Money Supply and Fed Reserve Credit

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By RodgerRafter
December 13, 2004

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8 times a year the FOMC meets to set monetary policy. They give us a clue after each meeting as to their plans by issuing a statement in Fedspeak that says what they'll try to keep the Fed Funds short-term rate at. They also give an indication of what they plan on doing in the future and make up a bunch of nonsense about how tame inflation is and how healthy of the economy is so that people don't panic and move to Canada.

Monetary policy, however, involves much more than just setting short term interest rates. For most of the year, I've been trying to track what the Fed actually does to intervene in the markets by keeping a spreadsheet with the Fed's reserve credit, repurchase agreements, the maturities of the treasuries they buy and sell and the securities they hold for foreign official and international accounts. I can't say that the data proves anything one way or another, but this is how it appears to me that the fed and other players have been acting this year:

For the first 6 months of the year, the Fed worked to keep short term rates low to boost the economy. The Fed gradually increased its holdings of treasuries that were expiring within 90 days by just over $21 Billion, creating money and spending it to suppress short rates. Holdings of longer-term notes declined by $2.5 Billion, so I figure the Fed was letting mid and long term rates go with the market. With the Fed's injections, and a big spread between short and long term rates fueling the Carry trade, money supply expanded rapidly during the first 6 months of the year (M3 at a 10% rate).

Foreign accounts were big buyers from Jan to March, eased off in April, picked up their buying again in May, then eased off in June.

At the late June meeting the Fed appears to have decided it was time to tighten before inflation got out of hand. For the next month and a half, reserve credit actually declined by about $13 Billion, which coincided with the big July-mid August steep stock market sell off. M1, M2 and M3 all contracted slightly during this time. The Fed used up repurchase agreements and bought back mostly 1-5 year notes, but holdings of short maturities dropped. Foreign activity slowed way down during this time as well.

At the early August meeting, they appear to have changed course again. While they raised rates by their "measured" pace just as they did at the previous meeting, the behind the scenes actions were quite different. Over the last 4 months (including 3 meetings) the Fed has increased reserve credit by $40 billion, increasing holdings of bonds maturing in over a year by almost $17 Billion and 90 days to 1 year by over $6 Billion, while letting their holdings of short term notes stay flat. Meanwhile, the amount of repurchase agreements has risen by about $14 billion, representing bonds (of unknown maturity) they've agreed to purchase from banks. Based on the recent past, these are probably mostly long-term notes.

Over the past 4 months, short rates have risen pretty much on their own, while the Fed appears to have been working hard ($40 B) to keep longer rates down. It may be that the Fed set policy for long rates at the 3 meetings, and had to inject increasingly more to keep them down. The biggest single week increase in reserve credit was $11 Billion from 11/4 to 11/11, mostly from increased repurchase agreements. The next week 90 day to 1 year holdings rose $2.68 B, 1 to 5 year holdings rose $2.88 B and 5 to 10 year holdings rose $3.67 B. Those are exceptionally large numbers, which really stand out in the data.

Meanwhile, money supply seems to be growing at an extreme pace again. Seasonally adjusted, M1 is up 4% in just the last three weeks. Unadjusted it is up almost 10% in only three weeks! Granted, there's a lot of volatility to money supply numbers, and the flight out of the dollar also probably has something to do with the dramatic rise in M1 (and M3 to lesser degree), but the amount of money the Fed has been injecting to keep rates down and the result it appears to be having on the money supply probably is making the Fed's nervous, just as it did probably did back in the Spring.

Official foreign purchases slowed to a trickle from mid-September to mid-October, but have returned to a more moderate level as the dollar has fallen. For some reason, about 80% of that activity has been in federal agency debt rather than treasuries. Normally, they buy 80%-90% treasuries, unless activity is extremely large for the week, in which case its about 30%-40% agency debt. If anyone has a clue what's up, with the agency debt, let me know.

Anyway, back to the Fed... Heading into the meeting next Tuesday, I think the Fed is planning on a change of course. Since the last meeting:

1. The dollar has had a mini-crisis.
2. Foreign banks have temporarily and grudgingly rushed in to support the dollar.
3. US money supply has taken off.
4. Fed credit has risen more in 4 months than it did in all of 2003.
5. Long rates have started up in spite of the Fed's heavy buying.
6. Portions of the stock market have risen to new yearly highs.

My own best guess is that after talking things over, the Fed will:

A. Stick to their 25 basis point per meeting "measured" rate hikes.
B. Significantly slow their rate reserve purchases of notes over 90 days and let them rise.
C. Issue more hawkish language intended to support the dollar as a way of fighting inflation.
D. Boast about the economy's robust growth as cover for continued rate hikes.

If the Fed does get tighter behind the scenes with their treasury purchases, it doesn't bode well for the stock and bond markets. We'll see what they say next week.

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