Liquidity, Credit & Monetary Policy

The broad measure of monetary plus credit driven
liquidity increased at a still high 9.2% yr/yr
through July. However, for the April - July period,
this measure rose at only a 4.4% annual rate. After
factoring out an acceleration of economic growth
over this interval, it turns out the financial and
capital markets faced a liquidity deficit or squeeze.

The slowing of liquidity growth follows directly in the
footsteps of the emergence of default problems with
subprime mortgage loans in the late winter. Since April,
banks have effectively capped off real estate exposure.
The banks did increase business loan exposure, but the
leveling off of the much larger real estate book
resulted in reduced funding needs and hence, slower
growth of financial liquidity to the economy. Real
estate lending is now as slow as it has been since the
wake of the international financial crisis of 1998-99.

To maintain net interest margin, banks jumped even more
aggressively into the deal and share buy-back games over
the April - July period, with business loans increasing at
a powerful 20% annual rate. Come July, as other speculative
lenders such as hedge funds grew chary, the banks were
loaded up with deal flow participations, some intended as
short term, but quite risky. As the banks stepped back,
Fred Molinaro, the CFO of Bear Stearns, complained bitterly
about the stalled pipeline.

Over the long pull, commercial banks like to maintain a
balance between business loans and their Treasury investment
holdings. One can use this measure as a quick check on
balance sheet liquidity within the banking system. Despite
the recent bulge in C&I loans, banking liquidity is still
adequate with a C&I to Treasury ratio of 1.075 to 1. In
fact, liquidity may be a little understated as banks have also
been buying munis for investments as well. On a long term
basis, banks are hardly loaned up or loaned out, and can
re-claim some liquidity as the deal pipeline restarts, if even
hesitatingly. What the banks cannot do for long, is generate
business loans at a 20% rate. Continued rapid growth of C&I
loans from here would sharply reduce liquidity, force the Fed
to raise short rates and lead ultimately to crunch time.

Above all, the Fed is interested in the stability of the
banking system. Its decision to maintain the FFR% at 5.25%
is an expression of willingess to allow the banks to regain
manegerial control over their exposures. Key economic data
that have been bedrock in setting monetary policy are far
stronger than in late 2006 - early 2007, and the Fed could have
raised the FFR% yesterday based on that data. My guess is that
They doubt the strong readings will hold. Realistically, since
inflation of 5% (annualized) wiped out all but 0.1% of the
increase in real household wages over the first half of the
year, the Fed does not see growth running away to the upside,
and sees no compelling reason to aggravate the credit picture.

Fed policy is in a higher risk zone now. Monetary liquidity has
grown rather sparingly since 2004, and the larger component of
credit driven liquidity has financed the expansion and the asset
inflation. But with credit driven liquidity growth now also low
in the short run, the Fed must be on its toes.