Financial System Liquidity

The banking system continues to contract as banks let loans roll off
the books and boost Treasury and other investment holdings. Thus,
banking system liquidity has improved sharply. The banks are still
recording a high level of loan loss reserves, although the momentum
in the system account is slowing. Businesses -- flush with cash --
have been steering clear of the banks and are using internal resources
to finance recovering sales. Businesses in desperate need of cash are
simply out of luck. Top quality borrowers with direct access to the
nonfinancial commercial paper markets do not seem to be paring back
further.

Over 90% of the increase in banking system primary funding levels
reflects growth in currency and checkables and this is directly
attibutable to Fed quantitative easing. The Fed is looking forward to
cutting back on this policy, but wisdom suggests that the situation
with bank private sector credit creation stabilizes first. (Keep in mind
that the basic money supply accounts for only 15% of primary bank
funding and that the Fed, rather than being profligate, has been
battling to curtail a deflationary contraction in private sector credit.)

Money market funds, both retail and institutional , are used to finance
capital markets transactions as well as purchases of goods and
services within the real economy. These balances built up sharply over
2005 -07, but have since been in substantial drawdown mode. Thus
liquidity from this sector although remaining substantial, has been
pared back.

The real economy is growing and the very broad measures of financial
liquidity have been declining modestly. Thus, by my approach, the
capital markets now face a headwind from reduced liquidity as the
real economy takes precedence.

The economy does tend to lead the broad measures of credit driven
liquidity in the system. As the economy continues to recover, it is
likely to become more credit dependent, which can, in turn, lead to
more liquidity on hand to finance the capital markets as well.