The Big Idea
Drowning in liquidity
Stephen Stanley | January 29, 2021
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
From an economist’s perspective, some of the more recent and unusual twists and turns in markets have a common root. The financial system, and the economy more broadly, are awash in liquidity provided by both monetary and fiscal policy. From that perspective, things are likely to get more extreme before they normalize.
The Federal Reserve aggressively responded to the pandemic, initially cutting rates to the zero bound and then adding liquidity through an array of lending programs as well as asset purchases. As of January 20, the Fed’s balance sheet had swelled to $7.4 trillion, up by more than $4 trillion from a year earlier. Much of this has been accomplished by its asset purchase program, as the Fed’s securities portfolio has risen over the past year by nearly $4 trillion to $6.9 trillion.
Ironically, before the pandemic, in the summer of 2019, the FOMC concluded that it had overshot and reduced its balance sheet too much, creating a shortage of bank reserves. A year ago, the level of reserves was about $1.5 trillion, and the Fed was in the process of expanding it. That program went into turbo boost mode after the pandemic hit, and the level of reserves has surged to $3.2 trillion, more than doubling in a year.
As aggressive as monetary policy was in 2020, fiscal policy was even more generous, exceeding anything seen in other modern recessions. The federal government authorized over $3 trillion in spending between the CARES Act and the subsequent top-up of the PPP program, and then approved another $900 billion in outlays in December. Now the Biden Administration wants to add another $1.9 trillion to the tab, including doling out another $400 billion or more in rebate checks to households.
To fund this spending, the Treasury on a net basis borrowed roughly $4 trillion in fiscal year 2020. This debt not only covered the budget deficit but allowed the Treasury to ramp up its cash balance from about $400 billion at the end of calendar year 2019 to over $1.7 trillion at the end of 2020.
That elevated federal government cash balance actually has absorbed some of the Fed’s liquidity provision, as an increase in the Treasury’s cash balance lowers bank reserves on a one-for-one basis. To understand why, consider that to achieve that higher cash balance, the Treasury has to borrow more, and that additional debt issuance takes cash out of the hands of the financial system. The surge in the Treasury cash balance is the primary reason that the Fed bought over $3 trillion in securities over the past year, but bank reserves only went up by $1.5 trillion.
Liquidity courses into the economy
All of that liquidity has to go somewhere. The Fed’s Flow of Funds data show that through September 30, household balance sheets had swelled. Incorporating checkable deposits and currency, time and savings deposits, and money market mutual fund holdings, households’ liquid assets rose by $2.3 trillion from December 31, 2019 to September 30, 2020. Federal government payouts, mainly in the form of rebate checks and supplemental unemployment benefits, exceeded the loss of wage and salary income, pushing personal income well above pre-pandemic levels last year.
The fiscal boost faded somewhat in late 2020, as the extra $600 per week in unemployment benefits expired and there were no new rebate checks. That all changed with the passage of the December Covid relief package, which authorized a renewed $300 a week in supplement unemployment insurance payments and $600 rebate checks. Moreover, the prospects look good for another larger round of rebate checks in the coming months, as well as other potential new aid.
With large parts of the economy constrained, household finances resemble the old idiom “all dressed up and no place to go.” Unable to spend on fancy dinners out, travel, concert tickets, and other usual pursuits, retail sales roared for a while, but one can only buy so many vehicles or TVs or appliances, and then one simply has to let the money accumulate and wait for the chance to spend it.
Of course, there are many households that are struggling through the pandemic and are in dire need of fiscal help. The aggregate numbers do not fully reflect the divergence in fortunes across households, but the numbers for the economy as a whole do show that the universe of households is awash in cash.
The findings from a New York Fed survey last June offer insight on how households deployed the first round of rebate checks in the first six weeks or so after they were issued. The sample of nearly 1,500 households saved 36.4% of the checks, used 34.5% to pay down debt (another form of net savings), and spent 26% of them (18.2% on essentials and 7.7% on non-essentials). The final 3% was donated. More than 70% of the checks were saved, while 26% were spent.
A separate study by NBER researchers published in September found that households with under $100 in their bank accounts spent over 40% of their checks within the first month, while households with more than $4,000 in their accounts barely spent any of the rebate checks. As an aside, these statistics constitute a strong case for narrowly targeting any future fiscal assistance to households.
On the business side, the buildup in liquidity has not been quite as sharp. Corporate revenues certainly suffered due to the drop in economic activity early last year. Still, the rock-bottom level of interest rates coupled with the Fed’s efforts to lower risk spreads led to an unprecedented corporate borrowing spree last year. As of September 30, nonfinancial corporations had added almost $1 trillion in liquid assets from the end of 2019.
It has to go somewhere
So, if households are sitting on a massive and growing pile of cash and can’t spend it, where does the money go? Well, apparently at least some folks with both money and time on their hands have decided to try their hand at day trading stocks. The “GameStop phenomenon” amounts to an army of individual investors hunting down stocks that hedge fund managers have shorted and then squeezing them until they capitulate. CNBC has spent hours and hours discussing the populist implications of this pitchfork rebellion of individual investors, but from an economist’s perspective, this is just one more, albeit unusual, result of the massive infusion of liquidity into the economy. Reporters tried this week to get Chairman Powell to admit to the Fed’s complicity in this phenomenon, but, as usual, he claimed innocence.
Meanwhile, the bulk of that cash pile, rather than being risked on stock options, is just sitting around in bank deposits and retail money funds. Clearly, this slow-moving pileup of cash is not responsible for the sudden volatility in the repo market over the past week, but the broad landscape is that there is so much cash being held as liquid assets over the entire economy that traditional money market players are constantly scrambling for investable assets. One money market practitioner declared that there is a shortage of Treasury bills. It might feel that way in the heat of the trading day, but the reality is that the Treasury added $2.5 trillion in bill supply in 2020, more than doubling the outstanding amount of T-bills. It’s not that there is a shortage of bills, it’s that there is a massive surplus of cash. And as the supply of bills drops on the margin, more cash flows into repo.
The situation is probably going to get more extreme before it begins to resolve itself. The federal government is discussing the largest round of rebate checks yet, which would feed another $400 billion into household coffers. In addition, the next round of federal outlays coupled with the legal requirement for the federal government to bring its cash balance down to around $150 billion this summer if the debt ceiling is not extended before the current deadline likely means that the Treasury is going to have to run down its cash balance and cut its bill issuance, which means more bank reserves and less high-quality liquid assets for those banks and money funds to invest in.
The pressure probably will ease when households have the opportunity to spend more robustly again. Once the economy reopens, pent-up demand could come back quickly for all sorts of services that have been shut down, draining those bloated household liquid asset holdings. Likewise, once corporations have more visibility and less near-term liquidity risk, they can either buy back all of that extra debt or deploy the money on paying more workers or investing in equipment or physical plant. These have the potential to spark a far larger surge in economic activity than is generally expected, perhaps in the spring or summer of 2021. Imagine pulling the drain plug on a $3 trillion pool of excess liquidity and having it gush into the real economy in short order. That could be a wild ride.