Excess Reserves Fall With Adjusted Monetary Base

One chart that we have to pay particular attention to this year is the excess reserves held by banks.  You can find that here.

This is an important piece of economic data, coupled with the adjusted monetary base.  You can find the adjusted monetary base here.

The excess reserves have been falling.  There was a peak of $2.7 trillion in August 2014.  Just for some context, excess reserves were around $2 billion prior to September 2008.  Prior to the financial crisis, most banks did not hold any significant amounts of excess reserves.  This is why the federal funds rate (overnight borrowing rate) was so much more important back then.

Since the peak of about $2.7 trillion over 2 years ago, the total excess reserves now stand around $1.925 trillion.  We have seen a drop of nearly $800 billion.

In August 2014, the adjusted monetary base was just over $4.1 trillion. (It had been just over $800 billion prior to September 2008.) The monetary base is now around $3.4 trillion.

In other words, the excess reserves have dropped with the dropping monetary base.  The excess reserves have fallen slightly more.

If excess reserves were to drop without a corresponding drop in the monetary base, then this would be highly inflationary.

The Fed is supposed to be maintaining a tight money policy now.  QE3 ended in October 2014, but the Fed is still rolling over maturing debt.  There are some technicalities of why the monetary base may be gradually decreasing.

The important thing right now is the relationship between excess reserves and the monetary base.  If we see a divergence at some point, it is going to give us a good indication of the economic environment that is coming.

The Fed has raised its target federal funds rate, which means it is paying a higher interest rate on reserves.  This should keep banks from lending, but it hasn’t seemed to have done much up to this point.

If the monetary base continues to gradually decrease or flatten while the excess reserves start going back up, then this will indicate a greater chance of recession.

If the monetary base flattens while the excess reserves keep falling, then this will indicate a higher likelihood of increasing inflation in the near future.

We will continue to watch these two sets of data throughout 2017.

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