Officials at the Federal Reserve said in December that the Fed would begin to "taper" its purchases of securities in January. The Fed did as the officials said it would.
From January 1, 2014 to January 29, 2014, the Federal Reserve showed a net increase in its holdings of securities by $74.1 billion. In December Fed officials said that it would purchase only $75.0 billion in securities in January 2014, down from its target amount of purchases in all of 2013 of $85.0 billion per month.
As we all know now, officials at the Fed, after the January meeting of the Open Market Committee, indicated that purchases in February would be reduced to $65.0 billion.
Note that the most recent Federal Reserve statistics indicate that over the past 52 weeks, from January 30, 2013 through January 29, 2014, "Securities Held Outright" at the Federal Reserve rose by $1,079.3 billion… or $1.1 trillion.
The increase was composed of an $533.2 billion increase in United States Treasury securities and a $566.4 billion increase in mortgage-backed securities. The Fed's holdings of Federal Agency securities dropped by a little more than $20.0 billion.
Even though the Federal Reserve only increased its holdings of securities by $74.1 billion, Reserve balances with Federal Reserve Banks actually rose by over $275.0 billion in January. In essence, that is, excess reserve in the banking system rose by more than $275.0 billion January.
The reason for this is that other balance sheet transactions actually pumped almost $200.0 billion into the banking system during the month.
The two major operating factors that accounted for this increase were a decline in US Treasury deposits at the Fed and a reduction in reverse repurchase agreements at the Fed.
In terms of the first of these, United States Treasury deposits at Federal Reserve banks fell by $66.8 billion. This is a seasonal movement and so was something that was expected. These deposits rise when the Treasury department takes government monies held at commercial banks and transfers them to the Fed. When the Treasury writes checks, the checks, in essence, are written against its General Account and as funds are transferred back into the banking system as bank reserves, the General Account is drawn down.
The other operating factor is something that has just reappeared over the past year… the activity of selling securities to approved government securities dealers under an agreement to repurchase them within a relatively short period of time. An increase in "reverse repos" takes reserves out of the banking system while a decrease in "reverse repos" results in an increase in bank reserves.
In 2013, the Federal Reserve began actively engaging in reverse repos in order to prepare itself for managing reserve flows in the short run since the repo market is basically a short-term market. The idea was that as the Fed began to taper its purchases, which would lead, potentially, to an actual withdrawal of reserves from the banking system, it had to begin working in the money markets to handle short-run dislocations that might occur within the banking system naturally or because of the reduction in the rate at which the Fed was purchasing securities… or because the Fed actually began to remove reserves from the banking system.
On January 30, 2013, there were no Federal Reserve initiated reverse repurchase agreements on the Fed's balance sheet. On January 29, 2014, reverse repurchase agreements on the balance sheet of the Fed totaled $94.3 billion.
Over the past four-week period, from January 1, 2014 to January 29, 2014, the amount of reverse repurchase agreements on the Fed's balance sheet dropped by slightly more than $100.0 billion. As stated above, this put reserves into the banking system. The action was like a short-term purchase of market securities.
It should be noted that over the past thirteen-week period, from October 30, 2013 to January 29, 2014, reverse repurchase agreements on the Fed's balance sheet actually rose by almost $90.0 billion. Overall, in this thirteen week period the Fed actually removed reserves from the banking system… in essence, the Fed made a short-term sell of securities that would be reversed within a matter of days or weeks.
Transactions like these are going to be very important to the Fed as it "exits" its policy of quantitative easing. Along the way to reducing the purchase of securities or even reducing the amount of securities it holds outright, the Fed is going to encounter some market dislocations of reserves. These dislocations will generally be of a short-term nature. The Federal Reserve MUST be able to react to these short-term movements in real time so that what is short-term does not culminate in a longer-run dislocation. Repurchase agreements and reverse repurchase agreements are the tools of central bank operations to smooth-out financial market adjustments so that events don't get out-of-control.
During the last six months there have been no market indications of any "tightness" in the money markets that might indicate some kind of fund dislocations or liquidity problems.
The effective Federal Funds rate has remained below 10 basis points, and through December 2013 and January 2014 the effective Federal Funds rate has lingered in around 7 to 9 basis points. In other words there is no evident market pressure on short-term money market interest rates.
So the Federal Reserve has begun to taper its purchases of market securities. United States money markets have seemingly been unaffected by the reduction in the amount of securities purchased by the Fed.
The current concern, however, is with some of the emerging market nations. The value of the currencies of several countries dropped rather dramatically over the past ten days. Short-term interest rates have been raised in a couple of countries while officials of other countries, the most notable one being Raghuram Rajan, the Governor of the Reserve Bank of India, and formerly a professor of finance at the University of Chicago, have criticized the United States for thinking only of itself in beginning the tapering of security purchases.
Officials at the Federal Reserve did not seemed to be backing off from their decision as they actually went ahead and planned to lower monthly purchases even further in February.
The Fed is beginning to ease off the gas pedal. Whether or not this continues is going to depend on what happens in the US economy, what happens in the emerging nations, and how the Federal Reserve actually handles all of these challenges.
The Federal Reserve is in unknown territory. It has never done before what it is attempting to do right now. As I have stated before that perhaps the biggest uncertainty in the economy right now is what the Federal Reserve will do over the next few months and next few years. It is basically learning by doing right now. A lot depends upon whether or not they get it right.