It was a very quiet week in the Federal Reserve balance sheet and very little turmoil in short-term money markets although Treasury bond yields fell, the value of the dollar showed quite a bit of volatility, and the stock markets continued to be quite volatile.
Average effective Federal Funds rate for the calendar week ending January 29 and for the first three days of February was 0.38 percent. This was up modestly from 0.36 percent the calendar weeks ending January 15 and January 22.
Reserve balances at Federal Reserve banks, a proxy for excess reserves, rose by $42.0 billion in the banking week ending February 3.
The largest portion of the decline came in the Treasury's General Account at the Fed, which declined by over $25.0 billion. As mentioned in my post last week, around this time in the year, the Treasury starts to write checks and reduce the balance in its account at the Fed.
This account should continue to decline until the Treasury starts to receive 2015 tax payments.
The General Account of the Treasury was built up by more than usual in the fall, as mentioned in my post last week. It appears as if the Treasury cooperated with the Fed in withdrawing its money from deposits in the commercial banking system in order to help the Fed tighten up banking markets modestly without disturbing the normal operations of the banks…or, the money markets with the movement.
And, most of the movement was from the largest banks which have, according to the Fed's H.8 release on banking statistics, the largest amount of cash assets on their balance sheets.
With the drop this week, the General Account of the Treasury at the Fed is still $220.0 billion above the level it was at on October 7 2015, about the time that the Federal Reserve seemed to start tightening up in preparation for the December rise in its policy interest rate.
It appears that the other major operational factor influencing reserve balances, Currency in Circulation, has stabilized from its holiday swings. Currency in Circulation increases from early November through until January as people use more and more cash for their holiday shopping adventures. In January, these amounts usually decline as individuals return coin and currency to the commercial banks. In the banking week ending February 3, Currency in Circulation increased modestly. Thus the wide swings here should cease and we should see this account increase in steady, small increments the rest of the winter months.
In terms of policy tools, the only other "tool" the Fed has been using recently, reverse repurchase agreements, showed a decline of almost $17.0 billion in the latest banking week. This puts reserves back into the banking system.
Since October 7, this account has only show a modest increase of $10.0 billion.
Again, the record shows that the Federal Reserve basically saw its "operational" factors do its work throughout the fall, up until it raised its short-term policy rate in the middle of December. These "operational" factors have continued to support the rise in the rate since the December decision.
As mentioned last week, the interesting work begins now.
Movements in Currency in Circulation should not be large over the next few months and, if anything, would contribute, modestly, to falling bank reserves.
The real mover during this time should be the Treasury's General Account at the Fed.
The General Account is already high, by historical standards at this time of year (see my post cited above) and this account usually declines through the first three months of a new year anyhow as a consequence of the income tax cycle.
As the General Account drops, commercial bank reserve balances should increase.
This would generate additional liquidity within the commercial banking system, which could put downward pressure on short-term interest rates.
The Federal Reserve will want to offset this flow of funds and again, at this time, the most likely tools the Fed would use to remove them would be reverse repurchase agreements and term deposits.
The question then becomes one of the Fed's intentions for the rest of the year.
Officials at the Fed have already given us their "forward guidance" for 2016: the Fed will raise its policy rate by 0.25 percent, four times during the year.
Investors, particularly given market volatility in January, have become more and more skeptical of the Fed actually accomplishing this with the probability that this will happen dropping to as low as 50 percent. More have taken the view that the Fed will increase rates only twice during the year, and there are even some that believe that the Fed will reverse the December increase before the end of 2016.
The reasons for this is that the US economy is so weak, the Chinese economy is so weak, the European economy is so weak, and Brazil and Argentina, among others are facing economic difficulties. Then there are the hot spots of the world, the Middle East, the Ukraine, and so on, and investors are just not seeing the rationale, let along the means, of pushing up interest rates any further.
And, if the Fed does try to support its "forward guidance," the question becomes "how"? The Fed cannot tighten up too much more just using its "temporary tools". Some time, if it follows this path, the Fed will have to start getting into its securities portfolio. What will kick this off?
This is why I believe that it is so important to keep a close eye on the Fed's balance sheet in order to find any kind of clue to what the Fed is doing and what it is going to do. Thus, I will continue to keep watching what it is the Fed is doing…regardless of what Fed officials are saying.
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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.