Federal Reserve Exit Watch: Part 9

by: John M. Mason

(For the previous post in this series click here, for the first post click here.)

The operating statement of the Federal Reserve is getting downright boring these days. Thank goodness! It brings back memories of the good old days when nobody really cared much about the Fed’s balance sheet or what the Fed was really doing operationally.

I remember calling a friend of mine at the Fed in February 2008. I had a question. There was a new thing called “Central Bank Liquidity Swaps” and I was trying to locate where it was on the Fed’s H.4.1 release, the “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.” At that time, because it was brand new, it didn’t have a separate line item to indicate what the Fed was doing with currency swaps with other central banks. I presumed that the numbers were added into the account “Other Federal Reserve Assets” which had changed substantially in recent weeks and was, formerly, just a miscellaneous collection of a number of different unimportant accounts.

After confirming that the “Other Federal Reserve Assets” contained the information on “Central Bank Liquidity Swaps”, my friend asked me why I was interested in writing about this in my new blog. “Nobody is interested in the Federal Reserve statement. You are just wasting your time!” he said.

Obviously, over the next 24 months or so, a lot of people got interested in the Federal Reserve statement. If we want to talk about financial innovation in the last twenty or thirty years, what happened inside the Fed during this period of time certainly represents some of most important “financial innovation” that took place. To not watch what the Fed was doing with its balance sheet was to miss a large part of the show.

Now, that show is coming to a dull close. Again, we can be very thankful for this. In the banking sector, “DULL IS GOOD!”

First, the Fed had supplied approximated $2.349 trillion in funds to the commercial banking system on March 31, 2010. I estimate that at most $200 billion of these funds are related to the special programs that were created over the past two and one-half years, only about 8.5%. These $200 billion in assets will slowly trickle off the Fed’s statement and will cause very little impact, if any, on the banking system or on financial markets. Good riddance!

Of course, the other $2.1 trillion in funds that the Fed has supplied to the banking system still looms over the financial markets and the economy because almost $1.1 trillion of those funds are residing in commercial bank reserve balances at Federal Reserve banks. In other words, the commercial banking system possesses about $1.1 trillion in excess reserves.

But, the situation is “boring” now because on March 31, 2010, the securities portfolio of the Federal Reserve amounted to slightly more than $2.0 trillion: $777 billion in U. S. Treasury securities; $169 billion in Federal Agency debt securities; and $1,069 billion in Mortgage-backed securities. The removal of funds from the banking system in the Federal Reserve exit strategy, we are told, will come from selling these securities through outright sales or, initially, through repurchase agreements. This is where most of the action will be in the future.

There is another vehicle that the Federal Reserve has cooked up with the U. S. Treasury Department to drain some reserves from the banking system using an account of the Treasury’s at the Fed. This is the “U. S. Treasury, supplementary financing account” and it appears as a liability of the Federal Reserve. (See my post from February which describes this facility) An increase in this account absorbs funds from the banking system so it can be used to remove reserves along with the Fed operations in its securities portfolio.

At the end of 2009, this supplementary financing account was at $5.0 billion. The Treasury Department had to wait until Congress raised the United States debt limit before it could again rebuild this account. The account has risen by $120 billion since December 30, 2009 and by $100 billion since March 3, 2010. This has helped to keep reserve balances at the Fed relatively constant since the end of the year while the Fed was, at the same time, supplying reserves to the financial markets during this time by buying mortgage-backed securities.

So, in the last 13-week period, the financial markets were relatively calm, the commercial banking system was peaceful, and the Fed did practically nothing except buy $160 billion more mortgage backed securities. The question is, “Is this the calm before the storm?”

No one knows how the “Great Undoing” is going to proceed. The Fed has stopped buying mortgage-backed securities as it promised it would do. There has been some reaction in the financial markets (See “Mortgage Risk Premiums Widen”.) Mortgage rates have also risen. We are told that “A lot of people are observing what’s going to happen now that the Fed is actually out.”

Now the waiting begins. The Fed has confirmed that it will continue to keep its target interest rate range at current levels for the near term. There are still many uncertainties in the economy that are keeping the Fed from removing the reserves from the banking system and raising its target interest rate range. One of these, of course, is the state of the economy. Economic growth continues to remain anemic, although it seems to be picking up, and the unemployment rate continues to hover around 10.0%.

Furthermore, the health of the banking system, itself, remains questionable as about one in eight banks remain on the problem bank list or near to it. Bankruptcies continue to rise (see here) as do foreclosures on homes. We are still waiting to see how the commercial real estate industry works through the next 12 months or so. The Federal Reserve does not want to remove reserves from the banking system if the banking system “wants” to keep those reserves to protect itself during the continuing financial workout period.

The Fed is now as ready as it ever will be to execute its “Great Undoing”. We continue to need to watch the Fed’s balance sheet to observe what the Fed is actually doing with its portfolio of securities and how the Treasury Department is contributing to the removal of reserves through the manipulation of its supplementary financing account.

As with the banking system itself, the thing to hope over the next year or so is for in the actual execution of the Fed’s exit strategy to be accomplished in an orderly fashion. Keep your fingers crossed!