Fed Getting Ready For Rate Increase: June Of July?

by: John M. Mason

Summary

After backing off earlier this year from its "forward guidance" of four interest rate increase in 2016, officials at the Federal Reserve seem to be preparing for an imminent rise.

The Federal Reserve seems to be tightening up its balance sheet preparing for such a move, similar to what it did in the fall of 2015 before its December move.

Participants in foreign exchange markets seem to be responding positively to this possibility as the value of the US dollar against the Euro continues to rise.

It seems as if the Federal Reserve is heading for an interest rate increase in June…or July.

Yesterday, Governor Jerome Powell indicated in a speech to the Peterson Institute for International Economics that suggested that the Federal Reserve might move soon on raising its target interest rate range. Many picked up on his comment that the rate should rise "fairly soon."

Economic data seem to be giving some support to Federal Reserve officials that are "data driven." Jobless claims dropped again, Durable goods orders rose at a 3.4 percent annual rate, and pending home sales are at recent highs. Added to this is the fact that the price of oil is now banging around $50 a barrel, up from about $40 per barrel about two months ago.

As I have written before, my concern is with how the Federal Reserve is preparing for this possible rise in terms of the positioning of its balance sheet.

Before the December rise in the Fed's policy range of interest rates, the Federal Reserve had gone about reducing reserve balances at Federal Reserve banks, a proxy for excess reserves in the banking system, for two months.

The Fed continued to see these "excess reserves" decline through to December 30, 2015 in order to support the new, higher level of the Federal Funds rate.

Reserve balances at Federal Reserve banks fell to $2,209 billion on December 30, the lowest level for this series since the Fed ceased its third round of quantitative easing in October 2014.

After the first of the year, the Fed eased up a little to handle the market turmoil at the start of the year, which took some pressure off of the value of the dollar against the Euro which was around $1.0800 at the start of the year.

The measure of "excess reserves" rose to $2,533 billion on March 9. This Fed "easing" contributed to a decline in the value of the US dollar against the Euro to over $1.1400 on February 22 and rose to over $1.1500 in early May.

Since then, the Federal Reserve has slowly reduced the amount of reserve balances in the commercial banking system. On May 25, reserve balances had dropped back to $2,340 billion.

Much of this decrease in reserve balances came a new Federal Reserve offering of term deposits.

In the week ending May 25, 2016, term deposits held by depository institutions had risen from zero to almost $67 billion.

It appears that Federal Reserve officials had to go back to this tool to offset a $20 billion fall in Treasury deposits held in the Treasury Department's General Account at the Federal Reserve.

The only other policy tool used by the Fed in the decline in reserve balances since March 16 is reverse repurchase agreements with general participants in the repo market.

Since March 16, reverse repos have risen $22 billion, over $17 billion coming in Fed initiated reverse repos with securities dealers, a fundamental tool of the Fed's policy operations over the past seven years.

The Fed has also been assisted by a $15 billion increase in currency in circulation, a movement in currency out of the banking system that was not replaced by Federal Reserve actions.

Another interesting bit of information is that the Fed's securities portfolio declined by almost $19 billion since the March 16 date. Very seldom over the past seven years has the Fed's security portfolio declined by any significant account. Most of the decline in securities held came in the Fed's portfolio of Mortgage Backed securities.

In total, reserve balances have fallen by almost $116 billion since March 16. This is not as large as the decrease in reserve balances that took place between the middle of October in 2015 to the December 16 rise in the Federal Funds rate, but it appears significant enough to claim that the Fed does seem to be preparing for an upcoming increase in the Federal Funds target range.

Although much could happen between now ant the June meeting of the Fed's Federal Open Market Committee, I believe that a strong argument can be made that Federal Reserve officials are preparing for an increase, whether in June…or July…in much the same way that they prepared for an increase in the Fed Funds target range in December.

Participants in the foreign exchange markets, who I believe want the Fed to pursue a policy that would continue to strengthen the value of the dollar, appear to be taking building a Fed move into the market.

Friday morning, May 27, the value of the US dollar against the Euro was down around $1.1170 down from the high reached at the start of this month.

To me, this is a signal that the market is expecting the Fed to raise its policy rate soon…and that market participants are in favor of such a move.

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.