Fed’s Balance Sheet BalloonsMarch 21, 2023
To shore up Silicon Valley Bank and the other failed banks, the Federal Reserve extended an open-ended line of credit via its Bank Term Funding Program (BTFP) and discount window borrowings. So far, this program has increased the Fed’s balance sheet equal to roughly half of the reduction done by its Quantitative Tightening (QT) program. In just one week, one year’s worth of tightening was cut in half.
Here we can see that total bank deposits had started to come down as QT played out, even before the recent bank crisis, thus reducing the money supply in the economy.
The drop in “M” in the Fisher Equation of MV = PQ points to the need for velocity to increase to offset the drop. Money, as commonly measured by the US Dollar M2 is shrinking rapidly.
Concerningly, the velocity of money has been structurally decreasing since the tech crash of 2000. It also crashed after the Great Financial Crisis, recovering briefly in the wake of the pandemic. Anecdotally, stories of banks tightening credit conditions have already surfaced in the wake of the SVB collapse. The senior loan officer survey conducted by the Fed showed banks have already been tightening credit standards on a range of loans. The drop in velocity has corresponded with a decreasing term premium (i.e., it is deflationary). Accordingly, any shock to the banking system that causes a renewed drop in velocity, such as tighter credit standards, could lead to a further decline in the term premium.
Given the recent banking problems, one is left asking whether the Fed will find it necessary to engage in additional rate hikes and/or QT in the face of such a deflationary backdrop. We’ll find out tomorrow.
As of 12.31.22, none of the securities mentioned were held in the Knowledge Leaders Strategy.