Monetary Policy & The Banking System

The Fed has convened its normal 2 day FOMC meeting. The basics
for rate setting that I follow continue to point to maintenance of a
low short rate. Business activity in the US has moved sharply from
deep recession to sufficient breadth to be just below the expansion
threshold. Change has been very rapid so far in 2009. However,
expansion must proceed apace for at least several months before it
would signal it was time to raise rates. As well, capacity utilization
remains depressed and would normally be expected to improve
substantially before the Fed reversed course. Finally, the short term
credit demand / supply pressure gauge continues to move in favor
of slack, as C&I loans run-off as expected. So, a change in FOMC
rate posture would be quite a surprise.

Now, since there has been some inflation pressure from the petrol
sector, and, since economic recovery is now expected to begin sooner
rather than later, the markets and the many observers of the Fed are
likely to begin questioning how long the Fed may maintain its several
large liquidity injection programs. This latter issue is distinct from the
rate setting function, and at some point soon, the Fed may well have
to provide more specifics about keys to closing out these programs.

There is a potential kicker here for the markets. Fed diligence in
framing out how it will move to restore long term integrity to its
balance sheet could have significant consequences for the US dollar,
Treasury securities and precious metals and commodities prices.
The impact of Fed commentary on this issue for equities is less
clear, but could be important nonetheless. Bottom line: the Fed
will want to show it is supportive of recovery but is also increasingly
sensitive to restoring monetary integrity. The sooner it does this,
the faster worries of substantial eventual inflation should dissipate.

Banking system lending has been flat now since mid-2008. No
surprise here at all. A deep recession brings lower private sector
credit demand which can persist for a while even as recovery begins.
C&I loans are running off, the real estate book is very sluggish, and
home equity loans, which did spike up over Half 2 '08, have begun
to level off as borrowers grow more confident about the security of
those lines. The real estate book for the industry is now running
about $800 billion below the longer term trend.

Even with the loss of momentum to real estate lending, total bank
lending is running about $1 tril. or 17% above its 10 year trend. This
suggests continued vulnerability of the banks to further significant
loan losses ahead. Bank net interest cash flow has flattened out, but
bank profitability can still improve markedly if loan losses come in
below recent horrific levels. Capital remains level and system
liquidity is improving as borrowers rely more on their internal
cash flows.