Financial System on Fed Life Support

"Stretched" is hardly the word to describe the Federal Reserve's balance sheet, which was revealed as usual to the public late Thursday in the release titled "Factors Affecting Reserve Balances." The new data make clear that the U.S. financial system is currently on life support, with the Federal Reserve seemingly the only lender of any consequence at the moment.

This was apparent in Thursday's figures on commercial paper issuance, which posted a record weekly drop of $94.9 billion, and in figures on bond issuance ($7 billion in three weeks -- a tenth of the norm), and bank lending, although new data indicate that there has been some shift to bank credit from other sources of borrowing.

Federal Reserve credit, which measures all monies injected into the financial system by the Federal Reserve, increased massively, by an unprecedented daily average of $253.6 billion to $1.388 trillion in the week ended Wednesday, following an equally massive $203.6 billion the previous week. Mind you, this is a figure that tends to increase only a few percent per year. Last week's increase was about five times greater than the last two large infusions, which occurred in September 2001 and the period surrounding Y2K.

Many factors bloated the Fed's balance sheet. For starters, primary dealers increased their borrowing by a daily average of $59.5 billion to a record $147.692 billion, a clear sign of stress amongst dealers. Three weeks ago, this figure was zero.

Second, commercial banks increased their borrowing by a daily average of $5.1 billion to $44.46 billion. Three weeks ago the figure was at $23.4 billion. The loan to AIG also increased, to $61.3 billion from $44.6 billion.

The longer the money injected into the financial system stays in the financial system, the more likely it is that banks will submit requests for actual currency, which would boost the money supply, growth and inflation. In fact, the total amount of currency in circulation grew at a relatively strong pace in the latest week, by $4.6 billion to $841 billion following a gain of $3.3 billion the previous week. These are strong gains considering the fact that the total increase for the past year, including recent weeks was just $20 billion.

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Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of the revised investment classic, The Money Market, first published in 1978 by Marcia Stigum, and The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. Crescenzi appreciates your feedback; click here to send him an email.

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