Federal Reserve Credit Contracts Further
We last wrote in July about the beginning contraction in outstanding Fed credit, repatriation inflows, reverse repos, and commercial and industrial lending growth, and how the interplay between these drivers has affected the growth rate of the true broad US money supply TMS-2 (the details can be seen here: “The Liquidity Drain Becomes Serious” and “A Scramble for Capital”).
The Fed has clearly changed course under Jerome Powell – for now, anyway.
Our friend Michael Pollaro* recently provided us with an update on outstanding Fed credit. As there are no longer any outstanding reverse repos with domestic banks, the liquidity drain is accelerating of late, with growth in net Fed credit contracting at fairly rapid rate of 3.4% year-on-year in September, the fourth consecutive month of decline:
The year-on-year contraction in net Fed credit accelerates. Since there are no longer any outstanding reverse repos with domestic financial institutions, the only force counteracting the negative effect on money supply growth is inflationary bank lending.
Michael also sent us a chart comparing the monthly trend in total net Fed credit in the course of 2017 with the trend in 2018 to date. When “QT” started in September of 2017, outstanding Fed credit initially kept growing well into 2018, largely because reverse repos with US banks ran off faster than securities held by the Fed decreased – but that has changed quite noticeably in the meantime:
Fed credit in 2017 (blue bars) vs. 2018 (red bars). The downtrend becomes more pronounced.
Keep in mind that the reverse repos mainly served to alleviate growing delivery fails due to a shortage in certain off-the run treasury securities which banks needed as collateral. As the Fed has stopped reinvesting all proceeds from maturing treasuries and MBS, banks no longer need to borrow securities from its portfolio.
The markets evidently never “missed” the liquidity tied up in these reverse repos, not least because high quality treasury collateral serves as a kind of secondary medium of exchange in repo markets, where it supports all kinds of other transactions. With net Fed credit actually decreasing, an important threshold has been crossed. The effect on excess liquidity is more pronounced, which definitely poses a big risk for overextended financial markets.
As an aside to this, bank reserves have in the meantime declined by roughly USD one trillion from their 2014 peak, but remain far above the amounts required to support the deposit liabilities of US banks. The main effect of the decrease is that the amount of fiduciary media (uncovered money substitutes) in the system is rising, but reserves are definitely not a constraint on inflationary bank lending.
Once the temporary effect of repatriation flows on the domestic US money supply abates, bank lending growth will be the only force counteracting the effect of the Fed’s liquidity drain on the broad money supply.
Bank reserves are down quite a bit (and the monetary base has declined accordingly), but the main effect of this was to reduce the percentage of deposit liabilities in the banking system consisting of covered money substitutes. This increases risks for depositors somewhat, but is not a constraint on bank lending – one only has to consider the paltry amount of bank reserves that supported the credit bubble leading up to the 2008 crisis.
