Federal Reserve Watch: Calm...So Far

by: John M. Mason


Federal Reserve is doing as it said it would with respect to securities purchases.

Federal Reserve continues to practice using "repurchase agreements" for when "normal" times return.

The path of a return to "normal" times is still the major unknown. Stay loose.

The Federal Reserve continues to taper its purchases of open market securities. Over the past four weeks ending April 2, 2014, the Federal Reserve added only a net increase in its portfolio holdings of just over $61.0 billion.

In the past thirteen week period, the Fed added a net amount of almost $215.0 billion to its holdings of securities, an average of about $71.5 billion per month.

Tapering continues, and the banking system appears to be holding up well. For one, commercial banks do not seem to be doing that much new lending except to hedge funds and private equity funds and some re-writing of old loans to commercial real estate interests. So, there is very little pressure on banks from the demand side to use their funds.

Regulatory pressure seems to be heavy on the supply side making many banks, especially the smaller banks, reluctant to offer much in the way of new loans.

In the Federal Funds market there is absolutely no pressure at all. The demand for funds is minimal and even the fact that the Federal Reserve is reducing the amount of securities it purchases every month produces no problems concerning the supply of funds to the banking system. The effective Federal Funds rate for January through March was in the 0.07 percent to 0.08 percent range.

So, other than the tapering that is taking place, the asset side of the Fed's balance sheet is very, very boring.

The only interesting things that seem to be happening are on the liability side of the Fed's balance sheet.

First, the demand for currency in circulation continues to be high. Currency in circulation continues to rise in the 7.5 percent to 8.0 percent range. This is still a relatively high number in the sense that currency in circulation only tends to increase this rapidly when there is some financial distress in the economy and people need reading cash assets to pay for things.

One can confirm this demand for "cash" by looking at the rate of growth of demand deposits in the economy. Demand deposits at commercial banks have increased almost 20.0 percent, year-over-year, through March. This is excessively high.

In "normal" times, one could argue that bank lending was spurring along the growth of demand deposits given relatively strong economic growth.

That is not happening in the current situation.

The growth in demand deposits is coming from other short-term assets. The dismal economic state of the economy and the exceedingly low interest rates have resulted in people transferring money from other short-term assets into demand deposits and cash.

We have seen this especially in the banking arena as small-denomination time deposits have actually declined, year-over-year, by more than 15.0 percent. In addition, retail money funds have also experienced, year-over-year, a decline in volume, actually falling by almost 2.5 percent.

Other types of bank assets have experienced very low rates of growth, indicating that funds are not going into these classes of assets the way they might if the economy were expanding or interest rates were higher.

The evidence supports the conclusion that money stock measures are not rising because of strong bank loan demand, but because of people needing to keep very liquid in order to pay for necessities and because interest rates are so low.

Another interesting line item from the liability side of the Fed's balance sheet is the line item titled Reverse repurchase agreements-Others. In order to prepare for the day when "tapering" is over and the Fed has to face the real world of day-to-day management of the money system and the short-term financial markets, officials at the Federal Reserve decided it needed to get back into the market for short-term injections or withdrawals of funds from the money market.

So, the trading desk at the Fed has resumed trading in repurchase agreements. Specifically, if the Fed sells securities into the money market under an agreement to repurchase the securities at the end of a specific time at a specific price, this is a repurchase transaction. From the side of the market that purchases this security under an agreement to re-sell it to the Fed, it is a reverse repurchase transaction and this is what it is called on the Fed's balance sheet.

It the Fed agrees to sell a security under agreement to repurchase, it is withdrawing reserves from the banking system and bringing those funds into the Fed.

So, the Federal Reserve is "practicing" conducting monetary policy in more normal conditions. Since April 3, 2013, fifty-two weeks ago, the Fed has added $106.0 billion in the asset sells to its balance sheet, basically removing $106.0 billion in bank reserves from the banking system.

Over the last thirteen-week period, the Fed's balance of these reverse repurchase agreements fell by almost $92.0 billion. And, in the last four-week period, these balances have risen by almost $30.0 billion.

Thus, the Federal Reserve is building up its practice of operating in the short-run money markets once again. This is good news to me, that the Fed believes that it is close enough to the time period it will need to use this facility on a "real" basis once again. One can only hope for the day when the economy and the banking and financial markets are back in sufficient order so that "normal" central banking operations can begin.

The major concern in this area, however, pertains to the ability of the economy and the Federal Reserve to get back to this kind of an environment. There are still basically $2.6 trillion of excess reserves in the banking system. I don't think anyone would disagree with the claim that this amount is excessive.

And, what is "normal"? Back in August 2008, these excess reserves were only about $0.004 trillion.

Even if "normal" excess reserves in the future totaled $100.0 billion…or 0.100 trillion…the Federal Reserve would have to see to it that excess reserves shrank by $2.5 trillion.

How is this going to happen? There is…and has to be…a lot of uncertainty about how the Fed is going to oversee this return to a more "normal" banking environment. Federal Reserve officials, as well as myself and a lot of other "Fed watchers", and financial market participants hope that this return can be done quietly, calmly, smoothly, and painlessly. If the Fed achieves this it will pull off one of the real, major "miracles" of the twenty-first century.

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.