Thursday, May 8, 2014

QE3 replaced credit with cash

Bank balance sheets continue to explode as QE3 tapers.  Here is a comparison of excess reserves at the Fed with Loans and Leases in Bank Credit at Commercial Banks:

I view the QE programs as a type of bank credit supplement, in the form of cash.  The Fed is a sort of bank that can only take deposits through other banks, so the excess cash and its corresponding deposits sit on commercial bank balance sheets, but are totally disconnected from the banks' operational balance sheets.  I have speculated that the inverse movement of these quantities might suggest that QE has served as funding for profitable investment, crowding out the banks' supply of credit for a limited supply of viable investments.  Now that QE is tapering, banks have a pent up supply of capital available to extend credit as a replacement for the cash that was previously being provided through QE3.  Bank credit has suddenly begun expanding at a rate that more than makes up for the decline in QE cash.

In a way, it is simply a semantic difference.  Cash rich non-banks have been buying up bank loans and real estate mostly as a result of this fact that credit since the fall of 2012 has been coming into the economy in the form of QE cash instead of in the form of bank credit.  Here is a measure, from of the collateralized loan market.  Notice that it seems to rise along with QE3.  And, in the next graph, also from, we see inflows declining along with the taper.

It seems to me that if the Fed can arrange a mechanism where they eventually trade the banks treasuries in exchange for excess reserves, while minimizing transaction mechanisms that would temporarily pull cash out of the economy (a reverse hot potato effect) the Fed's inflated balance sheet is relatively benign and mostly unconnected to the eventual position of monetary policy.

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