commercial banks operate under a fractional reserve banking system whereby
they must legally hold a set amount of cash reserves against the amount they
lend out to their customers. By adjusting the reserve ratio limits, the
Federal Reserve can affect the amount of money commercial banks are able to
lend. Increasing these ratios deflates the money supply because banks can no
longer lend out as much as before. Decreasing them has the opposite effect.
As of January 1, 2009 the reserve ratios are as follows:
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U.S. Reserve Requirements
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$0 to
$10.3 million
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0%
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$10.3
million to $44.4 million
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3%
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More
than $44.4 million
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10%
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Source: The Federal
Reserve Board
Inflation
and Deflation
Historically,
the term inflation referred to an increase in the
monetary stock. Deflation described the opposite
process. Modern-day usage of these two words now refers only to changes in
prices, which may lead to awkward, and potentially misleading, statements. While
prices do respond to changes in the monetary stock, it is not a direct
relationship, as there are other factors to consider. A ten percent increase
in the monetary stock does not directly correspond to a ten percent price
increase for all goods.
Reasons
for this discrepancy include the following:
- Unavoidable time
delays required for market participants to assess the impact of
newly created money entering the public domain. Components of the
economy that are the first to receive newly created money benefit the
most as they can spend it at full purchasing power. Those components
which receive little or none of it experience only higher prices.
- The supply and demand
dynamics for goods are independent from the supply and demand of
money. For instance, advances within the telecommunications industry
during the 1990's, outpaced the growth of monetary stock during this
period resulting in lower prices for related equipment and services.
- Speculation may lead to unfounded price levels well above what fundamentals
would suggest. The most recent example of this is the 70% price collapse
in crude oil from over $140 in July 2008 to around $40 today occurring
during a time when the U.S.
total monetary stock increased by 21.5% from $8.7 trillion to $10.6 trillion.
While
changes to the monetary stock do not account for 100% of the changes in
prices, they are especially important over longer time periods, often
becoming the dominant factor.
The U.S. Monetary
Base
Recent
announcements over the escalating U.S. monetary base have surfaced
in the financial media. The U.S.
monetary base consists of several components.
The currency in
circulation was historically the
predominant component. Recently, Federal Reserve Bank balances have become
sizeable components as well. So long as the reserve cash remains in bank
vaults or on deposit with the Federal Reserve, it is not
money.
The
sharp increase in bank reserves is a result of the current efforts to recapitalize
the U.S.
banking industry. The above graph visually shows the historic significance of
these actions. While bank reserve cash does not directly enter the financial
system as money, it can enter through the
fractional reserve banking system as debt.
The
Fractional Reserve Banking System
Fractional
reserve banking is the practice whereby the value of issued bank loans far
exceeds the amount of cash held in reserve.
Assuming
a ratio of ten percent, a commercial bank can lend out $10 million for every
$1 million it holds in reserve. This makes for particularly profitable
business, as annual revenue on $10 million in mortgages at 6% earns $600,000,
whilst the interest paid on $1 million in deposits at 2% is only $20,000. Thus,
the overall effect is net revenue of $580,000 from $1 million of depositor
savings.
Of
course, should those mortgages begin to default on a large scale,
this business model will begin to suffer.
The
recent explosion in bank reserves potentially sets the stage for an
unprecedented amount of lending. Prior to September of 2008, the typical
amount of Reserve Balances with Federal Reserve Banks stayed under $20
billion. A mere five months later, this amount increased more than
thirty-fold to over $640 billion! Considering that this balance was created
by the Federal Reserve in exchange for financial assets, the potential risks
to the purchasing power of the U.S. Dollar are significant.
The
commercial banks have been publicly criticized for not lending and thus are not encouraging consumer spending. Given the
circumstances, we may want to be careful what we wish for, as the creation of
US$ trillions of additional debt is the last thing the American economy
needs.
The
Financial Crisis Timeline
The U.S.
Federal Reserve's response to the current financial crisis has been
unprecedented in its magnitude. Extraordinary measures began with the December 12,
2007 announcement of a temporary Term Auction
Facility (TAF) for $20 billion along with coordinated efforts with the
European Central Bank (ECB), the Bank of England, the Bank of Canada and the
Swiss National Bank (SNB) authorizing "temporary reciprocal currency
arrangements" (known now as 'Central Bank Liquidity Swaps'). Initially,
the approved amounts for these swap lines was $20 billion with the ECB and $4
billion with the SNB.
Throughout
2008, the values for both of these measures increased steadily. As of
February 4, 2009 the TAF stood at $413 billion and the swap lines amounted to
$389 billion.
April
2008 saw the rapid rise of off-sheet balance lending which had historically
never exceeded $20 billion and typically remained around $2 billion. The April 10, 2008 news release indicated that "Securities Lent to Dealers" exceeded
$100 billion. By September 25, 2008 the amount had grown beyond $200 billion.
