Credit Driven Liquidity

The Federal Reserve has achieved some success in slowing the
growth of its prime focus monetary aggregates M-1 and M-2.
Part of the reason growth of these aggregates has slowed is
that banks have simply changed emphasis in how credit growth
is being funded.

Bank lending and leasing has been growing far faster than the
economy over the past eighteen months reflecting a sharp
acceleration of commercial and industrial loan growth as well
as a continued strong real estate loan book (mortgages and
development loans). Although growth of home equity loans has
slowed sharply, yr/yr growth of the real estate loan portfolio
tops 12.0% and has been trending higher so far this year.

Of interest now is that evidence of a slowdown in the housing
market has begun to accumulate. Should this continue as is
now widely expected, the real estate component of credit
demand at the banks will begin to slow, and this will reduce
the growth of bank funding, since the real estate portfolio
is by far the major component of the banking system's loan
book.

The Fed has to be on this like white on rice, because a slowing
of bank funding growth without a corresponding easing of
basic monetary liquidity can establish conditions that may well
lead to a liquidity squeeze and consequent damage to the
economy and the stock market.

Most real estate loans are still longer term, and it is the C&I
loan book that the Fed watches most closely in setting the Fed
Funds rate. The book of shorter term business loans is still
zipping along, and when momentum in this category rolls over,
the Fed normally stops tightening. Now, the Fed has to watch
both categories closely, because too rapid a slowing of the
growth of the real estate book could produce an unwanted
drag on liquidity. Time to watch all of this more closely.

A primary funding vehicle for banks is commercial paper issuance.
This category, which includes collateralized or asset backed
paper has grown rapidly over the past two years. The Fed
regularly releases data for the commercial paper markets on its
web site, and for a nice update from Haver Analytics click here.