Lots of Liquidity Entered the Economy. Where Did It Go?

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Despite significant amounts of liquidity injected into the economy, it seems like a large amount never made it to the people and entities that would find it most useful, according to an article in The Regional Economist.

Senior Economist Fernando Martin noted three ways liquidity expanded in response to the Great Recession:

• The Federal Reserve’s purchases of large amounts of securities through quantitative easing
• The Fed paying interest on bank reserves
• The federal government’s increased spending and tax relief

However, gross domestic product (GDP) is still below trend, growth has slowed down significantly, and inflation has been below the Federal Open Market Committee’s target. Martin suggested that a significant part of the additional liquidity did not go to those that would most use it, such as households and businesses. He noted: “It should then not be surprising that inflation has not picked up and that inflation expectations remain depressed.”

Where Did the Liquidity Go?

Martin covered the evolution of liquid financial assets, in terms of GDP, by sector. These assets include currency, checkable deposits, savings and time deposits, money market funds shares, Treasuries, and agency- and GSE-backed securities. He then discussed the holdings of these assets by three groups:

• The private nonfinancial sector (households and businesses)
• Other financial institutions (such as insurance companies, pension funds, mutual funds [except money market funds], security brokers and dealers)
• The rest of the world

Liquid financial assets held by the domestic sectors showed a small but permanent increase from 108 percent of GDP in 2007:Q4 to 113 percent in 2015:Q2. Martin noted that this increase was due to a rise in savings and time deposits owned by households. “If we were not counting savings and time deposits, we would instead see a temporary bump in this sector’s liquid assets holdings, around the time of the financial crisis and the subsequent recession, but no permanent increase.”

The increase was more prominent when including the rest of the world. Liquid financial assets increased from 139 percent of GDP in 2007:Q4 to 160 percent in 2015:Q2. Martin explained that Treasury security holdings by foreigners have been increasing since the 1980s but accelerated starting in mid-2007, most likely due to a flight to quality. He wrote: “In other words, most of the liquidity expansion was acquired by a sector (the rest of the world) that was hungry for it—supply and demand moving together.”

He concluded: “In sum, although fiscal and monetary policies have been unprecedentedly expansionary, the liquid asset holdings of the users of liquidity have not increased dramatically. If anything, the response appears comparatively muted and consistent with pre-existing trends.”

Additional Resources

• Regional Economist: Where Did All the New Liquidity Go?
• On the Economy: What Is Potential Output, and How Is It Measured?
• On the Economy: Why Did Loan Growth Stay Negative So Long after the Recession?