Federal Reserve Exit Watch: Part 3

This is the third post in a series (Part One is here and Part Two is here) designed to review the progress of the Federal Reserve in its efforts to exit the position it has created for itself by more than doubling the size of its balance sheet.

Some fear that if the Fed cannot reduce the size of its balance sheet that the amount of reserves that have been put into the banking system will explode in the creation of new credit, which will be followed by an explosion in the various measures of the money stock. This can only be inflationary with substantial concern that such inflation could turn into hyperinflation.

The fear of many others is that the Fed will withdraw these funds too quickly, thereby causing further problems for the banking industry and a second financial collapse.

Bottom line: Reserve Balances with Federal Reserve Banks rose by $190 billion in the four weeks ending October 14, 2009. The rise over the last thirteen-week period was $244 billion. These Reserve Balances totaled $1,049 billion on October 14, a new record high. These data are taken from the Federal Reserve Statistical Release H.4.1.

Required reserves in the banking system averaged about $63 billion in the two banking weeks ending October 7. Excess reserves in the banking system, as reported in the Federal Reserve Statistical Release H.3 were $918 billion for the same period of time. Reserve Balances with Federal Reserve Banks were $963 billion on October 7.

Obviously, there are plenty of reserves in the banking system and the banks still do not seem to be in any mood to begin lending again. See my post on the lending activity in the banking system to support this conclusion: .

Where did this $190 billion of new reserve balances come from?

Well, about $52 billion came from factors supplying reserves to the banking system, and another $137 billion came from a reduction in factors that were absorbing reserve funds. For the 13-week period, factors supplying reserves contributed $121 billion to the $244 billion increase and there was a $123 reduction in factors absorbing reserves. Let’s look at both in turn.

As was highlighted in the previous two reports on the Fed's exit strategy, the monetary authorities continued to allow accounts associated with the special facilities created to deal with the financial crisis to run off. These reductions were offset by purchases of financial assets. This seems to be the first move strategy of the Fed to achieve its exit from the big buildup.

Over the past four weeks, there was a $61 billion decline in three asset categories connected with the new facilities that were created: The Term Auction Facility (TAF) declined by almost $41 billion, the portfolio holdings of Commercial Paper declined by $3 billion and the line item associated with Central Bank Liquidity Swaps fell by a little more than $17 billion.

Over the last 13 weeks these three items declined by almost $260 billion: TAF dropped by $118 billion, the commercial paper facility by $71 billion and Central Bank swaps fell by $68 billion.

The Fed replaced these run-offs by open market purchases that more than covered the outflow, hence the overall increase in bank reserves. For example, Securities Held Outright by the Fed jumped $103 billion in the last four weeks and by over $360 billion in the last thirteen weeks.

The Fed is therefore allowing the special facilities to decline where possible and is then maintaining the liquidity of the banking system by purchasing securities in the Open Market.

In purchasing securities in the open market the Fed is buffing up the liquidity in these markets and helping to keep interest rates low. Of particular note, the Fed has added $78 billion in Mortgage-Backed Securities to its portfolio over the last four weeks and $237 billion over the last thirteen. The Fed has also purchased Federal Agency Securities in recent weeks. This portfolio has increased by $11 billion in the last four weeks and $35 billion in the last 13 weeks.

Two other items of note. First, something called Other Federal Reserve Assets rose by $6 billion over the last four weeks and by $13 billion over the last 13 weeks. What is in this account? Well, the Federal Reserve states that this account includes Federal Reserve assets and non-float-related “as-of” adjustments. These may include Assets Denominated in Foreign Currencies or Premiums Paid on Securities Bought. We don’t really have any information on the totals, but these amounts are relatively substantial, especially when the required reserves in the banking system only total $63 billion.

The second item that requires some attention is that the Special Drawing Rights (SDR) account at the Fed increased by $3 billion over the last four weeks. Actually the increase came in the banking weeks ending September 23 and September 30. Thus the Special Drawing Rights certificate account at the Federal Reserve rose from $2.2 billion to $5.2 billion during this period. I am going to have to do more research into this increase and what it means.

In the meantime, here is a definition of the SDR: SDRs were originally created to replace Gold and Silver in large international transactions. Being that under a strict (international) gold standard the quantity of gold worldwide is finite, and the economies of all participating IMF members as an aggregate are growing, a purported need arose to increase the supply of the basic unit or standard proportionately. Thus SDRs, or "paper gold," are credits that nations with balance of trade surpluses can 'draw' upon nations with balance of trade deficits. So-called "paper gold" is little more than an accounting transaction within a ledger of accounts, which eliminates the logistical and security problems of shipping gold back and forth across borders to settle national accounts.

The other major contributor to the rise in reserve balances at commercial banks was a movement out of federal government accounts at the Federal Reserve. There was a movement of $157 billion out of government accounts in the last four weeks and $149 billion in the last 13. A reduction in these accounts takes place when the government disburses money and the funds end up as bank reserves. In terms of the government's general account, the movement of funds in and out of this account is usually connected with seasonal tax collections and disbursements.

