Federal Reserve QE2 Watch: Part 5.0

On March 30, 2011, reserve balances with Federal Reserve banks, a good proxy for the amount of excess reserves in the commercial banking system, almost reached $1.5 trillion!

This total is approximately $450 billion more than was on the Fed’s balance sheet on September 1, 2010 which was soon after Chairman Ben Bernanke announced the advent of Quantitative Easing 2, or QE2, at a Federal Reserve conference in Jackson Hole, Wyoming.

The Fed’s basic plan was to purchase $900 billion in United States Treasury securities during QE2, $600 billion of the purchases were to be a net addition to the Fed’s portfolio of securities held outright and $300 billion were to replace maturing Mortgage-backed securities and Federal Agency securities.

Between September 1, 2010 and March 30, 2011, the Fed has achieved a net addition of about $550 billion to its holdings of Treasury securities which has resulted in a net addition of around $360 billion to its securities held outright. About $190 billion has run off from the Fed’s portfolio of Mortgage-backed securities and Federal Agency securities.

The plan was that the Fed would add about $2 in bank reserves to it’s balance sheet for every $3 it purchased in U. S. Treasury securities. Since September 1, the Fed has added about $3 for every $5 in Treasuries it has purchased.

However, over the past four weeks, the Fed has added about $4 for every $5 in Treasuries it has purchased.

In the first three months of this year the Fed has added, on average, approximately $100 billion in United States Treasury securities to its balance sheet every month.

However, securities purchases are not the only thing changing on the Fed’s balance sheet. Since September 1, 2010, the Fed’s net purchases of securities have supplied almost $325 billion in reserve funds to commercial banks.

The other $125 billion of the total $450 billion increase in reserve balances has come from the other side of the balance sheet. Here the primary contributor to the increase in reserve balances has been a $195 billion decrease in the Supplementary Financing Account of the United States Treasury.

In effect, the Treasury had $200 billion in deposits at the Fed in this account on September 1, 2010. The Treasury has withdrawn $195 billion of this $200 billion and when the Treasury spends out of its account at the Fed it creates bank deposits…or reserve balances at the Fed.

About $70 billion of this decrease has been offset by an increase in currency in circulation which draws funds out of commercial bank accounts and an increase in the Treasury’s General Account at the Fed. Currency in circulation rose about $55 billion since September 1 and the General Account of the Treasury rose by about $15 billion.

After about two years of almost total turmoil, the Federal Reserve’s accounts have settled down and are very open and straight forward. About all that is going on at the Fed right now is the activity related to QE2. And, the Fed is doing exactly what it said it was going to do.

The reason for QE2, we are told, is that the Fed is creating this excessive amount of liquidity to spur on bank lending in order to get the economy growing at a faster pace.

We are told that QE2 will be over by the end of June, 2011.

The average year-over-year growth of real Gross Domestic Product over the past three quarters has been 3.0 percent. Analysts have predicted that economic growth will probably end up around 3.0 percent for the whole year of 2011. Usually the American economy comes out of a recession at a faster rate of growth than this, but this rate of growth is very consistent with the compound rate of growth of real GDP over the past fifty years.

The point is, the economy is growing. It is not a spectacular rate of growth but it shows that the economy is growing at a rate that is close to its long run average. The growth rate is not rapid enough to cause a dramatic decrease in the unemployment rate, but this may be a result of the fact that the United States economy needs to restructure and restructuring a large economy takes time.

Does the fact that the economy is only growing around 3.0 percent warrant the injection of $1.5 trillion in excess reserves into the banking system? Will all this liquidity really cause economic growth to accelerate and with this acceleration bring down the unemployment rate?

It is here, I believe, that we have a disconnect between the story the Fed is trying to tell and the way that the economy is performing. To me, the facts just don’t seem to mesh with the urgency of the Fed’s expressed concern. And, this disjunction of words and economic behavior is made even muddier by the contradictory statements made by members of the Fed’s own Open Market Committee this past week.

But, Chairman Bernanke is going to make things exceedingly clear in the future by holding a press conference after four future meetings of the Open Market Committee.

The results of QE2 to this point: in terms of the purchase of U. S. Treasury securities, the Federal Reserve is doing exactly what it said it was going to do; in terms of economic activity, the economy is behaving just about the way it was behaving at the time QE2 was introduced.

Lots of activity on the part of the Fed and little or no reaction on the part of the economy.

In terms of understanding what the Fed is doing and what it hopes to accomplish…confusion.

Up to this point, the walk and the talk just don’t seem to coincide. My problem is that I was taught to watch the hips…not the lips. What the hips are doing, in this case, however, don’t make a lot of sense.

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