Douglas Rissing
The Federal Reserve has been conducting a round of quantitative tightening for over two years now.
During this time, since March 16, 2022, the securities portfolio of the Federal Reserve has been reduced by over $1.6 trillion. The number up through Wednesday, May 15, 2024, is $1,628.1 billion.
However, if we look at the rate of increase of the M2 measure of the money stock from March 2020 through March 2024, we see that the M2 money stock has risen from $16,051.5 trillion to $20,981.9 trillion.
This rise in the M2 money stock has been at a 6.9 percent compound annual rate.
Historically, this is a rather high rate of expansion for a four-year time period.
Of course, most of the expansion came in the first part of the period, but still, the money is in the system.
Here is the chart.
M2 Money Stock (Federal Reserve)
So, in calculating the 6.9 percent number, we are looking at the chart from March 2020 through March 2024… four years.
This monetary growth is what we are talking about when we argue that there is still plenty of money around in the banking system even though the Federal Reserve has been reducing the size of its securities portfolio.
Milton Friedman, the monetary economist, has argued that inflation everywhere, every time, is a result of the monetary expansion taking place in a country.
A 6.9 percent compound rate of growth in the M2 money stock is certainly much more than the rate of growth of the real economy in the United States.
Should we be surprised that price inflation has been an issue over the past few years?
Yes, the Federal Reserve has been reducing the size of its securities portfolio, but, the money stock growth has still been excessive.
There is plenty of money circulating around in the system.
The open question remains… are the efforts of the Federal Reserve to reduce the size of its securities portfolio sufficient to actually get the inflation rate in the U.S. down to the level the Fed is shooting for?
And, yes, the growth rate of the M2 money stock has been negative for the past two years, but the same question can be asked about this behavior. Has the behavior of the M2 money stock over the past two years really been sufficient to slow down the U.S. rate of inflation?
If one looks at the performance of the stock market in the U.S., one could argue that the answer to these questions is… no!
Friday, all three major stock market indexes hit, during the day, new historical highs. The Dow Jones Industrial Average closed at a new historical high on Friday, and the S&P 500 closed just below a new record, as did the NASDAQ.
This is not an economy where the investment community believes that the central banks’ monetary policy is restrictive.
The Federal Reserve continues to reduce the size of its securities portfolio.
According to the latest H.4.1 statistical release of the Federal Reserve, the release for May 15, 2024, the securities portfolio of the Federal Reserve declined by another $30.7 billion in the latest banking week.
This brings the size of the reduction down to $1,628.1 billion.
However, it should be noted that the “excess reserves” of the banking system rose last week to more than $3.4 trillion. This comes from the Federal Reserve H.4.1 statistical release, the line item “Reserve Balances with Federal Reserve Banks”.
If we look at the Fed’s H.8 statistical release, “Assets and Liabilities of the U.S. Banking System” we see that for the date May 1, 2024, commercial banks in the U.S. held $3.3 trillion in “cash assets.”
This is an enormous number.
The commercial banking system is sitting on a very large amount of cash.
Yes, the size of the Fed’s securities has shrunk.
Still, the commercial banking system is very, very liquid.
Here is the picture of commercial bank “excess reserves” going back to January 2020.
Reserve Balances With Federal Reserve Banks (Federal Reserve)
Excess reserves expanded very rapidly as the Federal Reserve fought against the effects of the Covid-19 pandemic. They reached a peak in late 2021.
Excess reserves declined as the Fed began its round of quantitative tightening, but then began to increase at the time of the commercial bank failures in 2023.
Note that even though the Fed has continued to reduce the size of its securities portfolio, it has continued to manage commercial bank reserves, increasing this measure since March 2023.
All this has been taking place as Fed Chairman Jerome Powell and the Federal Reserve continue to debate whether or not the Fed’s policy rate of interest should be reduced or not.
It is my belief that one reason Mr. Powell is being very careful about starting to lower the Fed’s policy rate of interest is that the commercial banking system continues to have such a large pile of cash hanging around.
With so much cash hanging around, inflation is still a major threat.
Remember, over the past four years, the M2 money stock has increased at a compound rate of just under 7.0 percent.
The threat of excessive inflation still lingers.
Mr. Powell doesn’t want to face the possibility that the Fed reduced the policy rate of interest, only to see inflation remain at current levels or even rise from where it is now.
Investors?
Investors realize that there is an excess of cash hanging around. This cash is the source of funds for rising stock prices.
This cash is also the source of the confidence in the continued growth in the U.S. economy.
Mr. Powell is dealing with a real “balancing” problem.
When do you start to reduce interest rates?
How much longer do you keep interest rates at current levels?
And, there is a presidential election coming up in about six months…
The last thing a Chairman of the Board of Governors of the Federal Reserve System wants on his or her watch is for the Fed to do something to disturb the markets or the economy in a way that impacts the outcome of the election.
Mr. Powell will be very cautious over what he and the Fed do in the next six months.
If the Fed does act so as to keep financial markets peaceful going through the election, then investors should find financial markets acting well. That is, the stock market could be in for some more gains and more “new” historical highs if the Federal Reserve is able to keep financial markets stable.