There is another account that saw a large reduction, $100 billion, over the last four weeks. This was in an account called the U. S. Treasury Supplementary Financing Account. The Fed defines this account in this way: “With the dramatic expansion of the Federal Reserve's liquidity facilities, the Treasury agreed to establish the Supplementary Financing Program with the Federal Reserve. Under the Supplementary Financing Program, the Treasury issues debt and places the proceeds in the Supplementary Financing Account. The effect of the account is to drain balances from the deposits of depository institutions, helping to offset, somewhat, the rapid rise in balances that resulted from the various Federal Reserve liquidity facilities.” Thus, a movement out of the Fed injects deposits into depository institutions.” We need more information on this decline.

To conclude: The Fed continues to reduce dollars associated with the new facilities created to combat the financial crises. It is replacing these dollars with open market purchases that keep the banking system liquid. Other transactions have also taken place related to federal government disbursements that add reserves to the banking system. In restructuring its balance sheet the Fed is being sure to err on the side of being too loose in supplying bank reserves. Obviously, the leadership at the Fed does not feel that any type of constraint should be imposed upon the banking system at this time.

Comments

[Leftfield:]

A $trillion here, a $trillion there..... I draw attention to SDR's, created to replace gold and silver in international transactions. "Being the quanitity of gold worldwide is finite and the economies of all the participating IMF members as an aggregate are growing, a purported need arose to increase the basic unit or standard proportionately." What's proportionate about a wildly inflated, leveraged fiat system to the purported "growth" (much of it, fake, in the US) of IMF economies?
It is leveraged to the moon for financial engineers who need the kind of grotesque numbers they inflate exponentially to do their work of wringing out the remaining value for themselves in a system that is in an advanced state of imploding that is based on vapor and paper promises.

Oct 19 11:26 AM

[CautiousInv...:]

The more I think about this the more I am certain the Fed will take into account the financial health (profitability) of banks and incorporate this into their broader plan to tighten monetary policy and withdraw surplus liquidity from the system. Each component of monetary policy has profit implications for banks and, with all other things being equal, I'm inclined to think the Fed will leave in place....for as long as possible... those policies which most directly benefit the banks. Given what has been done for the banks thus far, this should come as no surprise.

Oct 19 12:27 PM

[Moon Kil Woong:]

"Obviously, the leadership at the Fed does not feel that any type of constraint should be imposed upon the banking system at this time."

I suppose this also means that they feel that the Federal Reserve, being a part of the banking system, should be free from auditing, elected officials, accountability to the public, regulation, or any reasonable expectation to be fiscally prudent or solvent.

Already the Feds capital to Asset ratio is over 40 without taking into account any asset degradation or losses from their trillions of bond backstops. That gives them the problems of Bear Stearns and AIG combined. Their only saving grace today is that they don't have to disclose their losses nor mark to market and can deflate the dollar infinitely to pay for their gross negligence.

Really, is this Constitutionally legal or ethical?

Oct 19 07:05 PM

[Zell:]

Like I have said in the past the Fed is behind the "End the Fed". It's just the Leninist model being refined and modified "Lead the Opposition".

Oct 19 07:24 PM

[ebworthen:]

"Paper Gold" SDR's - isn't that an oxymoron?

Wait, we're talking about FED, nevermind!

The FED reduces nothing. They have flooded the banks and the money supply with TRILLIONS, not 200 billion, or 250 billion, but 2+ trillion in quantitative easing, money at 0% to banks, backstopping, purchase of treasuries, etc., etc., etc.

Did you see the news today? Fannie and Freddie are going to package mortgages from local and state housing agencies and sell them as bonds to the Treasury Department.

OMG!!!

"Giiimmmmeeee thaaat botttle of whiskey back!...I need me another drink...just another drink....and everything will be better....wait...I have a hangover...hair of the dog....here's a Ben Franklin boy...go get me more Glenlivet and Patron...hiccup!"

Oct 19 09:11 PM

[Bill S. Friend:]

Another test of the lows and the financial system is toast. The banks are betting on oil and everything but what their supposed to be doing. I only hope they are shorting themselves and each other again. Give them enough rope and they will hang themselves... I could see a collapse of paper gold while physical maintains its stature, and at that point the Chinese will establish a new currency backed by gold. I know its a novel and unique model for a currency, just think how they could lead us around by the nose for a change!

Oct 20 10:26 AM

[Duvanie:]

I don't really understand all the numbers and can't remember them anyway. But I do read a lot, and after all I've read - trillions, deflation, inflation, hyper-inflation, gold, Cycle, Fed, banks, 0% money, more zero-down subprime mortgages, backstop, FannieMae (et al)...Taxpayer bailout - the two words thing that make the most sense to me are CURRENCY CRISIS.

Oct 25 02:11 PM