What Is The Federal Reserve Planning?

by: John M. Mason


The Federal Reserve, operationally, is standing on the edge of some profound movements needed in its balance sheet over the next few months.

To prepare for the December rise in its target rate of interest the Fed used "operational" factors to provide an incremental reduction in commercial bank reserve balances.

Now, the contribution of these "operational" factors is near an end so the Fed will be facing other decisions if it hopes to maintain its December increase.

Since the Federal Reserve raised it policy rate of interest in the middle of December, then gave us the "forward guidance" that they would likely raise their target rate range by 25 basis points four times in 2016, a lot of discussion has been generated around the subject, "Will the Fed have to reverse itself this year?"

Well, let's look at how the Fed is behaving and see if its behavior might give us any idea about what it will do in the future.

In terms of its policy rate of interest, the effective Federal Funds rate continues to inhabit the middle section of its new policy range. Through the calendar week ending on Friday, January 29, the effective Federal Funds rate has average 38 basis points. This is just modestly above the weekly average for each week since the calendar week ending December 18, the week in which the range was raised. In the week ending December 18, the effective Federal Funds rate averaged 14 basis points.

During this time from the middle of December to the end of the banking week January 27, commercial bank reserve balances at Federal Reserve banks, a proxy for "excess reserves" have fallen by almost $61.0 billion. Of this decline, almost $52 billion came in the past two banking weeks.

A large portion of this decline came from a movement of Treasury funds from commercial banks to the Treasury's General Account at the Federal Reserve. The Treasury collects revenues in deposits in the commercial banking system. This way there are no disruptions to the reserves that exist within the banking system itself.

Usually the Treasury keeps funds in the banking system until the time it is ready to write checks and then draws the funds into its General Account, which is reduced soon after as the Treasury checks clear and these funds are then redeposited back into commercial banks.

One can raise the question this year about whether or not the Treasury might be working along with the Federal Reserve in helping the Federal Reserve reduce reserve balances incrementally within the banking system so that the Fed does not have to use other short-term tools, like repurchase agreements or term deposits, to begin to reduce the size of its securities portfolio, something that it has indicated that it does not really start to do yet.

If one goes back to the banking week ending October 15, the week I have picked out as the one in which the Fed really began to reduce "excess reserves" so as to prepare the commercial banks for the December increase in the interest rate, the General Account has risen by about $250.0 billion.

The other "operational" experience during this time period has been the "seasonal" increase in currency in circulation, which has risen by almost $23.0 billion.

Thus, the rise in the Treasury's General Account of $250.0 billion plus the increase in currency in circulation of $23.0 billion accounts for $273.0 billion in the total decline in "excess reserves" since that time of $280.0 billion.

Furthermore, during this time period, the Fed used no term deposits to withdraw reserve balances from the commercial banks and the reverse repurchase agreements the Fed initiated for monetary policy purposes actually declined by $26.0 billion.

The difficulty with this, is that these "operational" factors generally reverse themselves.

For example, whereas currency flows out of the banking system and into the hands of the public in the build up to Thanksgiving, Christmas, and New Year's, the movement is in the opposite direction after the new year starts.

For example, since the banking week ending December 30, 2015, currency in circulation has declined by $13.0 billion. This will not be a big factor in the next several months.

The Treasury's behavior is another case. The General Account was at $338.0 billion on January 27 of this year. This is quite high.

On January 28, 2015, the General Account was at $194.0 billion. On February 25, the General Account was at $47.0 billion and the Fed had Term deposits on its books of over $400.0 billion and reverse repurchase agreements of $180.0 billion.

The point of this is that the Treasury's General Account is going to decline as the Treasury writes checks and the next real increase will come when "seasonal" tax payments start flowing in the banking system.

In other words, in order to keep "excess reserves" where they are, the Fed must be prepared to begin using its short-run "tools" once again.

The question then becomes, just how much the Fed can use these "short-run" tools to maintain the current level of the effective Federal Funds rate and possibility prepare for another rise in the Fed's target range of 25 basis points in March, let alone even more increases during the year.

Currently, reserve balances at Federal Reserve banks stand at $2,399.0 billion. On January 29, 2015, reserve balances were $2,663.billion, $264.0 billion higher.

Can the Fed "tighten up" further? Can the Fed do much more "tightening" without having to move into reducing its securities portfolio?

And, of course, this doesn't even get into other questions about raising the Fed's target rate of interest further, or about other issues going on in the world.

The Fed has a tough job ahead of it. The Fed has a tough job anyway, but, in my mind, it has gotten into a position where it is its own worst enemy.

We must keep a close eye, not only on what the Fed is saying but what it is doing. What it is doing, of course, is really the most important point because what it is saying only seems to add to the "white noise" going on around the financial markets these days.

Disclosure: I/we 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.