Raising Money On Wall Street Has Become Cheaper And Easier

An interesting dilemma seems to have arisen in the United States financial markets.

Kate Duguid and Nicholas Megaw write in the Financial Times:

“Raising money on Wall Street has become cheaper and easier despite the Federal Reserve lifting interest rates to the highest level in 15 years, suggesting an ongoing and deep disconnect between investors and central bank officials.”

“Measures of financial conditions–the ease with which companies can access funding–have tumbled in recent months, with one closely watched index returning to the level it was at shortly after the Fed started raising rates last March.”

“The divergence has led some investors to caution that the Fed fades a serious communications challenge that could threaten its efforts to keep inflation under control.”

Ms. Duguid and Mr. Megaw point to the Goldman Sachs US Financial Conditions index as one indicator of this fact. The index reached its lowest level since August… after the Fed raised rates last week.

Also mentioned is a weekly measure compiled by the Federal Reserve Bank of Chicago which showed “the lowest level since April.”

The reason for the decline is given that there has been a change in inflationary expectations.

The financial markets seem to have a different view of the future of inflation than does the Federal Reserve, and this difference is the reason for the different outlook.

Jay Barry, co-head of US rates strategy at JPMorgan, argues that

“The difference between market pricing and the Fed’s own forecasts is a difference in inflation expectation.”

The market expects U.S. inflation to come down faster than the Federal Reserve does.

If one looks at the difference in the nominal yield on the ten-year U.S. Treasury note and the yield on the ten-year U.S. Treasury Inflation Protected securities (TIPS), one calculates a number that many refer to as the inflationary expectations built into the bond market.

Recently, this market estimate of inflationary expectations is right around 2.20 percent. That is, the expected compound rate of inflation over the next ten years is 2.20 percent.

The Federal Reserve currently seems to believe that inflation will come in higher than that over the next ten years.

Consequently, Chairman Jerome Powell keeps making cautionary remarks warning against the Federal Reserve “loosening” up too quickly.

On Tuesday, Mr. Powell reiterated that continued evidence of a booming labor market or persistent inflation could force the central bank to raise interest rates more than the market at present expected.

But, Mr. Powell’s comments have not been strong enough to convince the investment community that he is really that serious.

Or, could it be that the banking system is not suffering from a “tight” monetary policy and has more than enough money to get by in the near term, even though the Federal Reserve is actually reducing the size of its securities portfolio and raising its policy rate of interest?

Commercial Bank Excess Reserves

Let’s take a look at the “excess reserves” that exist in the banking system.

If we look at the Federal Reserve’s balance sheet we see an item titled Reserve Balances with Commercial Banks. (This is found on the Fed’s H.4.1 statistical release titled “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.”)

This line item is often used to serve as a proxy for the excess reserves of commercial banks.

Here is a picture of what has happened to the “excess reserves” of the commercial banking system.

You can see from the chart that “excess reserves” in the banking system amounted to about $3,600 billion, or, $3.6 trillion, in early August of 2022, several months after the Federal Reserve began its exercise in quantitative tightening.

These excess reserves have fallen since that date and now total somewhere around $3,000 billion, or, $3.0 trillion.

So, the Fed’s quantitative tightening has removed about $600 billion from the excess reserves now held by the commercial banking system.

Do we find similar numbers elsewhere so as to confirm the volume of excess reserves on bank balance sheets?

Here are some numbers that are comparable — cash assets for all commercial banks. (This information is found in the Federal Reserve release H.8 “Assets and Liabilities of Commercial Banks in the United States.”)

One can see here that cash assets at all commercial banks totaled about $3,382 billion or about $3.4 trillion on August 1, 2022, and dropped to about $3.125 billion or about $3.1 trillion on January 25, 2023.

The numbers don’t match because the second series, Cash Assets, include deposits at the Federal Reserve plus vault cash.

But, the pictures are roughly the same.

“Excess reserves” in the commercial banking system have dropped since the Fed’s “tightening” has begun, but there are still massive amounts of “excess reserves” still remaining in the banking system.

If the Federal Reserve removes about $1.5 trillion in bank asset reserves from the banking system, there will still be a huge about of “excess reserves” on the balance sheets of the commercial banks.

Is this a “tight” banking system?

Is this banking system still under the control of the Federal Reserve?

Commercial banks in the U.S. banking system still have a massive amount of “cash assets” on their balance sheets.

Commercial banks can still do lots of things that might go against what the Federal Reserve is trying to do at any time with the situation as it is.

U.S. commercial banks have liquidity, lots and lots of liquidity.

This means that U.S. commercial banks can do lots and lots of things that the Fed cannot immediately control.

To repeat,

Ms. Duguid and Mr. Megaw point to the Goldman Sachs US Financial Conditions index as one indicator of this fact. The index reached its lowest level since August… after the Fed raised rates last week.

Potential borrowers can find obtaining money easier than it had been for some time.

This is because the “cash” is just sitting around in bank vaults.

The Fed is reducing the amount of cash in bank vaults, but…

There is only so much the Fed can do to reduce the liquidity position of the banks.

I guess the Fed could ‘freeze” the cash assets of commercial banks, stop them from lending these monies.

But, that is really something I would not like to see happen.

Bottom line: the Federal Reserve has injected a massive amount of “cash” into the banking system.

Inflation raised its ugly head.

How much must the Federal Reserve “backtrack” to bring the system back into a more controllable position?

Sooner or later, Mr. Powell and other Federal Reserve members are going to have to work this out.

It may not be pretty.