Watching A 'Smug' Federal Reserve After The Brexit Vote

by: John M. Mason

Summary

At its recent meeting of the FOMC, the Federal Reserve decided not to raise its policy rate at this time and indicated that future increases would be done slowly.

At her testimony, Fed Chair Janet Yellen indicated that one of the reasons that interest rates were not raised at this time was because of the Brexit vote.

For a change, the Fed seemed to be right on target as Great Britain voted to leave the European Union creating a situation in which financial markets might increase volatility.

Officials at the Federal Reserve must be feeling very smug today.

Fed Chair Janet Yellen gave testimony this week in front of the US Congress and got headlines for her comments that the Fed didn't raise its interest rate because of the possibility of the British voting to leave the European Union.

This is the first thing the Fed has done in a while that seems to coincide with reality.

The Fed needs all the credibility it can get these days due to the loss of face it has earned through its "forward guidance" over the past twenty months.

As it has since the middle of October 2014, the Federal Reserve, at its last meeting, swallowed hard after it backed off of another go at an interest rate increase and presented a much more benign picture of future rate increases.

The general expectation for Federal Reserve action over the rest of the year is that investors shouldn't look for any rate increases, and with the potential turmoil arising in markets due to the British actually voting to leave the EU, Fed officials will continue to err on the side of monetary ease.

In terms of the Fed's balance sheet, one should expect that most of the Fed changes will be the result of operational factors.

Over the longer term, most of these operational movements should balance out and leave the changes in the Fed's balance sheet pretty neutral.

For example, since the end of the year, December 30, 2015, the Federal Reserve has increased bank reserves by $110.0 billion. However, all of that increase can be attributed to a decline in the Fed's use of the short-run operational tool, reverse repurchase agreements.

As the Fed had taken money out of the banking system using reverse repurchase agreements in preparation for its December interest rate increase, after the first of the year, it substantially reduced these outstanding instruments. This put reserves back into the banking system as all the reduction of reverse repos on the Fed's balance sheet went to bank reserve balances.

In this past quarter (since March 30, 2016), reserve balances have declined slightly, but almost all of this decline has come as people have taken currency out of the banking system, as they always do seasonally, with the Fed doing nothing to replace the currency moving into general circulation.

In the past week, the Fed, once again used repurchase agreements, but this time, they increased the total of reserves taken out of the banking system to offset funds flowing into the United States from foreign sources so as to not let the money markets get too liquid where the effective Federal Funds rate might fall.

Given that the financial markets are likely to be even more volatile over the next six months than they have been over the past 18 months, one can expect that the Federal Reserve will be very active in attempting to keep money markets, and the banking system, stable.

But, all this activity should be directed at calming markets as well as possible in the face of Brexit, and other things, and not directly connected to any move, one way or another, in the direction of monetary policy.

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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.