The Stock Market: The Federal Reserve Is Tightening UP

The Federal Reserve is tightening up on its monetary policy!

On July 28, the Fed raised its policy rate of interest by 75 basis points. This followed an earlier increase of 75 basis points on June 16. And, these were preceded by 50 basis point increases on May 5 and on March 16.

Since March 16, 2022, the Federal Reserve has reduced the size of its securities by almost $52.0 billion.

All of this came with Federal Reserve officials talking about the need for the Fed to seriously tighten up on its monetary policy to combat inflation that seemed to be getting out of hand.

Stock prices continue to rise.

Over the past four weeks, the Standard & Poor’s 500 stock index has risen from 3,803 on July 15, 2022 to 4,280 at the close on August 12, 2022. This represents a 12.5 percent rise in the index.

The NASDAQ index has risen from 11,452 at the close of the market on the earlier date and closed Friday, August 12 at 13,047. This represents a 13.9 percent rise.

The Dow Jones Industrial Average went from 31,288 to 33,761, increasing by 7.0 percent over this period of time.

For much of the past 12 years, the Federal Reserve underwrote a rising stock market, with all three of these indices hitting new historical highs on a regular basis.

Now, the Federal Reserve seems to be heading in the opposite direction and stock prices continue to rise.

What is going on here?

Monetary Tightening

One could argue that monetary tightening is relative.

Yes, the Federal Reserve is raising its policy rate of interest.

But, given all the liquidity the Fed has put into the commercial banking system over the past 12 years or so, especially since early 2020 and the start of the spread of the COVID-19 pandemic, one can question just how “tight” the commercial banking system really is.

If one looks at the Fed’s H.8 statistical release, “Assets and Liabilities of Commercial Banks in the U.S.” one can see that the banking system, as a whole, is carrying $3,390.2 billion in “cash assets” on its balance sheets.

Yes, that’s $3.4 trillion!!!

Large, Domestically Chartered commercial banks in the U.S. are carrying $1,554.6 billion on their balance sheets.

This category contains the largest 25 commercial banks in the country.

On average, each “Large, Domestically Chartered ” commercial bank is holding $62.2 billion in cash assets on its balance sheet.

Another measure of cash assets on the balance sheets of commercial banks is to look at the Fed’s balance sheet in the Federal Reserve Release H.4.1, “Reserve Balances with Federal Reserve Banks.”

On August 10, 2022, Reserve Balances with Federal Reserve Banks totaled $3,357.2 billion, almost the same as the total cash assets commercial banks held on their balance sheets.

Note that just before the Great Recession in 2007, Reserve Balances with Federal Reserve Banks totaled $6.0 billion!!!

This total amount is only 1/6th of the amount one of the largest banks, on average, maintains.

Today’s reserve balances are 560 times the amount of total balances the commercial banks used to hold in this account.

How much liquidity exists in the banking system?

How much monetary tightening does the Federal Reserve have to do to actually cause some discomfort for the commercial banking system?

But, also note that the Fed’s statistics show that “Foreign Related Institutions” in the United States have cash balances that total $1,236.2 billion, or $1.2 trillion.

The foreign banks, in the U.S., also are carrying a lot of cash on hand. There is money all over the place.

The rest of the U.S. banking system, or the small domestically chartered commercial banks, maintain cash assets of around $600.0 billion. This amount is 100 times the amount of cash assets the whole commercial banking system held in 2007!

Liquidity All Over The Place

There appears to be plenty of evidence that many others are holding on to major amounts of cash assets throughout the economy.

Yesterday, I wrote about the cash balances that the venture capital industry has on hand.

At the end of July 2022, venture capital firms have $539 billion in cash assets on their balance sheets. Before the Great Recession in 2007, the industry was sitting on only $100 billion in cash assets.

The venture capital industry is not the only sector of the economy that is sitting on large cash balances.

Yes, some areas are having corporate struggles with firm performance and financial stability, but, when one looks at the larger picture, there the financial markets are flush with cash.

And, this seems to be what investors are picking up on.

The Federal Reserve is tightening up on monetary policy.

But, investors seem to be asking us to “look behind the curtains.”

Federal Reserve officials are saying that they will do what is necessary to bring inflation under control.

But, investors seem to be saying that there is so much liquidity afloat in the financial system that what the Federal Reserve has proposed to do in terms of fighting inflation seems far short of being able to actually restrict the system.

In other words, the Federal Reserve has injected so much money into the financial system that it will take more than just incremental actions to constrain these monies that as they will have little or no effect.

The Stock Market

Right now, the future of the stock market seems closely tied to what the Federal Reserve wants to do and what the Federal Reserve can do.

There is little doubt that the Federal Reserve has been the primary creator of the current situation. The Fed has been dominating the market for the last twelve years or so with its three rounds of quantitative easing, its efforts to always err on the side of monetary ease as it attempted to guide the economy, and its efforts to avoid a financial collapse created by the COVID-19 pandemic and subsequent recession.

The stock market, of course, was a major beneficiary of the Fed’s efforts.

But now, the Fed has to live with what it created.

Years and years of stimulus cannot be removed, painlessly, in just a couple of months.

Investors seem to be telling us that the stock market has room to rise, given all the liquidity that exists within the system.

Wealthy/sophisticated investors seem to be ready to take advantage of a turnaround. These individuals seem to be ready to move on to the “new” Age, the next era of economic structure and development.

The venture capitalists are not the only group that is waiting for this transformation.

Much of the radical uncertainty connected with this situation is the consequence of the Federal Reserve. Unfortunately, this is not what the Federal Reserve should be doing.