On March 16,
2008 the Primary Dealer Credit Facility (PDCF)
was established to extend credit to primary dealers at the primary credit
rate against a broad range of investment-grade securities. On September
14, 2008 the collateral eligibility was
lowered to that which can be pledged in the tri-party repo systems of the two
major clearing banks.
On June 26,
2008 the Federal Reserve Bank of New York extended
credit to Maiden Lane LLC to facilitate acquisition of Bear Sterns Companies
by JP Morgan Chase & Co.
An $85
billion line of credit was announced on September
16, 2008 as part of the restructuring of
American Insurance Group (AIG). To further assist with these efforts, a Residential
Mortgage-Backed Securities Facility (Maiden Lane II) and a Collateralized
Debt Obligation Facility (Maiden Lane III) were later announced on November 10,
2008.
On September
19, 2008 the Asset-Backed Commercial
Paper Money Market Mutual Fund Liquidity Facility (AMLF) was established to
provide liquidity to markets. Plans were also announced to support market
functioning by purchasing short-term obligations issued by the Government
Sponsored Enterprises (GSE) known as Federal National Mortgage Association
(Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac) and the
Federal Home Loan Bank, the details of which were announced on November 25,
2008.
The $700
billion Troubled
Asset Relief Program (TARP) passed through Congress
and was signed into law on October 3, 2008. Under the program, on November 23,
2008 the Federal Reserve provides protection
against the possibility of unusually large losses on an asset pool of
approximately $306 billion of loans and securities backed by residential and
commercial real estate and other such assets on Citigroup's balance sheet.
On November 25,
2008 the Federal Reserve Board announced the
creation of the Term Asset-Backed Securities Lending Facility (TALF), under
which up to $200 billion would be lent on a non-recourse basis to holders of
AAA-rated asset-backed securities and recently originated consumer and small
business loans.
The
Federal Reserve Board announced the creation of the Commercial Paper Funding
Facility (CPFF) on October 7,
2008 to provide a liquidity backstop to U.S. issuers
of commercial paper. By February 4, 2009 portfolio holdings of the CPFF
exceeded $259 billion.
On January 16,
2009 the Federal Reserve along with the U.S.
Treasury and Federal Deposit Insurance Company (FDIC) announced a package of
guarantees, liquidity access, and capital for Bank of America. The Treasury
and the FDIC entered a loss-sharing arrangement with Bank of America on a
$118 billion portfolio of loans, securities, and other assets in exchange for
preferred shares. In addition, and if necessary, the Federal Reserve will
provide a non-recourse loan to back-stop residual risk in the portfolio. Separately,
the Treasury invested $20 billion in Bank of America from the TARP in exchange
for preferred stock.
Below is
a graphical timeline of the Global
Financial Crisis showing the events and actions
of the Federal Reserve against a backdrop of their balance sheet and the Dow
Jones Industrial Average.
Concluding
Remarks
The
author believes that the present-day monetary system rests upon two
questionable fundamental principles.
- Unsound monetary
unit - currency is not backed by any
tangible asset and subsequently has no theoretical limit to its supply.
- Fractional reserve
banking - institutionalized
practice whereby banks lend out far more than they hold in assets.
The
recent actions are the latest in an on-going process whereby collapse is
delayed by issuing additional debt. These actions never correct the
underlying problem, but merely delay it until a future time.
The
greatest risk at present is that the magnitude of the latest efforts to
stabilize the system destroys public confidence in paper money, thereby
sparking the phenomenon of hyperinflation.
Notes
Pre-1959 monetary data
may be found on the St. Louis Federal Reserve website,
however such data does not indicate a breakdown and uses a somewhat different
methodology.
One definition of
insolvency is a situation whereby liabilities exceed assets. It is
interesting to note that the fractional banking system, by
definition, is insolvent. It is only through the existence of the
central bank, acting as a 'lender of last resort', that bank runs can be
avoided. If an abnormal number of depositors demand return of their money
simultaneously, the central bank has the ability to create the necessary
amount of money and thus fully refund all withdrawals.
The Central Banks and
Monetary Authorities of New Zealand, Brazil,
Mexico, Korea and Singapore join the program in
October of 2008. The Central Banks of Australia, Denmark,
Norway and Sweden would
later join the program on January 30, 2009.
Mike Hewitt
Editor
DollarDaze.org
Mike Hewitt is the editor of www.DollarDaze.org, a
website pertaining to commentary on the instability of the global fiat
monetary system and investment strategies on mining companies.
Disclaimer: The opinions expressed above are not intended to be taken as
investment advice. It is to be taken as opinion only and I encourage you to
complete your own due diligence when making an investment decision.
© 2007 DollarDaze
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