Tuesday, February 24, 2009

US Monetary System.

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.1
Components of U.S. Monetary Aggregates
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.
Components of U.S. MZM

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.
Effective Federal Funds Rate

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.
Composition of U.S. Federal Reserve Assets

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:

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:
  1. 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.
  2. 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.
  3. 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.
U.S. Monetary Base
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.2
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.
courtesy: http://news.goldseek.com/GoldSeek/1234540800.php

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