Since early March 2020, banks’ reserves have increased by $2.25tn (Chart 1). A $3.2tn expansion in banks’ assets accompanied this increase. This likely reflects that the Fed purchased securities mainly from the nonbank sector. When banks sell bonds to the Fed, the size of their balance sheet does not change. Rather, the composition of assets changes, with an increase in reserves offset by a decline in banks’ bond holdings. By contrast, when the Fed purchases bonds from outside the banking system, the seller is paid through an increase in their bank deposits that increases banks’ balance sheets.
This suggests that, althought reserves already represent nearly one fifth of banks assets (and nearly one third of large domestically chartered banks assets) there is ‘room’ for further reserves expansion. Banks cannot refuse to hold the reserves created by the Fed and associated deposits. They can however—and they have—charge fees on deposits and associated transactions. At the same time if banks cannot find enough opportunities to lend, they are likely to buy securities instead. In addition the deposit multiplier, the ratio of deposits to cash (roughly equal to broad money divided by the monetary base), is likely to fall.
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Summary
- Fed asset purchases have led to a $3.4tn increase in banks’ assets, but more than 90% of this increase has comprised of credit to the public rather than private sector.
- Fed easing has supported higher corporate leverage, yet this leverage has funded an increase in financial rather than tangible investments.
- Market tolerance for the Fed inflation outlook and Fed plans to continue with LSAPs at least until end-2021 suggest more upside to equities.
Market Implications
- Positive equities, negative bonds.
Banks Are Buying Public Sector Debt Rather Than Lending to the Non-financial Private Sector
Since early March 2020, banks’ reserves have increased by $2.25tn (Chart 1). A $3.2tn expansion in banks’ assets accompanied this increase. This likely reflects that the Fed purchased securities mainly from the nonbank sector. When banks sell bonds to the Fed, the size of their balance sheet does not change. Rather, the composition of assets changes, with an increase in reserves offset by a decline in banks’ bond holdings. By contrast, when the Fed purchases bonds from outside the banking system, the seller is paid through an increase in their bank deposits that increases banks’ balance sheets.
This suggests that, althought reserves already represent nearly one fifth of banks assets (and nearly one third of large domestically chartered banks assets) there is ‘room’ for further reserves expansion. Banks cannot refuse to hold the reserves created by the Fed and associated deposits. They can however—and they have—charge fees on deposits and associated transactions. At the same time if banks cannot find enough opportunities to lend, they are likely to buy securities instead. In addition the deposit multiplier, the ratio of deposits to cash (roughly equal to broad money divided by the monetary base), is likely to fall.
Fed Easing Is Funding the Public Rather Than the Non-financial Private Sector
Like banks, the Fed is buying debt from the public sector, which has only a limited direct impact on the non-financial private sector. That QE raises bond prices, which in turn raises the price of riskier assets is well established by now. Where the transmission of QE to the real economy breaks down is with the limited impact of higher asset prices on private sector demand. For instance, higher asset prices will likely have limited wealth effects because of the skewed distribution of wealth in the US. Households in the top income decile own nearly 90% of all corporate equities and mutual fund shares. High-income households tend to have a high propensity to save, suggesting they will likely save, not spend, an increase in their wealth.
The main impact of QE is therefore through supporting the funding of expansionary fiscal policy. But the impact of fiscal policy on the economy varies, depending on the type of fiscal expansion. For instance, tax cuts for high-income households, that have a high propensity to save, or for corporates, will likely increase their savings (i.e., the demand for financial assets) rather than their spending on goods and services, as shown for instance by the impact of the 2017 tax cuts. Fiscal policy is likely to have more traction on the real economy if it consists either of tax cuts/transfers targeted at households with a high propensity to consume, i.e., low-income households or of increased government spending. At the same time government spending, for instance on infrastructure, can take a long time to be implemented.
And more broadly, monetary policy works by bringing forward planned spending. Because lifetime spending is finite, there is a limit to how much spending can be brought forward. After over a decade of ultra-loose policy, monetary easing is probably now pushing on a string, as far as the real economy is concerned. Monetary easing still has great potency in financial asset markets.
Market Consequences
Money flows show that Fed easing is having a stronger impact on financial asset prices than on the real economy. I think the market tolerance for the Fed’s inflation outlook together with the Fed’s plan to avoid tapering until 2022 (although a December 2021 formal announcement is my base case) make for more equity upside. Based on the latest Treasury refunding plans and the current pace of Fed asset purchases, bank reserves could increase by another $750bn and Fed securities holdings by another $540bn by end-Q3. With the 10-year yield around 1.7% and limited macro headline risks, a good chunk of that liquidity could well end up in the stock market.
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Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)