Monetary policy is an important driver of economic growth. It sets in motion and controls, by and large, the supply of money available for lending and commerce. As 2013 comes to a close, the Dow Jones Averages, the S & P and the Nasdaq are setting new highs. On December 20, 2013 the Dow closed at 16,221.14, the S & P at 1818.32 and the Nasdaq at 4,104.74. Much of this spectacular gain was the result of US Federal Reserve Monetary Policy.
On Wednesday December 18, 2013, outgoing Chairman, Ben Bernanke, made an all-important speech, outlining a change in direction for monetary policy going forward. The Board of Governors of the US Federal Reserve agreed to taper their buying of Mortgage Backed Securities and US Treasuries by $10 billion per month, down from their present $85 billion. A reduction of $5 billion each for Mortgage Backed Securities and Treasuries was declared.
Since 2009, the Fed has been buying Treasuries and Mortgage Backed Securities from banks and lending institutions. The effect of this has been that the Fed credits bank balances with the proceeds. The Fed’s “Book” or balance of securities held is approximately $4 Trillion. This incredible pile of money given to the bankers has given them a field day. They originally were supposed to lend out the money to jump start the economy. Instead they used much of it to speculate in the markets. The rest of the money is sitting at the Fed as “Excess Reserves” and is drawing interest from the Fed at .25%. So, there is little incentive to lend out money when all you need to do is let your excess reserves sit at the Fed and draw interest. This helps to explain why the Stock Market is at new highs while Main Street is just hovering just above the flat line. One of the best ways to jump start the economy is for the Fed to stop paying banks interest on Excess Reserves. That would force banks to put the money to work lending out the money which is what they were supposed to do.
One important result of the Fed’s tapering is that it “does not” reduce the Fed’s “Book” of securities. In fact, the continuing buying of Mortgage Backed Securities and Treasuries will all to the Fed’s “Book.” So, there will still be plenty of money pumped into the economy.
The second important decision of the Fed’s meeting was that they plan to hold the Fed Funds rate at 0-.25%. The Fed Funds rate is the rate at which banks trade balances held at the Fed with each other. What this means is that if a bank lends out money, it reduces its balance at the Fed. They can borrow from another bank that has excess reserves to lend.
Taken together, these two major decisions are setting the stage for continued growth in US economy into 2014. The key will be the extent to which banks accelerate their lending. Lending money “creates” new money.
If a bank lends a small business owner $500,000, it credit’s the company’s checkbook with $500,000. The company can then expand, hire more workers, who, in turn can spend more money, and reduce the unemployment rate at the same time. This increases the “velocity” of money, that is the driver of further growth.