Over the past four weeks, the commercial banking system has experienced a drop in reserve balances held at the Federal Reserve by slightly more than $100.0 billion.
Over the past 13-week period, these reserve balances have decreased by $7.0 billion.
These numbers are from Federal Reserve release H.4.1, "Factors Affecting Reserve Balances of Depository Institutions".
While the world has been focusing on the Fed's continuation of its "tapering" operations, other things have been going on within the Fed's balance sheet.
Actually, tapering did not occur over the past four weeks. In the four weeks ending July 2, 2014, the Federal Reserve added $41.8 billion in securities to its portfolio, whereas in the four weeks ending June 4, 2014, the Fed added only $38.5 billion in securities.
Little or no attention has been given to the fact that reserve balances held at the Federal Reserve, a proxy for excess reserves in the banking system, have declined over the past quarter.
The behavior of these reserves is important for understanding the future of short-term interest rates. Generally, as excess reserves in the banking system decline, short-term interest rates tend to rise.
And the whole world seems to be trying to determine when the Federal Reserve is going to begin to cause short-term interest rates to rise. This was a topic in my review of Federal Reserve actions last month.
As exhibited in the Financial Times, it continues to be a topic on the mind of many others. When is the Federal Reserve going to begin to raise interest rates?
Many are concerned that the inflation numbers in the United States seem to be picking up. Furthermore, the latest report on the labor market has been taken as another positive that the economy is returning to a more normal level of activity. Unemployment in June dropped to 6.1 percent, down from 6.3 percent a month earlier.
A "warmer" economy is taken by many as a sign that the Federal Reserve is going to have to do something in the relatively near future to begin to back off from its efforts to flood the banking system with liquidity, so as to create an upward movement in wealth to get the economy going again.
This is what Henny Sender is trying to get across in the Financial Times article mentioned above, "The Federal Reserve Must Not Linger Too Long on QE Exit." The concern is that once the Fed does move to exit its quantitative easing, there will be a shift the bond market's expectations of future interest rates, and this will result in a more painful leap in interest rates.
Sender believes that the longer the Fed waits to begin this "exit," the more painful the leap will be.
Whereas this analysis may be true in the longer run, let's look at some of the other things going on at this time, to attempt to build a more complete picture.
First off, whereas reserve balances at the Federal Reserve have declined in the past 13-week period and some economic indicators have shown some further strength in the economy, there still appears to be a lack of demand for short-term money in the financial markets.
The effective Federal Funds rate still indicates an absence of any demand pressure to rise. At the start of April, thirteen weeks ago, the effective Federal Funds rate averaged 8 basis points. At the end of June, the effective Federal Funds rate averaged only 10 basis points. There appears to be absolutely no pressure at this end of the market.
Historically, demand pressure begins to rise in short-term money markets as the economy picks up speed and short-term interest rates begin to feel some pressure. This time around, there has been little or no pickup in demand.
Secondly, the money stock statistics indicate that both measures of the money stock continue to support the conclusion that most of the money stock growth occurring at this time is still coming from people moving money from other short-term assets to transaction balances. Readers of my blog know that I have been arguing this way during the past five years of the economic recovery.
With the very low interest rates and the shaky job situation, people have continually moved their funds around from short-term assets to transactions balances that are available for spending. This, I have argued, is not a sign of a healthy economy. For example, demand deposits at commercial banks have risen by a little more than 19.0 percent year-over-year, whereas the non-M1 portion of M2 has risen by only 4.7 percent. The reason for the difference is that money has been leaving small-time accounts (down 10.5 percent, year-over-year) and retail money funds (down 2.3 percent, year-over year). Furthermore, institutional money funds are down 1.0 percent year-over-year.
If the economy were really healthy, both money stock measures would be growing at a more similar pace. Furthermore, the growth in the money stock measures would be coming from increasing demands for bank loans and not from a re-arrangement of assets. The loan demand is not there, and the re-arrangement of assets is occurring. This is not a sign of a strong economy.
Furthermore, when one looks more closely at the reason for the decline in commercial bank reserve balances at the Federal Reserve, one sees that the decline is taking place through Federal Reserve actions. I have written over the past several months that the Federal Reserve has gotten back into the repurchase market. More specifically, the Fed has become much more active in the selling of securities to dealers under an agreement to repurchase the securities at a future date.
Under the Federal Reserve's accounting system, these transactions are recorded as reverse repurchase agreements, or reverse repos. Over the past 12 months, the Federal Reserve has increased the amount of reverse repos on its balance sheet to almost $150 billion. The Federal Reserve has started doing this to develop the tools it will need to exit its reign of quantitative easing. And using this tool, it can work to reduce the excess reserve balances that are in the banking system and do it in line with how the financial markets are responding to the economy and to the current actions of the Fed.
Thus, while most analysts have been focusing on the Fed's "tapering," the Fed has been "gently" removing reserves from the banking system, and to-date, it has been doing this with very little disruption to short-term money markets.
This, of course, is what the officials at the Federal Reserve would like to see continue.
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