Liquidity Cycle

My broad measure of financial system liquidity, excluding direct QE from the Fed, rose by
6.3% over the past year. Thus, private sector funding topped total demand from the economy
by a modest margin, allowing a small amount of excess liquidity to flow into the capital and
real estate markets. When you add in the QE 3 program, the yr/yr change in liquidity provided
jumps to 11.9 %. Even though the QE securities purchases are primarily filtered through the
banking system, there has been heavy liquidity support for the markets with stocks and
housing prices being the notable beneficiaries.

Private sector loan demand did pick up just recently, but the banking system has been loafing
along for the past year, with total interest earning assets having risen by just 2.2% and the
system's loan book by 2.6%. This meager output from the banks is far below normal for an
economic recovery approaching a duration of around 4.5 years and shows the economy's
reliance on the QE programs from the Fed as the banking system continues to repair. Yet,
other sources of private credit such as shadow banking are taking share from the banks, and
so it is fair to wonder how bankers have been filling their time at the office.

Going forward, if the economy can sustain faster growth momentum, business and household
sector cash flows will improve, but the banks are going to need to step up lending activity if
the economy is to able to grow decently without the unprecedented QE support.

From a policy perspective, the Fed is officially following employment growth and the inflation
rate as primary policy parameters. However, it would indeed be very risky for the US economy
if the QE program is eliminated before private credit creation begins functioning more normally.