Federal Reserve Is Getting Ready For The End Of Tapering

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by: John M. Mason


The Fed is right on target to cease its tapering of security purchases in October.

The Fed is using reverse repos more and more as a tool to smooth markets.

People are still using their financial assets in a very conservative manner because of low interest rates and still high levels of unemployment and part-time employment.

Only two more months to go until the Federal Reserve ends its tapering exercise. This month the Fed is expected to add only $15.0 billion to its securities portfolio. Then $5.0 billion in October. Then…well we really don't know.

The big discussion now is when…and how…will the Federal Reserve raise interest rates?

There is no pressure on short-term interest rates to rise. The effective Federal Funds rate remains around 9 basis points. And, "safe-haven" money from abroad continues to flow into the bond market with the yield on the 10-year now around 2.35 percent.

And, reserve balances at Federal Reserve banks, a proxy for excess reserves in the banking system, now are just around the $2.8 trillion level.

Money supply growth remains high, by historical standards, but consistent with the movements in the financial system we have grown used to during the past five-year period.

The (estimated) year-over-year growth of the M1 measure of the money stock for August was about 11.5 percent, down from the July figure of 12.5 percent and down from the 20.0 percent range of much of the period of recovery.

There are two reasons for this rate of increase. First, with short-term interest rates so low, people don't see much reason to keep funds in savings accounts or money funds. Might as well just keep them liquid in bank accounts.

Second, there are still a lot of people without jobs or with only part-time jobs that are living out of their transaction balances. That is, they are either putting all the money they get there or they are transferring money from other sources into these accounts so as to be able to buy food or pay bills. As I have argued for five years, this is not a sign of economic strength.

Notice where the growth is: demand deposits have increased, year-over-year through August, by a little more than 17.0 percent; and currency in circulation has increased by almost 7.5 percent.

Total savings accounts have only increased by 5.5 percent, while retail money funds have actually declined by 2.0 percent and institutional money funds have fallen by about 1.5 percent.

Money is primarily moving laterally in the financial system from interest-bearing assets to transaction-type assets. Even though it seems as if loan growth is increasing, the loan growth is not causing much of an increase in measures of the money stock. Hence, the increases in the money stock are not driving any kind of growth in the economy.

Right now, the Federal Reserve seems to be testing just one means of money market operation to help it with the end of tapering. That means the use of reverse repurchase agreements. Note that transactions we are talking about represent the Federal Reserve selling securities to securities dealers under an agreement to repurchase them back at a given time. From the Fed's viewpoint this is just a "repo" for it represents a sale of a security with the liability that it needs to repurchase it in the future.

From the standpoint of the securities dealer it's a "reverse repo," but on the Fed's balance sheet is entered as a liability.

At the close of business on August 27, 2014, the Fed had a total of just under $180.0 billion in reverse repos to "others" on its balance sheet. One year ago, there were none although the Federal Reserve has had reverse repurchase agreements on its balance sheet at that time but those were with "Foreign official and international accounts."

Over the past four weeks it looks as if the Federal Reserve took reserves out of the banking system to offset another movement of funds into the banking system. The Federal Government makes its payments out of its account at the Federal Reserve. When the government removes tax monies out of the commercial banking system and puts them in its account at the Fed, the Federal Reserve will often engage in some activity to replace those reserves so that the banking system does not lose liquidity.

When the government writes checks that are paid from its account, which puts reserves back into the banking system, the Fed withdraws reserves from the banking system so that the banks don't have too much liquidity.

Well over the four weeks ending on August 27, 2014, the federal government paid down its balances at the Federal Reserve by almost $44.0 billion. The Federal Reserve worked to offset this flow of reserves into the banking system by putting on $64.0 billion in reverse repos. Thus, there the Federal Reserve does these "operational transactions" not as a part of its monetary policy actions, but in order to keep markets from being impacted by transactions not related to current monetary policy.

The more important point is that the Fed is operating in the "repo" market and getting ready to use this facility as it works its way from a policy of quantitative easing.

We really don't know what the officials of the Fed are going to do in an effort to raise interest rates. The use of repurchase is just a short-run effort to smooth market bumps. They cannot be used to achieve a reduction in reserves of, say, $1.0 trillion.

The take-away from this review is that the American banking system and the American financial markets are very tranquil right now.

The number of banks in the banking system is still shrinking…but the Fed and the regulatory system seem to be very comfortable with what is going on.

There are still clouds looming on the horizon…the economic problems being experienced in Europe, the Russian mess in Ukraine, the middle-east uprisings…that may interfere with the focus upon getting the banking system back to "normal." And, we need to be aware of these things.

I think the important thing over the next six months or so is to keep a steady eye on the Fed and what it is doing. The Fed is not going to tell us exactly what it is going to do in the near future or how it is going to do it. We are going to have to figure that out ourselves. So, be prepared for analysts watching and commenting frequently on Fed actions. Be prepared for being drawn one way or another for a while. But, keep watching…because what is going to happen next at the Fed and in the banking system and in the financial markets…has no historical precedent.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.