Financial Liquidity & Banking System

Narrow and broad measures of money and credit driven liquidity
remain inadequate to fund continuing economic recovery if the
tighter liquidity situation persists through 2010. That is my
current "guesstimate". We are not experiencing a conventional
cyclical liquidity squeeze with fast rising short term interest rates
and overheated credit demand. Rather, we have a liquidity "freeze"
as the Fed presumably waits to see whether higher economic
demand will trigger a resumption of private sector credit demand
growth and an upturn of lending to qualified borrowers. the Fed is
jawboning the banks to lend to businesses with rising order books
and solid cash flows. If lenders and borrowers remain unresponsive
to super low interest rates, the next monetary step would be to
resume quantitative easing to support a shallow "cash and carry"
economy.

Now, monetary and the broader measure of credit driven liquidity
have both been expanding in recent weeks. Even the monetary base
has inched up. Moreover, the downtrends in private sector credit
demand -- business and households -- has eased very substantially.
All to the good, but not enough to signal sustainable positive change.

Banks have restored liquidity and are witnessing a decent recovery
of capital. They are also issuing a little more commercial paper and
are offering more large or jumbo time deposits (mostly reserve free).
The system is still carrying a massive loan loss reserve although it
has started to drift down. But, a number of banks have to be
positioned to lend moderately to high quality borrowers, including
households.

At this stage, the tighter liquidity position of the system is probably
forcing a number of investors to make asset allocation decisions with
more limited reserves and to be tempted to follow relative strength
among asset classes even more closely. Retail money market funds
are at their lowest levels since 2006, and institutional funds have
been heavily drawn down to the tune of 25%. The latter marks a
large reversal for a business with strong underlying growth.