“Why America’s economy proved surprisingly resilient to the biggest rise in interest rates in 40 years isn’t a question of merely historical interest?”
This is the question asked by James Mackintosh in the Friday issue of the Wall Street Journal.
The answer I have been giving for some time now is that all we have to do is note the amount of bank reserves the Federal Reserve has pumped into the economy over the past several years.
Look at the reserves that have been built up at depository institutions since the middle of 2019. Right now the banking system has 102.2 percent more reserves in the banking system than it did in June 2020!
Yes, the total reserves in the financial system have declined from their peak, but, financial institutions still are flush with funds.
Look at all the cash assets held by commercial banks in the U.S. banking system.
Right now, the commercial banking system in the United States holds just under $3.4 trillion in cash assets.
Notice that before the recession connected with the expansion of Covid-19, the banking system held less than $1.6 trillion.
One could argue very strongly that banking does not need two times the cash assets now than it did in June 2020.
A measure of excess reserves in the banking system, Reserve Balances with Federal Reserve Banks, can be found in the H.4.1 statistical release of the Federal Reserve System.
As can be seen on the chart, U.S. commercial banks are carrying close to $3.6 trillion in these “excess reserves,” at present.
Why do commercial banks need so much in the way of “excess reserves” at this time?
With so many excess reserves around, one might think that the Fed’s policy rate of interest need not be so high. The current target range for the Fed’s policy rate of interest is 5.25 percent to 5.50 percent.
And, most of the discussion about monetary policy, at the current time, is about where the need for the policy rate to be reduced.
This is the essence of the James Mackintosh article quoted above.
But, what about the “quantitative” thing that the Fed is doing to its balance sheet? There is very little discussion about this aspect of the Fed’s current monetary policy at this time.
The Federal Reserve, through its policy of “quantitative tightening,” has reduced its securities portfolio by $1.378 trillion since the program was started in the middle of March 2022.
One should note that this reduction is only a “starter” to returning the securities portfolio to around the size it was at an earlier date.
In this next chart, we see exactly what the Federal Reserve did in terms of supplying the excess reserves to the banking system during the panic and beyond.
Note, that the total securities held outright by the Federal Reserve totaled around $$3.5 trillion in 2019.
By the middle of March 2022, the total had risen to $8.5 trillion.
The Fed’s quantitative tightening program has removed just under $1.4 trillion, so the Federal Reserve has a pretty long way to go to return its securities portfolio to earlier levels.
And, this is my point.
The Federal Reserve pumped lots and lots of money into the financial system during the time it was responding to the threats of the Covid-19 pandemic.
A lot of this money is still “out there” and the economy seems to be using it to keep the economy growing even with very little inflation.
James Mackintosh and others like him are primarily focused on the level of the Fed’s policy rate of interest and so seem to be missing the basic story that is now the foundation of the Fed’s efforts to get the economy back under control.
This is also the reason, to me, why the stock market is growing. The investor community is focusing on how the economy is responding to the “excess liquidity” available to it. The money is there. The economy is using the money to finance the further growth of the economy.
The Federal Reserve, through its policy of quantitative tightening, is trying to sustain this economic growth but to keep it going without rekindling the inflationary tendencies that still remain in the economy.
If the Federal Reserve can maintain the stability of its effort, then investors should do very well during this Federal Reserve policy effort.