Federal Reserve Stays On Tapering Track Through February

by: John M. Mason

At the end of January, I wrote that "The Federal Reserve Did What It Said It Would Do In January." Now, at the end of February, we can also say that the Federal Reserve did what it said it would do in February.

Over the past four banking weeks, from January 29, 2014 through February 26, 2014, the Federal Reserve added just a little over $69 billion to its portfolio of securities.

Since the Federal Reserve really began its tapering exercises toward the end of December 2013, it has added just under $137 billion to its portfolio.

The plan was to reduce purchases from the $85 billion a month it was purchasing as a part of the third round of Quantitative Easing to $75 billion in January. In February, the Fed planned to only add $65 billion to its portfolio. Thus, the two-month total of securities acquisitions was expected to be $140 billion, so the Fed was pretty close on mark.

Now, one has to be careful about assuming that this purchase of securities goes directly into the creation of bank reserves. For example, over the past four weeks, as mentioned above, $69 billion in securities was added to the Fed's portfolio.

Over this time, however, that Reserve Balances with Federal Reserve Banks rose by almost $85 billion. This is because of other "operating" factors that either supplies reserves to the banking system or withdraws them from the banking system.

In the last four weeks, for example, Currency in Circulation rose by a little more than $24 billion. This represents currency that left the banking system to go into the hands of businesses and consumers.

Offsetting this was a drawing down of government deposits and other deposits that were being held at Federal Reserve banks. Over the past four weeks, for example, the US Treasury Department paid down its account by more than $68 billion, and this puts reserves into the banking system.

There is another factor that withdrew reserves from the banking system over the past four weeks. Over the past three to four months, the Federal Reserve has begun enter into reverse repurchase agreements with government securities dealers. Over the past four weeks, the Fed increased the amount of reverse repos on its balance sheet by about $36 billion. This action removes reserves from the banking system.

The Federal Reserve System has started entering into these transactions to get back into the market and prepare itself for closer managing of the money markets, something it did regularly before the Federal Reserve started behaving in different ways so as to moderate the impacts of the financial collapse.

So, the net impact of the Fed's purchase of securities over the past four weeks was to supply about $58 billion in reserves from the asset side of the balance sheet and to provide another $27 billion in reserves from the operating transactions that took place on the liability side of the balance sheet. The sum of these two factors gives us the $85 billion increase in Reserve Balances with Federal Reserve Banks.

Over the past thirteen weeks, the Federal Reserve's portfolio of securities rose by almost $238 billion. Overall, the factors supplying reserves to the banking system from the asset side rose by $234 billion. In terms of factors absorbing reserves, these operating factors withdrew just $112 billion from the banking system. Thus, over this thirteen-week period, Reserve Balances with Federal Reserve Banks rose by only $122 billion.

It should be noted that over the past thirteen weeks, Reverse repurchase agreements rose at the Fed by $124 billion. This accounts for all of the difference between the factors supplying reserves to the banking system and the final total for the increase in Reserve Balances.

There are a lot of seasonal factors that impact reserves one way or another. Most of these seasonal factors wash out over a year's time. For example, over the past 52 months, the Fed's portfolio of securities rose by $1.061 trillion. Factors supplying reserves to the banking system rose by $1.069 trillion. Thus, the asset side of the Fed's balance sheet rose by approximately $89 billion per month.

The two major factors that absorbed reserves over this time period was currency in circulation. This can generally be considered a secular increase because the seasonal factors have been taken out. Currency in circulation rose by almost $80 billion in the past 52-week period.

In addition, the increase in reverse repurchase agreements was $130 billion. Thus, the factors absorbing reserves totaled a little over $210 billion. Thus Reserve Balances at Federal Reserve Banks rose by close to $860 billion during the last 52 weeks.

The Federal Reserve has now, for two months, tapered its purchases of securities in its portfolio. Still reserves continue to pile up at commercial banks - just at a slower pace.

It should be noted that during the time period that the Federal Reserve has been tapering its purchases, the effective Federal Funds rate has actually fallen. In December, the effective Federal Funds rate averaged 0.09 percent, or 9 basis points for the month. In January, the effective Federal Funds rate averaged 0.07 percent, or 7 basis points. And, so far in February, the effective Federal Funds rate has averaged 0.06 percent, or 6 basis points.

In terms of longer-term interest rates, the yield on the 10-year Treasury note was around 2.90 percent in the middle of December when the decision to taper was made. Although this yield rose to 3.00 percent by the end of the year, on Thursday, February 27, the yield closed at 2.65 percent.

Even though the Federal Reserve slowed down the rate it added securities to its portfolio, both short-term and long-term interest rates fell. The reason for these declines appears to be the flow of risk averse funds coming into the United States from overseas financial markets and especially from investors selling bonds in the sovereign debt of several emerging market nations. Whereas US dollars flowed into these countries as the Federal Reserve pumped billions and billions of dollars into both the financial institutions of both the United States… and in European… and in emerging market countries, the reality of the Fed's tapering actions has frightened holders of the debt of many of the emerging market countries. As a consequence, some of these monies are returning to the United States and causing US interest rates to soften.

Thus, the Federal Reserve is carrying out its plans to reduce the monthly amount of securities it adds to its portfolio in an orderly manner. This is expected to continue, although on Thursday the new Federal Reserve Chair, Janet Yellen stated that the Fed would definitely be "looking closely at a recent run of disappointing economic data" to make sure that it did not continue to taper if the economy was showing signs of a slower recovery. The hope is that these "disappointing economic data" are weather caused.

The belief is that the Fed will continue to reduce its monthly purchases of securities in an orderly manner throughout the year. So far they are doing what they said they would do.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.